Archive for July 23rd, 2008

Understanding finance and growth models

July 23, 2008

Thorsten Beckis one of the leading financial economist. He along with Ross Leveine, Asli Demirguc Kunt  have devoted substantial time unravelling (and defending) financial systems role in various ways.

I came across this fantastic paper where Beck for a change shows how he analyses various issues related to finance. In this paper he discusses various models used to understand how finance helps in growth etc.

This paper reviews different econometric methodologies to assess the relationship between financial development and growth. It illustrates the identification problem, which is at the center of the finance and growth literature, using the example of a simple Ordinary Least Squares estimation. It discusses cross-sectional and panel instrumental variable approaches to overcome the identification problem.

It presents the time-series approach, which focuses on the forecast capacity of financial development for future growth rates, and differences-in-differences techniques that try to overcome the identification problem by assessing the differential effect of financial sector development across states with different policies or across industries with different needs for external finance. Finally, it discusses firm-level and household approaches that allow analysts to dig deeper into the channels and mechanisms through which financial development enhances growth and welfare, but pose their own methodological challenges.

Though, he tries his best to explain in English, it is slightly tough to grasp all the concepts. Anyways a nice reading on the various econometric models.

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The first best and second best schools of financial systems

July 23, 2008

In 2007, BIS conducted its annual conference and the theme of the topic was the same – Financial system and Macroeconomic resilience. BIS has been raising concerns over the dangers of financial system for a while (in particualr economists like William White, Caludio Borio etc) but has found deaf ears.

Earlier BIS posted papers presented at the conference and now it has also released detailed comments presented at the conference. ( I will try and write about the papers presented as well)

Bill White sets the agenda.  He talks about calm financial market conditions and macroeconomic reselience (great moderation) and says:

What are the specific channels through which identified changes in financial markets might have contributed to the welcome set of macroeconomic circumstances just identified? This line of reasoning leads to two different schools of thought. Let us characterise them as the “first best” and “second best” schools of thought.

One is essentially supportive of the hypothesis, while the other is also supportive, but only to a point. In particular, the latter cautions that much of the good news to date might be at the cost of significantly worse news looking forward. Both schools stress the interaction of monetary policy and recent structural changes in the financial system. Evidently, however, they come to quite different conclusions as to what macroeconomic outcomes these interactions might produce.

What do they mean?

The “first best” school looks at monetary policy over the last two decades and concludes that it has done an excellent job. The growing commitment to price stability and associated policy actions produced price stability and an associated credibility. The firming of inflationary expectations, around a low level, allowed economic upturns to go on longer than would have been normal earlier. It also allowed a rapid easing of monetary policy whenever growth seemed under threat for whatever reason.

The “second best” approach agrees with some of the above, but asks whether there might not also be some significant downsides, in a world where neither markets nor our understanding is yet complete. Consider an alternative view of monetary policy over recent years. Perhaps low inflation, and low inflation expectations, actually owe more to positive supply side shocks than to the credibility of monetary policy. After all, the growth rates of financial and monetary aggregates have been unusually high in recent years. Moreover, real rates of interest have generally gone down, even as the potential growth rate of the global economy seems to have gone up.

We all know now second best school is more in line with reality. I have always believed in this second best school more than the first school.

I was also reading Fed Vice Chairman Donald Kohn’s views (page 4):

I will base my remarks on our experience in the 1987 and 1998 market episodes. In my view, one lesson of those episodes is that central bank actions to counter financial distress can rely more on macroeconomic policy tools, which carry less potential for moral hazard, than on discount window credit to fund individual banks, which was often used when bank weakness threatened the intermediation process.

I actuallly read that statement many times. He says a lesson is to use macroeconomic policy tools and not discount window credit to fund individual banks. Though, he does not specify what he means by macroeconomic policy tools, still Fed seems to have reversed its stance by first lowering the discount window rate and then opening up various other discount windows (TAF, TSLF, PDCF… it is ironical that problems in one set of alphabet soups -CDO, CLO, CDS, CPDO etc has led to another set of alphabet soups – TAF, TSLF, PDCF etc). And Fed then also helped Bear Sterns and now has extended support to Fannie/Freddie.

The entire document is a good reading on various perspectives of the first and second school.

Assorted Links

July 23, 2008

1. WSJ Blog points Bernanke is the most market moving Fed official. WSJ Blog points to Fedspeak- Plosser

2. Nudges Blog points how do you nudge students to work harder?

3. Mankiw reminds– whip inflation now doesn’ t work


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