Archive for March, 2009

A review of Bundesbank monetary targeting strategy

March 23, 2009

Manfred Neumann (Univ of Bonn) has written a nice overview of Bundesbank’s (Germany Central bank) monetary targeting strategy (see this paper as well). The overview was presented at ECB colloquium held in honour of Otmar Issing.

Neumann begins by presenting the background on why monetary targeting was adopted:

The background to the adoption of monetary targeting was the systemic need for a reorientation of monetary policy after the break-down of the Bretton-Woods-System.

The move to flexible exchange rates freed monetary policy from having to stabilise the exchange rate vis-á-vis the dollar and provided central banks with the potency of controlling domestic money and credit creation. However, along with this potency goes the burden of responsibility for securing domestic price stability. It is not easy to fulfil this task successfully because the absence of a binding exchange rate constraint implies that monetary policy is not anchored anymore.

In the mid-1970s this analysis was not known, of course. Nevertheless, quite a few central bankers in Germany and, by the way, in Switzerland appeared to understand that the regime change from fixed to floating rates required a new policy strategy in order to be able to check inflation expectations. They concluded that it would be useful, if not necessary, to commit to some type of rule that credibly constrains monetary policy.

The historic opportunity to start monetary targeting came in 1974 when, due to the quadrupling of the oil price and a sharp monetary deceleration, the German economy began to cool down. The Bundesbank wanted to switch towards easing without giving labour unions a signal for higher wage demands. Announcing a monetary target appeared to be the solution.

He then touches brief on the type of targets – point target, annual average, range (planned growth rate of money stock looking at growth of this quarter over previous quarter).

He then points that monetary targets were missed quite a few times  (1976,1977, 1978, 1986, 1987 and 1992). In all the years reason for missing the target was exchange rate considerations. 

To sum up this brief review of historic cases: the largest misses of monetary targets were caused by the Bundesbank’s temporary subordination of monetary policy to exchange rate considerations either with respect to the dollar or/and with respect to EMS-currencies. An exception was 1986 when the Bank went for reflation but avoided a consistent increase of the target range.

 So much so, debates were held whether to continue with monetary targeting or not.

Despite the misses, Bundesbank had an excellent inflation control record compared to other economies. However, the puzzle remained

But isn’t this a puzzle? Why got the Bundesbank away with its practice of deviating time and again from announced targets? Why was it able to keep nevertheless the credibility that it truly cared about price stability?

The answer, I believe, is that the Bundesbank was the first central bank that provided the public with an intelligible numerical framework that facilitated the evaluation of its policy course from the outside (Neumann, 1999; Lohmann, 2003). Naturally, the population at large does not understand much about central banking and hardly knew anything about monetary targeting or its implications for inflation. But there is and was an elite audience consisting of bankers, economists and financial journalists. By offering public monetary targeting, the Bundesbank invited to be put under closer scrutiny as regards its aims, its model of how the economy works, its implementation procedures, its capability to do a good job. It enabled the elite to differentiate more closely between monetary policy actions that were defensible and those that were not.

Interesting analysis. What it says is it was not as much with setting monetary targets but setting a monetary policy framework which was transparent and considered credible by the market participants.

To be sure, the institution of targeting as such was not sufficient. The Bundesbank needed to provide detailed reasoning for the numbers it offered and for the final outcomes. And that the Bank did from the outset. Each year the Bank explained in detail what its evaluation was as regards last year’s target fulfilment, on which expectations the target range for the following year was based on and on which particular developments it would aim at the upper or the lower region of the range. During the course of the year the Bank reported and commented on ongoing developments and the degree of target fulfilment and mid-year the Bank checked officially whether the target was to be kept or revised.

Finally, it may be noted that the Bundesbank, if not all times, for most of the time was quite frank in its explanations. Remember that the Bank had no scruple to point out that the target overshot of 1992 was an all-time high. It fits that the Bank even admitted lack of knowledge on several occasions.

Great insights. It also conveys indirectly that it does not matter what mon pol strategy you choose (now the debate has narrowed to inflation targeters vs non-inflation targeters), what matters is whether you are transparent and credible in your operations.


Assorted Links

March 23, 2009

1. Krugman is baack. He says we need to be wary of quant easing by Fed. He also has a graph showing decline in industrial production in GD and now. He also does not like the new Obama Toxic Assets plan which has been leaked

2. Mankiw explains Ricardian equivalence

3. Urbanomics on India deflation issue

4. Econbrowser says Fed quant easing announcement has not been received well

How about forecasting US Per capita income for 2007 in 1928 and getting it almost right?

March 20, 2009

I came across a very interesting note on economic growth from Fatas- Mihov duo (see another paper on growth here, and the excellent blog here).  It lists four factors as critical for economic growth – innovation, initial conditions, investments, and institutions.


IMF says first global contraction in 60 years!

March 20, 2009

IMF has released a new report on the crisis which has new forecasts and coverage of the policy options taken so far and future. The press release is here.

IMF has revised the growth forecasts downwards once again:

  March forecasts Jan forecasts Nov forecasts
  2009 2010 2009 2010 2009
World -1.0 to -0.5 1.5 to 2.5 0.5 3 2.2
Advanced -3.5 to -3.0 0.0 to 0.5 -2 1.1 -0.3
US -2.6 0.2 -1.6 1.6 -0.7
Euroarea -3.2 0.1 -2 0.2 -0.5
Japan -5.8 -0.2 -2.6 0.6 -0.2
Emerging 1.5 to 2.5 3.5 to 4.5 3.3 5 5.1

This implies first global contraction since world war II. The forecasts have been revised severely for major economies.

Towards the end, the note also has an excellent analysis on the fiscal policy during the crisis. It breaks the fiscal stimulus into two types- automatic and discretionary. It presents these figures for G-20 economies and shows the impact of stimulus on output, deficit, debt etc.

This leads to two things I have noted in this crisis. The research on fiscal policyis growing and is highly welcome. Two, it is very interesting to note that IMF has switched its attention to using fiscal policy during the crisis. In previous emerging market crisis, it had always lamented usage of fiscal policy and instead focused on mon policy. Infact, it asked countries to cut govt expenditure in times of crisis. I first noted this IMF switch in July 08 Update and since then it has been quite aggressive. What has brought this change? Why has IMF started to believe that fiscal stimulus is the way out? What is so special about this crisis when we are told that the crisis is similar to others, and is as not as severe as it is made out to be. I am actually interested to know how and why this fiscal policy activism has picked up in this crisis?

A great website for policy research papers

March 20, 2009

I came across this website Policy Pointerswhich provides all latest research,views on various aspects of policymaking. It is like an aggregator website which provides links to all latest stuff on policymaking.

It has listed the various policy areas and provides research on the same. For instance, if you click Economic Policy you get latest research from various sources on economic policy. And best part is all is free to download.

It also has an email and RSS subscription. A link that should go immediately in one’s favorites. Excellent source.

Assorted Links

March 20, 2009

1. ASB points that there is a need to fix financial regulatory architecture. I think we need to first fix what do we really mean by financial regulation. Architecture will only work if we know what to really regulate.

2. ACB asks where are the good political orators in India?

3. Indicus blog on irrelevance of economic theories

4. MR says it was Fisher not Keynes who analysed Great Depression

5. WSJ Blog points ECB member Smaghi answers Krugman. Also Trichet says ECB stands alone. Fatas has an excellent post on the EU problems

6. Econbrowser on quant easing

7. Mankiw points to some innovative thinking of pushing interest rates below zero.

8. Rodrik points to a Mundell presentation on the crisis

All recessions end some day

March 19, 2009

This is one of the common messages of the speeches of both Obama team’s top members – Larry Summers and Christy Romer. Summers summarises the Obama plans and Romer compares the  crisis with guess what- Great Depression.

Summers says:

Our problems were not made in a day or a month or a year, and they will not be solved quickly. But there is one ineluctable lesson of the history of financial crises: they all end.

Romer says:

Finally, the last lesson that I want to draw from the 1930s is perhaps the most crucial, right? A key feature of the Great Depression is that it did eventually end. Despite the devastating loss of wealth, chaos in our financial markets, and a loss of confidence so great that it nearly destroyed Americans’ fundamental faith in capitalism, the economy came back. Indeed, the growth between 1933 and 1937 was the highest we have ever experienced outside of wartime.

🙂 This is pretty obvious. All good and bad things come to an end someday.


A good short note on deflation

March 19, 2009

Charlotta Growth of Bank of England has written an excellent short note on deflation:

 This article examines the different economic costs associated with deflation. It explains that it is important not to confuse the economic costs associated with the circumstances that caused prices to fall with the costs of deflation itself. The costs of deflation are most likely to be associated with debt deflation and downward nominal wage rigidities. But if policy responds sufficiently promptly and decisively then these costs are likely to be modest and short-lived. 

It also provides a neat description of previous deflation episodes (mainly occured because of gold standard). Nice crisp reading.

AIG hearing

March 19, 2009

Though, I agree with Prof Mankiwthat one should not waste time as much time on AIG. But the manner in which bonuses keep getting distributed in Wall Street despite all the crisis and govt help deserves a closer look.  It isn’t just about AIG, but similar news was seen when NY city in its report showed billions have been distributes in 2008. Obama is his speech has chided AIG and says the same:

But these bonuses, outrageous as they are, are a symptom of a much larger problem. And that is the system and culture that made them possible – a culture where people made enormous sums for taking irresponsible risks that have now put the whole economy at risk. So we are going to do everything we can to deal with these specific bonuses. But what’s just as important is that we make sure we don’t find ourselves in this situation again, where taxpayers are on the hook for losses in bad times and all the wealth generated in good times goes to those at the very top.

Moreover, the way AIG CEO has defended the bonuses and blogsindicating Obama team members Summers and Geithner not knowing how to deal with it. It just tells you how bad this entire thing is. As James Kwak puts in his blog :

However, this scandal may yet serve a purpose. One characteristic of both administrations’ responses to the crisis has been to devise subsidies for the financial sector that are too complicated for even conscientious readers to make out, such as the asset guarantees for Citigroup and Bank of America, or the preferred-to-common conversionfor Citigroup.

All the above allegations are further confimed by recent testimony by Fed  Vice Chairman Donald L. Kohn. First, it requires a lot to understand the various interventions by Fed/Treasury in AIG. Second, Kohn says they have been managing AIG incentives, compensation etc as part of the deal:

The Federal Reserve does not have statutory supervisory authority over AIG or its subsidiaries as we would over a bank holding company or state chartered bank that is a member of the Federal Reserve System.  Rather, the rights of the Federal Reserve are those typical of a creditor and are governed by the credit agreement for the Revolving Credit Facility.  Using these rights, the Federal Reserve works with management of AIG to develop and oversee the implementation of the company’s business strategy, its strategy for restructuring, and its new compensation policies, monitors the financial condition of AIG, and must approve certain major decisions that might reduce its ability to repay its loan.

The testimony was given on 5 March 2009, and in just a week’s time we have information that shows AIG collateral saved quite  a few banks and the bonus thing showed compensation was never really managed.

Now, House Committee on Financial Services has started a two part hearing. In first part AIG CEO talks and in second Bernanke and Geithner would present their views (25 March 2009). The first part hearings are available on the website. I haven’t read AIG CEO’s testimony. Have heard it is interesting. WSJ Blog has some live bloggeryof the event. NYT reportsthat he has asked employees that have received bonuses to give half the amount back!! I mean how ridiculous can things get in US??

Assorted Links

March 19, 2009

1. MR points AIG gave a total of $130,000 to Obama in 2008, while McCain accepted a total of $59,499. Pol eco at its best.

2. WSJ Blog has live blogging on AIG hearing

3. Mankiw points how his blog is helping his textbook stay updated

4. FCB points why Buffet is silent on credit rating agencies

5. Pestonblog points to new UK financial regulation reports

Research on Globalisation and Monetary Policy

March 18, 2009

Dallas Fed has a Globalization and Monetary Policy Institute which does research on the same. It recently released its firts annual report which summarised the agenda, research done so far etc etc.

It has an interesting short note within the report – First Steps: Developing a Research Agenda on Globalization and Monetary Policy. It has lots of insights on globalisation and its impact on monetary policy.

First, it looks at how globalised US economy is in both real and financial terms. In real terms, US appears to be quite closed when we look at imports as a % of GDP. However, when we measure real globalisation by comparing domestic prices with international prices, there is no real conclusion.  While Measuring financial globalisation, US seems to have become more globalised overtime.  However, in both we need better ways to measure globalisation. It also raises an important issue:

How do we combine a measure of financial globalization with a measure of real globalization to arrive at a single index? Indeed, how do we incorporate information on the extent to which the U.S. labor market is open into our measure of globalization? The United States has long been a destination of choice for international migrants. Over the past decade, net international migration into the U.S. has amounted to more than 1 million people a year. Some 12.5 percent of the current U.S. population is estimated to have been born overseas. The ability of the U.S. to draw on a large stock of foreign workers has been a significant source of strength for the U.S. economy over the years, and the cyclical response of migration to economic conditions in the U.S. helps alleviate labor market pressures.

They then look at the question which has been a rage with monetary policy- whether globalisation has impacted inflation (read my criticism of the issue here). It also points that research has indicated more globalised economies tend to have lower inflation over a longer time.

In all it suggests despite these issues, more research is needed to understand how globalisation (both real and financial) has impacted mon policy and economies.

This essay has reviewed some of the themes emerging from the research being conducted at the institute. We are developing many more themes, which will be highlighted in future institute annual reports. We have not addressed issues concerning financial globalization in any great depth, yet it is clear that the growth of international capital markets is a crucial element of globalization and has very direct implications for monetary policy, as recent events have shown.[10] Nor have we addressed the issue of international pricing, which is at the core of many debates in contemporary international macroeconomics. We expect to make significant contributions to this issue in the years ahead.

In short, while economists already have many tools available for understanding globalization and what it might mean for monetary policy, there are numerous open questions, and these questions will form the institute’s research agenda over the years to come.

A nice review on globalisation literature.

Impose new Glass Steagall Act and nudge for better financial regulation

March 18, 2009

Luigi Zingales of Chicago Univ has written an excellent paper on future of financial regulation. Abstract:

The U.S. system of securities law was designed more than 70 years ago to regain investors’ trust after a major financial crisis. Today we face a similar problem. But while in the 1930s the prevailing perception was that investors had been defrauded by offerings of dubious quality securities, in the new millennium, investors’ perception is that they have been defrauded by managers who are not accountable to anyone. For this reason, I propose a series of reforms that center around corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management.

He highlights financial system has gone through a sea change from being individually owned to institutions owned. What has also happened is that large number of people now depend on financial markets for their retirement purposes. So earlier you had to pass laws/regulation to save people from frauds etc, we still need regulations to save people from such dramatic collapses in financial markets.

The massive increase in the use of financial markets for retirement purposes has made the financial markets much more important for ordinary people. In 1975, the value of privately-held pension assets represented only 18% of the GDP and 70% was represented by defined benefit plans, which did not directly expose workers to financial market risk; today, pension assets represent 60% of the GDP, 70% of which is in defined contribution plans and thus exposed to financial market risk. As a result, the efficiency of individual investment choices and the costs they bear is not just an issue of fairness, but a primary public finance consideration. Without wise investments, the vast majority of Americans will not have enough to support themselves in retirement.

He proposes 3 measures:

First, a reform of corporate governance aimed at empowering institutional investors to nominate their  own directors to the board. This reform will make it worthwhile for directors to develop a reputation of acting in the interest of shareholders and hence to make corporate managers accountable. However, to minimize the risk that institutional investors pursue a self-interested agenda, institutional investors should be themselves independent. To achieve this goal, I propose a new Glass-Steagall Act, which instead of separating commercial and investment banking will separate mutual fund management from investment and commercial banking.

The second goal should be the protection of unsophisticated individuals with regard to their investments. The minimum this protection entails is enhanced disclosure. At the time of purchase, investors should be provided with a dollar estimate of all the expenses that will be charged to their investment, including the amount paid in trading commissions, itemized as commissions paid for trading and those paid for services. Similarly, at the time of the purchase, brokers should disclose the fee they receive on the different products they sell, including the “soft dollar” they receive in the form of higher trading costs. The same strict standards should apply to both brokerage accounts and money management accounts.

The third goal should be that of reducing the regulatory gap between public markets and private markets. The recent trend of migration from the former to the latter suggests that this differential is excessive. This migration should be stopped not only by deregulating the public market, but also by introducing some disclosure standards in the private one. In the public market, the empowerment of institutional investors will make it possible to transform some of the mandatory regulation into optional rules, following the British comply-or-explain system. On the private market front, there are compelling reasons to mandate a delayed disclosure provision in which hedge funds, private equity funds, and even companies private equity funds invest in report information and performance with a 1 to 2 year delay.

So, in first he talks about a new Glass SteagalL Act which seperates MFs from Commercial and I-Banking. I think there is a need to seperate all investment management options (MF, hedge funds, private equity etc) from C-Banking and I-Banking. What is also happening is that most of these C-Banks/I-Banks also own (partially or fully) quite a few of these investment vehicles.

Second is basically a nudge which nudges  the MF/brokers etc to disclose all about the expenses charged by them to the investors. Thaler/Sunstein had also proposed something similar in this WSJ article using internet. Zingales also adds:

A more delicate topic is whether to take a more paternalistic view toward investors who seem to behave in an uninformed or irrational way. At the very least, there is a strong case to apply some version of the “libertarian paternalism” à la Thaler and  Sustein (2003), by introducing default options that favor low-cost indexed funds. For example, it could be required that every 401(k) plan contains at least one low-cost index fund, which should be the default option for investors, unless they specify otherwise.

India’s pension authority has already taken lessons from the same.

The third proposal is a follow-up to the first proposal. It is only when we know enough about private financial market participants can we know whether they are independent or not. This has been raised many a times but nothing has really been done. The Private financial market activity has only exploded without any regulation.

A very interesting and readable paper with loads of interesting stuff (a Luigi Zingales paper always is).

Assorted Links

March 18, 2009

1. MR points what is Russia’s GDP? Take your pick 🙂 

2. Urbanomics points to a WB report which says which claims that 17 of the G-20 countries have erected new trade restrictions over the past few months

3. Mankiw on AIG Bonuses. Econbrowser as well

4. CTB has developed a database on fin sector interventions in US and UK

Design symbol for Indian Rupee and send it to India Fin Min

March 17, 2009

I came across this interesting press release at Finance Ministry website:

Major currencies of the world e.g. US Dollar, Pound Sterling, Yen and the Euro have an Identification symbol. The Government of India also proposes to have a symbol for the Indian rupee to be selected through public competition. Accordingly, all Resident Indians (both Professional artists and Non-professionals) are hereby invited to participate in a Competition for design of the ‘Symbol for Indian Rupee’.

So, USD symbol is $, GBP is £, Euro is €, and Yen is ¥. Now India Fin Min wants to have a symbol for INR as well. The contest is open till 1300 hrs on 15 April 2009. The other details are in the press release.

I was just seeing the conditions and found 2 interesting ones:

3. The symbol should represent the historical & cultural ethos of the country as widely accepted across the country.

5. The symbol should be applicable to standard keyboard. The symbol has to be in the Indian National Language Script or a visual representation.

It will be interesting for someone to fit both the conditions. Time to get creative juices flowing. Pass it on to the artists you know.


1 Reading this, I recall there was a competition for design of Euro notes as well. It was won by an Austrian artist Robert Kalina (more here).

2. BBC has an interesting article on this. It says Russia also planned a similar move but was not successful. It has some interesting comments as well towards the end.

3. Fin Min has released an update on the contest

4. The first list of shortlisted candidates is here.


Mostly Economics on

March 17, 2009

Here is another achievment for Mostly Economics.

Christian Zimmerman, a professor at  University of Connecticut is also a manager of the famous economics research paper portal- IDEAS. He started a blog Econacademics, which is an aggregator blog for economics academics. He says:

The purpose of this blog is to encourage the discussion of research in Economics. This is not a traditional blog, as it mainly serves as a portal to other blogs. As was discussed (1, 2) a while ago on the RePEc blog, there is currently little in the Economics profession in terms of forums to discuss current research. Here, we would like to highlight those blogs where this happens and hopefully encourage others to join the fray.

The selection of the featured blogs is made on the following criteria:

  • A fair share of posts discusses current research. The discussion is more about papers and articles than other blog posts, op-ed or newspaper articles.
  • The bloghas been active for at least one month and seems to be managed in a sustainable manner.
  • The blog is about Economics, Finance and their fringes. It needs to be of academic nature.

Mostly Economics missed the list earlier and was included in the list on the right – Some blogs than did not quite make the selection.

It gives me pleasure to note that the blog has now been selected and made it to the list of academic blogs. It is a personal list of Chris but it gives a great feeling nonetheless. He managed REPEC so knows what economic research is. Again there are some great blogs like Becker-Posner Blog, Stern on Finance, Stumbling and Mumbling etc (I have only read them, yet to read the others in the list). What is also interesting is that he has a very few blogs on the list and am sure he has read through the other top econ blogs.

After getting ranked in other lists, this addition to econacademics is very satisfying. as the purpose of the blog was to highlight research on economics and finance. It is great to get acknowledgement from a reputed source.

Thanks to all the visitors for their support.

Understanding Risk Management failures

March 17, 2009

Rene Stulz has written a paper explaining what risk management and its failures are. 

He says the job of the risk management is to identify the risks and try and quantify it. If risks do materialise for the worse, it is the problem of senior management which took the risks. The blame lies on the management.

Deciding whether to take a known risk is not a decision for risk managers. The decision depends on the risk appetite of an institution. However, defining the risk appetite is a decision for the board and top management. That decision is at the heart of the firm’s strategy and of how it creates value for its shareholders. A decision to take a known risk may turn out poorly even though, at the time it was made, the expectation was that taking the risk increased shareholder wealth and hence was in the best interest of the shareholders.

….Whether taking large risks is worthwhile for an institution ultimately depends on the firm’s strategy. Risk managers do not set strategy. Suppose that a firm sets its risk appetite by choosing a target credit rating. Such an approach is well-established. Once the credit rating is chosen, there are multiple combinations of risk and capital that achieve the target rating. For a given choice of leverage, the firm does not have much choice in choosing its risk level if it wants to achieve its target rating. However, faced with good opportunities, the firm could choose to have less leverage so that it can bear more risk or it could choose to depart from its credit rating target.

In summary, risk management does not prevent losses. With good risk management, large losses can occur when those making the risk-taking decisions conclude that taking large, well understood risks creates value for their organization.

This is all well understood. However, the problem is with implementation. The risks are taken and no one really knows about them. After the risk turns bad, the stakeholders suddenly realise that all is over. What is needed is if a particular risk is taken, the risk management of the organisation should highlight and quantify the risks of the project.

What we instead get is all +ves about the project as put by top management with risk management being in the sidelines. What is needed is to treat risk management like an independent department in the organisation whose views should be shared with all stakeholders.

All this is difficult for a private organisation but should be implemented for a publicly listed firm.

Risk Management needs serious changes for financial sector for two reasons.  One, as Bank of England member said in his paper that people took risks knowing they would be bailed out. Two, large number of players in the sector are unregulated, unmonitored but can cause huge damage to the entire financial system by taking excessive risks. Just like Stulz says in his paper, LTCM knew the risks it is taking. As risks turned worse, it posed concern to the entire financial system.  

Stulz also highlights what risk management failures are:

1) Mismeasurement of known risks.
2) Failure to take risks into account.
3) Failure in communicating the risks to top
4) Failure in monitoring risks.
5) Failure in managing risks.
6) Failure to use appropriate risk metrics.

Interesting reading on risk management.

Fed’s balance sheet expansion explained

March 17, 2009

I have written number of posts on Fed’s Balance sheet (see this, this, this, this). The posts have mainly focused on explanations of various Fed program on its asset side. What is still needed is a detailed analysis of Fed’s Balance Sheet in the crisis.

William Gavin of St Louis Fed has written an excellent short paper on the same. He has presented a detailed analysis of Fed’s balance sheet providing more clarity on the nature of expansion.

Assorted Links

March 17, 2009

1. ASB points to 4th meeting of the NIPF-DEA research program

2. ACB on introspection time for economists

3. WSJ Blog points if finance sector declines so would consumer spending and consumer stores. It also points to GS report that says Fed would need to expand its bal sheet to USD 10 trillion!!

4. Finprof points to a Bernanke interview (it is a video)

5. FMB on whether there will be hyperinflation in US

6. CTB points to Larry Summers’ speech at Brookings

The role of policy volatility on growth

March 16, 2009

I came across this interesting paper on Growth Commission’s website. It is by Antonio Fatás and Ilian Mihov (the duo have started an excellent blog as well).

There is a lot of literature on what drives growth. Read the Growth Commission Report for insights and vast literature survey. One can also read the various papers available on the Growth Commission website.  All the numerous factors can be clubbed in two broad factors – macroeconomic policies and institutions. The research lately has stressed on role of latter (pioneered by Douglass North and advocated by Daron Acemoglu), and has even added that institutions determine policies as well.  (A counter was provided by Henry Blair in this paper)

With all this, the authors add that it is not just policies alone but volatility in policies that matter.

In this paper we argue that these criticisms have overlooked the possibility that policy volatility is an independent and strong determinant of economic growth. Looking at the relevance of volatility is not new; there is a long tradition, especially among emerging markets, of studying the effects of volatility on growth.

In particular, we have looked at how the volatility of fiscal policy fits into this debate. By looking at the growth effects of volatility induced by fiscal policy  we are able to address the endogeneity concerns of the volatility and growth literature. By showing that this policy variable is a determinant of growth rates in a cross‐country regression and that the result is robust to many specifications and the introduction of other controls and variables, including measures of institutional quality, we are showing that macroeconomic policy matters for growth.



What about policy implications?

Our results have strong policy implications. Recent academic research has pushed policy makers to focus on institutional reform. This has turned out to be less productive than anticipated because of the inherent difficulties in reforming institutions. While the advice was sound, progress was limited.

The results reviewed in this paper do not deny the importance of institutions; in fact we show that they are strong determinants of economic policy. But we show that even without institutional reform, there is room for increasing growth rates through good economic policies.

Most of the results reviewed in this paper are about fiscal policy and in particular about the discretion that governments have and exercise regarding changes in fiscal policy that are not related to the business cycle. There is a  strong message that the more discretion governments have, the more they will exercise it and it will cause unnecessary volatility and lower growth.

Interesting findings. It is further additional research on role of fiscal policy. There has been a dearth of research on fiscal policy and we see so much of it now. The findings also have implications for today’s times. The role of government in an economy is increasing across the globe and if it continues after the crisis, it will be interesting to note the impact on future growth prospects.

It will also be interesting to expand this study from fiscal policy to other policies as well.


In their blogpostthe authors point evidence that institutions are not really helpful for low income economies. However, once you get to $12,000 per capita incomes, quality of institutions is critical.

Linkages between Central Bank Liquidity, Funding Liquidity and Market Liquidity

March 16, 2009

Kleopatra Nikolaou of ECB has written an excellent paper (primer actually) on liquidity. He links Central Bank Liquidity, Funding Liquidity and Market Liquidity.

Central bank liquidity is the ability of the central bank to supply the the liquidity needed to the financial system. It is typically measured as the liquidity supplied to the economy by the central bank, i.e. the flow of monetary base3 from the central bank to the financial system.

The Basel Committee of Banking supervision defines funding liquidity as the ability of banks to meet their liabilities, unwind or settle their positions as they come due.

The notion of market liquidity has been around at least since Keynes (1930). It took a long time, however, until a consensus de.nition became available. A number of recent studies define market liquidity as the ability to trade an asset at short notice, at low cost and with little impact on its price. It therefore becomes obvious that market liquidity should be judged on several grounds. The most obvious would be the ability to trade.

He says the trouble begins when a firm begins to have problems with funding liquidity, which then spreads to market liquidity and creates problems for all. The central bank liquidity comes into picture when market liquidity becomes a full-fledged problem (or about to become one).

All this is pretty well-known. However, the paper is written in a lucid manner and is worth a quick read.


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