Archive for September, 2009

Ketchup Economics and Financial Economics

September 30, 2009

Krugman in his long overview on state of macro says:

Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

Those interested in this short-paper of Summers can read it here. Though the comments may sound funny but is quite thoughtful on financial economics.


Lessons for Inflation targeting cenral banks from this crisis

September 30, 2009

Lars Svensson has a useful speech on lessons from this crisis for inflation targeting central banks. He points that zero interest rate bound is a mystique and central banks can easily go negative. He is actually walking the talk as Riksbank went  negative in this crisis. One should also read his views in the Minutes of MPC meeting held in September.

He also says one should not mix central banks for price stability with central banks for financial stability. We need supervision to look at financial stability. Also, we need finance to have a bigger role in macro models.

Are Government owned banks necessarily bad?

September 30, 2009

Well eco research never fails to surprise. I just discovered this paper by Svetlana Andrianova et al. I haven’t read it but found the findings pretty interesting. It says:

We show that previous results suggesting that government ownership of banks has a negative effect on economic growth are not robust to adding more ‘fundamental’ determinants of economic grwoth, such as institutions. We also present regression results from a more recent period (1995-2007) which suggest that, if anything, government ownership of banks has been associated with higher long run growth rates, even after controlling for institutions and other variables suggested by the growth literature. Drawing on the current global financial crisis, we provide a conceptual framework which explains why under certain circumstances government owned banks could have a greater effect on economic growth than privately-owned banks.

Read on….

Sovereign Credit Ratings pre and post crisis

September 30, 2009

Carmen Reinhart works on the sovereign credit ratings pre and post crisis in this oldish 2001 paper.


This paper has addressed the following questions: Do sovereign credit ratings systematically help predict currency and banking crises? If not, why not? What needs to change? What is the behavior of credit ratings following the crises? Are there important differences in the behavior of credit ratings between developed and emerging markets?


Her conclusion:


As to the ability of rating changes to anticipate financial crises, the empirical tests presented here on sovereign credit ratings and financial crises suggest that sovereign credit ratings systematically fail to anticipate banking and currency crises. This result appears to be robust across alternative crises definitions, model specification, and approaches. Only for the Institutional Investor ratings is there some (weak) evidence that downgrades precede currency crises. In none of the cases are banking crises systematically preceded by downgrades.


As regards the behavior of ratings after the crisis and differences between developed and emerging markets, there is evidence that sovereign credit ratings tend to be reactive– particularly when it comes to EMs. Both the probability of a downgrade and the magnitude of the downgrade are significantly higher for EMs. Taken together, these findings point to a procyclicality in the ratings.



Hmm.. Why do they fail?


On why are sovereign ratings such poor predictors of financial distress, we conclude that generally, financial crises are difficult to forecast–witness the poor performance of  international interest rate spreads and currency forecasts. Specifically, however, the results presented here offer a tentative (although partial) answer to this question. Rating agencies have tended to focus on the “wrong” set of fundamentals. For instance, much weight is given to debt-to-exports ratios–yet these have tended to be poor predictors of financial stress. Little weight is attached to indicators of liquidity, currency misalignments, and asset price behavior.

Hmmm. wondering ehat has changed.. The focus did shift to all the three factors listed at the end but still the performance of CRAs was much to be desired. Actually, too much weight is given to credit rating agencies. They have become too powewrful financial entities which is a bigger problem.



First quarterly report of impact of Obama fiscal stilmulus

September 29, 2009

CEA has released the first quarterly report assessing the impact of Obama’s fiscal stimulus plan. The report was released on 10 Sep 2009 but did not get any coverage. It has interesting analysis of the Obama plan and has some tall claims. The key findings are:


High costs of non-participation in economics of global warming

September 29, 2009

The focus on climate change and its impact is capturing the minds everywhere. Quite a few reports are being written with this theme. This year’s Nobel Prize predictions are heavily tilted towards Environmental Economics and non- environmental Economists  like Michael Spence are now thinking and writing about the several issues.

The topic is highly technical and most of it goes above me. All I understand is the economic perspective and am really interested in the economics of climate change. So have started reading a bit.

I was reading this Bill Nordhaus speech – Economic Issues in a Designing a Global Agreement on Global Warming. In this speech he lays out 3 economic issues with climate change:

First, raising the price of carbon is a necessary condition for implementing policies in a way that will reach the multitude of decisions and decision makers over space, time, nations, and sectors.

Second, universal participation at a harmonized level is a critical part of an efficient global-warming regime. There are extremely high costs of non-participation.

Third, the cap-and-trade approach embodied in the Kyoto model is a poor choice of mechanism. It is completely untested in the international context; it has been unable to attain anything close to universal participation; it loses precious fiscal revenues; it leads to volatile prices; and it is an invitation to rent-seeking. It is unlikely that the Kyoto model, even if strengthened, can achieve its climate objectives in an efficient and effective manner. A harmonized international carbon tax is likely to be a more effective mechanism for responding to the threat of climate change.

The first point is well-known. We need to price carbon. It is difficult to do , but unless we price carbon we cannot have people reacting to it. The consumers and producers will only react to adverse impact of carbon if there is a price attached.

The third point is Cap and Trade will not lead to desired impact.

The second point is what interested me most. The costs of non-participation are very high.

Economics leads to a second important truth about climate-change policies. The analytical basis for an efficient global-warming policy is extremely simple. Because global warming is a global public good, everyone, everywhere must face the same price.

The difficulty arises because, for global public goods like global warming, there are widely disparate incentives to participate in measures to mitigate the damages. The differences reflect different perceptions of damages, income levels, political structures, environmental attitudes, and country sizes. For example, Russia may believe that it will benefit from limited warming, while low-lying countries may believe they will be devastated. Within the United States, some regions are energy exporters and resist measures to tax carbon fuels, while others are environmentally oriented and have already enacted local legislation to limit carbon emissions.

Current international agreements differentiate among countries in their responsibilities to undertake measures to limit emissions. Under the Kyoto Protocol, Annex I countries must limit their emissions, while non-Annex I countries have a variety of non-binding commitments as well as the ability to participate in the “clean development mechanism.” Moreover, while some countries have implemented strong internal mechanisms to control emissions, these often cover only a limited part of national emissions. For example, the European Trading Scheme covers only about half of EU emissions.

A centrally important question is the extent of inefficiency inherent in the patchwork nature and incomplete participation that characterizes the current international control regime.New evidence from economic studies suggests that the costs of non-participation are much higher than was earlier thought.

He then looks at what he calls as “participatory function” and points that if US does not participate in the reduction, the costs are expected to be much higher. In the end of this points he says:

There are extremely high costs of non-participation. A rough estimate is that the penalty from exempting half the global emissions from an agreement will increase costs by around 250 percent.

Interesting stuff. Interesting dimension to the problem. I knew about the costs of non-participation but never knew it to be so high.

I was just thinking about this problem from an Indian perspective. India being a Federal country also has the same kinds of problems. If the centre agrees to certain issues but some states have objection and don’t participate, the costs are likely to be higher. Let us just take hypothetical example. Himachal Pradesh which is a high-lying state may not be as worried about flooding as much as say Uttar Pradesh, Bihar etc (just like Russia in Nordhaus example). So it may not be as interested in the discussions and instead focus on other challenges. But then this increases the cost rightaway as unless HP gets serious low lying states can do very little. And gradually the impact would be felt on HP as well as all that melting of glaciers will impact their ecosystem at some point of time.

I am sure the Indian policymakers are aware of these challenges. Am wondering how are they approaching this problem.


Is the crisis problem going more severe post Bretton Woods?

September 29, 2009

I have been wanting to read this paper for a while as have seen it mentioned in  many papers as references. Anyways I finally read it over this weekend. The paper is written by Michael Bordo, Barry Eichengreen, Daniela Klingebiel and Maria Soledad Martinez-Peria. When Eichengreen and Bordo combine, you are bound to get tons of information and mostly on economic history.

In this paper they look at the crisis problem in 120 years of financial history (Though Rogoff and Reinhart have extended this to nearly 800 years). They divide the financial crisis across various ages- Pre 1914 Gold Standard, World Wars Time, Bretton Woods (1945-72) and Post Bretton Woods (1973 till now). They ask has the crisis problem become more and severe in this era?

The crisis problem is one of the dominant macroeconomic features of our age. Its prominence suggests questions like the following: Are crises growing more frequent? Are they becoming more disruptive? Are economies taking longer to recover? These are fundamentally historical questions, which can be answered only by comparing the present with the past.

To this end, this paper develops and analyzes a data base spanning 120 years of financial history. We find that crisis frequency since 1973 has been double that of the Bretton Woods and classical gold standard periods and is rivaled only by the crisis-ridden 1920s and 1930s. History thus confirms that there is something different and disturbing about our age.

However, there is little evidence that crises have grown longer or output losses have become larger. Crises may have grown more frequent, in other words, but they have not obviously grown more severe.

Our explanation for the growing frequency and chronic costs of crises focuses on the combination of capital mobility and the financial safety net, including the implicit insurance against exchange risk provided by an ex ante credible policy of pegging the exchange rate, which encourages banks and corporates to accumulate excessive foreign currency exposures. We also provide policy recommendations for restoring stability and growth.

Hmmm. The crisis problem may have grown in this era but the output losses were less severe.

The authors also look at three kinds of crisis- Banking, currency and twin crisis and each era has different findings:

  • Currency crisis hasve become more frequent post 1973 leading to higher overall number of crisis. However, we also had high number of currency crisis in Bretton Woods time despitye capital controls and fixed exchange rates
  • Banking crises were higher during the War period because of Great Depression. However, this era is not far behind. So, Bretton woods restrictions limited banking crisis but not currency crisis.
  • Moreover, in pre 1914 there were hardly any crisis of both kinds. This was an era of active financial and trade liberalisation. So we cannot really associate liberalisation with crisis. It is faulty policies which have led to expansion of financial safety net and moral hazard which have led to higher number of crisis.

Interesting paper. This crisis is likely to change the depth and duration severity dring this era as well. Both are likely to go up in this crisis.

New Structural Economics – A new framework for development

September 29, 2009

Justin Lin World Bank’s chief economist has written a new paper arguing for fresh thinking on development issues. The paper is here and was presented at a WB conference titled- Industrial Policy and The Role of the State in Promoting Growth. The paper was pointed by PSD Blog and Urbanomics also had some comments on the paper.

He begins with a useful history of development economics. He points to two main thoughts – Old Structural Economics (OSE) and Neoclassical Economics (NE) . OSE became mainstream post World War II and argued for a bigtime government role as everything was Keynesian at that time. NE came post stagflation and 1970 inflation episodes and was taken over by rational expectation revolution.

He then looks at his new approach and says we need a mixture of the two. There are 3 main ideas of this approach:


Romer compares Great Depression and Current Crisis

September 25, 2009

Christy Romer speeches are the ones to look forward to. Her speeches and testimonies are excellent and does full justice to her new role. She combines great insights from her research to look at the events now and all this makes it a fascinating reading. Earlier, she had looked at whether fiscal stimulus is working.

In her new speech, she compares the economic indicators in current crisis with the initial times in Great Depression. She finds that on quite a few financial indicators, the current crisis was more severe than Great Depression (fall in equity markets, decline in household wealth, asset price volatility, Moody Spread) etc) . The economic indicators of Great Depression are still much worse.


A debate over Fed independence

September 25, 2009

US Congressman Ron Paul has for long advocated that there is no need of Fed. As he does not make any progress here, he has advocated another idea- complete audit of Fed operations by Government Audit Office.  He has introduced a Bill called Federal Reserve Transparency Act of 2009 which is currently being debated bigtime.

Bernanke has clearly expressed his dislike for the bill. In his presentation of Semiannual Monetary Policy Report to the Congress, he said:


Memories of high inflation persist for a while

September 25, 2009

ECB has an interesting working paper based on the title. It is written by  Michael Ehrmann and Panagiota Tzamourani.

Inflation has been well contained over the last decades in most industrialized countries. This implies, however, that memories of high inflation are likely to fade, because over time larger parts of the population have never experienced high inflation, whereas those who have might forget. This paper tests whether memories of high inflation affect agents’ preferences about the importance attached to price stability, using a large database covering over 52,000 survey responses from 23 countries over the years 1981-2000.

It finds that memories of hyperinflation are there to last, whereas those of less drastic inflation experiences tend to erode after around 10 to 15 years. The recent decline in the importance attached to price stability does therefore most likely reflect mitigated inflation concerns in an environment of low and stable inflation, but also the consequences of fading memories of high inflation. The longer central banks have successfully delivered price stability, the more important it is for them to engage in a proactive communication, especially with the younger generations, about the merits of low and stable inflation.

This is quite interesting. If a country has faced hyperinflation the memories linger for a long long time. For instance, the article suggests Bundesbank became an inflation fighter at all cost because of the hyperinflation experience.

Inflation outcomes are very likely to, at least partially, reflect the preferences of societies. Without public support, central banks will find it much more difficult to disinflate a high inflation economy, or to prevent inflation from rising in the first place. The different inflation experiences across countries in the 1980s, for instance, have often been explained by variations in the inflation aversion of the general public. In that debate, references have typically been made to the German case, where allegedly public support for the Bundesbank’s anti-inflationary stance was high due to the German experience of hyperinflation in 1923.

This discussion suggests that memories of high inflation are a relevant factor in shaping a society’s preferences. If this is the case, industrialized countries might be about to experience a reduced inflation aversion among their citizens, given the fact that inflation has been moderate over the recent past. Over time, fewer and fewer members of the societies of industrialized countries will have a vivid memory of the great inflation of the 1970s/1980s (and of course even more so of the hyperinflation episodes, which date back much longer) – either because they have not experienced it, or because they forget over time.

Another interesting point is central bankers cant sit easy after years of demonstration of price stability. As younger generation has not experienced the inflationary times, they need to understand and remember the painful lessons of history.

Reading the paper made me remember another paper by Ulrike Malmendier and Stefan Nagel. The authors said:

We investigate whether individuals’ experiences of macro-economic outcomes have long-term effects on their risk attitudes, as often suggested for the generation that experienced the Great Depression. Using data from the Survey of Consumer Finances from 1964-2004, we find that individuals who have experienced low stock-market returns throughout their lives report lower willingness to take financial risk, are less likely to participate in the stock market, and, conditional on participating, invest a lower fraction of their liquid assets in stocks. Individuals who have experienced low bond returns are less likely to own bonds.

All results are estimated controlling for age, year effects, and a broad set of household characteristics. Our estimates indicate that more recent return experiences have stronger effects, but experiences early in life still have significant influence, even several decades later. Our results can explain, for example, the relatively low stock-market participation of young households in the early 1980s, following the disappointing stock-market returns in the 1970s, and the relatively high participation of young investors in the late 1990s, following the boom years in the 1990s. In the aggregate, investors’ lifetime stock-market return experiences predict aggregate stock-price dynamics as captured by the priceearnings ratio.

The role of human memory in economics is quite interesting. I think it has some very interesting applications. Most models/theories assume consumers get on with life  but reality is we take decisions based on past experiences. How will this crisis remain in people’s memories? Billed as the second worst crisis since Great Depression, it clearly will have some impact in the way we make economic and financial decisions. This should be a crucial aspect of any future work after this crisis.


A review of Banking Business Models

September 25, 2009

Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECB has given an insightful speech on Bank’s business models.

She first says why banks are special and why they need to be studied seperately. Then  looks at business models of banks post Glass Steagall Act and how they have changed after deregulation around the world.  She points to changes in both – revenue side (increased relaince on non-interest income) and liabilities side (increased relainmce on wholesale markets than retail deposits) of bank’s balance sheet over the years.

Towards the end  says:

I started this speech by briefly describing why banks are special. The last two years have painfully stressed how special and important they really are. When the financial system fails, the whole economic system is affected. The financial sector has undergone an unprecedented wave of innovation, change, consolidation and now crisis. We now have a better understanding of the business models that may not be sustainable, but there are still many open questions.

For example, will future capital requirements provide banks with better loss bearing capabilities and the economic system with less procyclicality? How can future compensation and corporate governance principles support the long term value creation of banks? And, how can risk management practises and risk pricing models better represent possible gains and losses? 

Overall, there seems to be no simple answer on banks’ best practises and their business model. Therefore, we need the contribution of the academic community for the future design of banks’ business models and for the policies supporting them. I am – of course – already looking forward to this conference providing some answers to the important questions at stake.

There has been a lot of research/discussion on regulation of banks/non-banks. However, little has flown in terms of what should be the business model of banks? There were some initial suggestions that banks should get back to basic banking and some have even suggested of narrow banking. However, much is still in grey. We need more ideas….

Are crises predictable?

September 24, 2009

There is tons of literature on this subject which gets very confusing. However, this short and simple note from Bharat Trehan of FRBSF is a nice way to have some idea. This is Part I of the two article series. It says:

The enormity of the current financial collapse, widely described as a bursting bubble, raises the question whether the crisis could have been predicted, possibly permitting action to offset its effects. In the first of two Economic Letters on the subject, we look at developments in the United States and find evidence suggesting that simple indicators based on asset market developments can provide early warnings about potentially dangerous financial imbalances.

He looks at two simple indicators – credit gap and change in property price to suggest we can see some signs of distress ahead.

Excessive financialization of primary commodity markets

September 24, 2009

The UNCTAD yearly publication – Trade and Investment report -2009 was released recently (heavy pdf file here). The theme of the  report is – Responding to the global crisis Climate change mitigation and development. Climate change is becoming a hot topic as World Development Report 2010 is also based on the same theme (for an economic perspective see this Spence paper).

Anyways, the UNCTAD report has a interesting chapter on the topic of the post. It says:

The impact of the financial crisis on developing and transition economies through the slowdown of trade was amplified by the sharp fall in international prices for primary commodities in the second half of 2008. To a large extent this is a symptom of the financial crisis itself. Commodity prices, stock prices and the exchange rates of currencies affected by carry trade speculation moved in parallel during much of the period of the commodity price hike in 2005–2008, during the subsequent sharp correction in the second half of 2008 and again during the rebound phase in the second quarter of 2009.

It is true that deteriorating global economic prospects after September 2008 dampened demand for commodities; but the downturn in international commodity prices was first triggered by financial investors who started to unwind their relatively liquid positions in commodities when the value of other assets began to fall or became uncertain. And the herd behaviour of many market participants reinforced such impulses. Financial investors in commodity futures exchanges have been treating commodities increasingly as an alternative asset class to optimize the risk-return profile of their portfolios. In doing so, they have paid little attention to fundamental supply and demand relationships in the markets for specific commodities. A particular concern with respect to this financialization of commodity trading is the growing  influence of socalled index traders, who tend to take only long positions that exert upward pressure on prices. The average size of their positions has become so large that they can significantly influence prices and create speculative bubbles, with extremely detrimental effects on normal trading activities and market efficiency.

Under these conditions, hedging against commodity price risk becomes more complex, more expensive, and perhaps unaffordable for developing-country users. Moreover, the signals emanating from commodity exchanges are getting to be less reliable as a basis for investment decisions and for supply and demand management by producers and consumers.

Hmmm… so finally there is some reckoning of the problem by an international institution. When prices were rising last year, all was  considered well and demand -supply reasons were given.  As usual, a crisis tells you the nature of the probelm.

The chapter does some fresh analysis on whatever little data is available and sees financial speculation as a cause of concern. What is the way out:

In order to improve the functioning of commodity futures exchanges in the interests of producers and consumers, and to keep pace with the participation of new trader categories such as index funds, closer and stronger supervision and regulation of these markets is indispensable. The financialization of commodity futures trading also confronts the international community with the issue of how supply-side measures can address excessive commodity price volatility. This issue is of particular importance for food commodities, because, despite some recent improvements, current grain and oilseed inventories remain very low. This means that any sudden increase in demand or major shortfall in production, or both, will rapidly trigger significant price increases. Hence, physical stocks of food commodities need to be rebuilt urgently to a level adequate enough to be able to moderate temporary shortages and buffer sharp price movements.

I couldn’t understand much of the analysis as I don’t understand commodities markets. But these policy lessons are interesting. Policymakers please take note….

Central Banker chips on state of macro and modelling

September 24, 2009

There are tons of articles these days on the state of macro/eco. The fire has been ignited in  particular by Krugman NYT article but before this also there were a few thoughtful pieces – (see this, this, this, this etc etc). Mark Thoma has a detailed list on the response of economists on the Krugman article. All this actually is very exciting but is fairly sad at the same time as there is just too much infighting. And with interent you can all see it happening. Some of the words being used are also not kind and is getting nastier by the day.

Now, a central banker chips in. José De Gregorio, Governor, Central Bank of Chile has given a much sober and useful speech on state of macro and finance. His main view is:

it is important to insist: models are only a part of the reality that allows us to organize our ideas before diagnosing and prescribing. The arguments’ logic and a good deal of judgment are also critical when it comes to making economic policy decisions.

He explains the tow types of models used by central banks- Real Business Cycle and New Keynesian Model (which is the basis for the much criticised DSGE models):

There are two categories of models that are commonly used in macroeconomics and that require some specific references, namely the Real Business Cycle model (RBC) and the New Keynesian model (NKM). Both share the characteristic of being general equilibrium intertemporal models with complete markets and rational expectations.3 Under the RBC model in its more traditional versions, the economy is fully flexible and there is no role for macroeconomic policies, whereas under the NKM there are sticky prices that result in money not being neutral, which assigns a role to monetary policy. These provide the conceptual basis for the formulation of inflation-target regimes.

It is important to place both types of models in their right dimension. The strategy of RBC models is to try to replicate economic fluctuations in the simplest, least distorted model possible. It originated in the attempt to use the neoclassical growth model to explain the business cycle as a result of productivity shocks, which is surely an interesting effort with theoretical consistency. These are very elegant models, but the difficulty of solving them analytically results in having to solve them using calibrations. As a result, there are often doubts regarding the values of the parameters, which in general are unobservable. To the extent that these models are free of distortions, there is no role for active monetary policies, since economic fluctuations are socially optimal. Certainly this is an attractive theoretical proposition, but it is absurd to think that this is how the world works. It will be difficult to explain the financial collapse with this type of model, because it has no frictions and provides very limited policy implications.

The New Keynesian model features no realistic frictions in financial markets either, at least to generate problems as severe as the current ones, so it has nothing to say about the origins of the crisis.4 These models are widely used in central banks to calibrate the monetary policy that is consistent with an inflation target.5 In that sense, they are a very useful tool for establishing well-specified, well-estimated transmission mechanisms, but they are certainly limited, and it is unrealistic to believe that they can provide a full description of the economy. 

He says NKM models are still useful as they help central banks understand monetary transmission. What is instead needed is a seperate model to understand finance:

while a different type of model will have to be found to address the issue of financial stability, together with extensions that are yet to be formalized.

This brings me to the theory of finance. If there ever was one discipline that should have anticipated the vulnerabilities that were building up in financial markets, it was finance. Had the origin of the problem been inflationary, then the problem would have been macroeconomics, but the origin was financial. The origin of the crisis is closely related to financial innovation and the creation of instruments that should have diversified risks. Low interest rates, search for yields and a monetary policy that promised to rescue after severe falls in asset prices prompted the creation of a housing bubble.

Enormous efforts were made to price many extremely complex financial instruments, but even those academic efforts failed to build valuation models that realistically considered the instruments’ insolvency probabilities. No evidence is necessary to assert that these methods failed because of an extreme event that struck everything. These failures were exacerbated by severe liquidity shortages and widespread panic in the markets.

Broadly speaking, the theory of finance has two branches: asset price theory and corporate finance theory. It is paradoxical that while asset price theories, and their application to the real world, are based on the existence of complete markets and full arbitrage (consider, for example, CAPM), corporate finance theories that explain firms’ financial decisions are essentially dominated by information asymmetries and are plagued by frictions from principal (owner)-agent (executives) problems. This dichotomy will have to be corrected over time to ensure that more realistic models of how financial markets work become available, models which will shed more light on economic policy recommendations.

Excellent stuff. This is what is needed from economists now. There is an urgent need to learn from the mistakes and incorporate these in eco theories.

He then goes on to cover issues like crisis prevention and  crisis management. In the end he says:

Nonetheless, that macroeconomic theory has failed is an overstatement. In particular, the comparatively better performance of emerging economies – with the exception of a few cases such as Eastern Europe that remind us of our mistakes of the past – demonstrate that economic research has taught us something. In particular, the majority of macroeconomic policies have sought not to replicate past mistakes. Now it is necessary to analyze more carefully the role of financial markets, their virtues and, of utmost importance, their vulnerabilities.

This crisis is an admonishment to professional arrogance. We must recognize that the real world is much more complex than what our models can explain. This is why so-called professional orthodoxy is discredited. However, we must also avoid the arrogance that comes from ignorance, which leads to abandoning all we have learned about the fundamentals of good macroeconomic policies.

🙂 Thank you Dr Gregorio…

Monetary Policy and Financial Stability: An Emerging Markets Perspective

September 23, 2009

Brookings hosted a panel discussion on the topic which has some interesting thoughts. The panel was started by  a speech from José de Gregorio, Governor , Central Bank of Chile. It was followed by a discussion by the panel members.

The other members were – Guillermo Calvo, Marvin Goodfriend, Eswar Prasad/ Calvo and Prasad are emerging market eco experts and Goodfriend on mon and fiscal policy issues. There are some interesting points and dicussions. Read the transcript here.

IMF WEO and GFSR chapters

September 23, 2009

IMF has released the chapters of October WEO and GFSR. The main chapters (as in Economic Outlook and Financial Conditions assessment) would be released in first week of October.

These are not the main chapters of the report  but is an analysis of topical issues. They decide these chapetr topics 6 months in advance and are actually quite good at it, as when they are finally released it really is topical. IMF may not be able to forecast outlook (which is the main part of the report) etc but is quite good at thinking on these topical issues.

WEO has 2 chapters:

  • Chap 3: Lessons for Monetary Policy from Asset Price Fluctuations
  • Chap 4: What’s the Damage? Medium-Term Output Dynamics after Financial Crises

GFSR also has 2 chapters:

  • Chap 2: Restarting Securitization Markets: Policy Proposals and Pitfalls
  • Chap 3: Market Interventions during the Financial Crisis: How Effective and How to Disengage?

Here is summary of WEO chapters: Chap 3, Chap 4. Here is a summary of GFSR Chap 3.

IMF also had press conferences to discuss the main findings of WEO and GFSR chapters. The transcript of WEO is here and video of GFSR is here ( the transcript has not been uploaded yet).

I just finished reading the transcript of WEO chapters. So what do they say? Chap 3: Lessons for Monetary Policy from Asset Price Fluctuations says:


  • The first part of the chapter takes a look back at history, takes a look at asset price busts in advanced economies over the last four decades, and what we find is that there are some clear macroeconomic patterns leading up to these busts, including the most recent crisis. For example, rapidly expanding credit is often associated with a bust one to three years followed, and, to that, we can also add the phenomenon of deteriorating current account balances and rapid shifts of expenditures into residential investment.
  • At the same time, we also find that output and inflation are not actually very good leading indicators of ensuing busts. So they’re not good indicators of that kind of overheating, and this also holds for the current crisis.
  • we also take a look at the role of monetary policy in the lead-up to asset price busts, including the current crisis. Now, we find that monetary policy was not the smoking gun in the sense that monetary policy does not provide an encompassing, systematic explanation of the differences in asset price experiences across countries. There are too many exceptions in countries’ experiences with asset prices for this to be a totally convincing explanation as a cause of the crisis. However, we do find that many of the same macroeconomic patterns of the lead-ups to asset price busts apply to the lead-up to the current crisis.


  • what lessons can we draw from this about how monetary policymakers should act going forward?….. We look at whether monetary policy could and should be responsible for more than just targeting goods price inflation, in particular, whether there’s a role for leaning against some of these phenomena like the expansion in credit and whether that can produce more stable outcomes.
  • And, we say that on the assumption that policymakers can correctly understand the drivers of the shocks going on, in the case where, for example, there are financial shocks, there is a good case for reacting more strongly than would otherwise be usual to those underlying phenomena.

The 4th chapter Market Interventions during the Financial Crisis: How Effective and How to Disengage? says:

The second study, the one that we’ve been working on, looks at output dynamics following 88 banking crises that took place over the past four decades in a very wide range of countries — advanced, emerging, developing. Our focus was on the medium run, which here we define as seven years after the crisis. Since the first glance at the data told us that there was a wide range of experiences after a banking crisis, we also sought to try to link the various outcomes with initial conditions and policies after the crisis.


  • The first one was that banking crises tend to have a long-lasting impact on the level of output. And, for the average country, about 7 years after the crisis, the level of output was still around 10 percent below its pre-crisis trend although there was a very large variation across crisis episodes. It’s interesting that this result holds for both advanced and emerging economies.
  • The second finding was that this depressed path of output was mainly due to reductions in all factors of production, which, the employment rate, capital and productivity.
  • Now the third result which we have in our study was that initial conditions have a strong impact on the size of the ultimate output losses, and also policy efforts, post-crisis, can tend to be associated with lower output losses.
  • we find that economies that apply macroeconomic stimulus in the short run following the crisis tend to have smaller output losses over the medium run, and there’s also some evidence that structural reform efforts are associated with better medium-run outcomes.


in some ways, the analysis has sobering implications for the medium-run output prospects in economies that have suffered recent banking crises. However, the very forceful macroeconomic policy response so far, in the form of substantial fiscal and monetary stimulus, should help mitigate the impact of the crisis on output this time around. Still, to the extent that there are remaining concerns about losses, they underscore the importance of implementing reforms that help raise medium-term output prospects and facilitate the reallocation of resources across sectors.

Both these issues are being discussed quite a bit already. Central Banks to have an expanded role and banking crises lead to loss in potential output for a long period of time.

Why US has so many banks?

September 23, 2009

US financial system is popularly known as a market based system. There are two main reasons for it- One , US banks are large in number and as a result banking industry is a lot less concentrated than say in European economies. Though the second point has changed with concentration picking up, it still is lesser than other developed economies. Two, because of first reason, US relies more on capital markets to channelise financial resources.

The question is why did US come to acquire such a system. Why it has so many number of banks? For instance, if we see this FDIC statistics, it says there are around 7000 commercial banks as of June 2009 (In this crisis, 122 banks have closed so far). If we see 1990, it had around 12,343 banks and all this does not include savings and thrift institutions.

 I was reading this speech from Marc Olson, Fed Governor where he shed some light on this issue.  Though the speech is much like the Larry Meyer speech on explaining FOMC, still gives some idea:

The Federal Reserve System is generically described as the central bank of the United States. In the late eighteenth and early nineteenth centuries there were two attempts to establish a central bank of the United States, and neither endured for more than twenty years–in contrast to most European nations, where central banks were well established by the nineteenth century.

Though you may not be familiar with the history of our central bank, you may well remember learning about the debates on the concept of federalism by our nation’s founders, when the forces favoring decentralization, led by Thomas Jefferson, fought the proponents of a more centralized government, led by Alexander Hamilton. The Jeffersonian forces largely prevailed. As a result, the United States lacked a strong central bank presence but had no authority even to grant national charters to commercial banks until the Abraham Lincoln Administration. All bank charters were originally granted by the states and, as a consequence, the United States at one time had more than 25,000 bank charters. Today, we have about 8,000 separate bank charters. By contrast, most other developed nations have fewer than 100 separately chartered banks. 

Hmmm… this is very interesting. As is always the case, knowing history is very important. As US did not have a central banks it led to development of so many chartered banks in the various states.

How certain economies acquire certain type of financial systems is a very very interesting area, especially if explored from the political economy angle. Most economic studies ignore the political reasons and focus on economic reasons. But it is always politics which leads to the long term structure in anything.

Conference on 10 years of Euro

September 23, 2009

ECB hosted a conference on 13 – 14 November 2008 to celebrate and discuss 10 years of Euro. Now it has just complied all the papers in a conference volume  (heavy pdf file) which also has a summary of all the papers and discussions in the beginning.

Happy reading.

Do we (Indian policymakers) deserve accolades?

September 22, 2009

The speeches of K.C.Chakrabarty the newly appointed Deputy Governor of RBI, are a fresh breather (so far atleast). Not that other RBI speeches are not, but his speeches come with a different perspective and has useful references towards the end (which means more reading). It is full of interesting tables and charts which can be used for further research as well. 

In this new speech he covers the reforms and progress in Indian economy. He divides the progress in real economy and fin economy and is a nice short read. He suggests how the reforms have got India onto a higher growth trajectory and onbe of the most sought after economies.

However, towards the end he asks –

Do We Deserve Accolades?

42.       Structural transformation of almost all the segments of the economy during past two decades has brought discernible improvement in terms of efficiency, competitiveness and productivity. This reflects in economy moving over to higher growth trajectory with far greater integration with the rest of the world in terms of diversification of goods and services as well as destinations to which exports are being made. Of course, we take pride in these achievements and we together deserve it.

But, there are enough reasons that we must not get complacent with regard to transformation process. We need to ask ourselves a few relevant questions. How far the benefits of economic progress have percolated down? Whether standard of living of the population has uniformly improved? Can we say economic transformation has brought prosperity to public at large and could we make dent in poverty?  I would like to flag and touch upon some of these areas, though do not claim to know the answer for all these questions.

He then covers our performance in Poverty, Socio-Economic Development, Health, Education with some interesting charts. Needless to say the performance is abysmal in each of these exspecially considering the high growth we have achieved. He adds we need action in 4 areas: agri investment, labour reforms, demo dividend and financial inclusion.

Clearly something has gone wrong.  The policies are trying to address them but again we are just too married to high growth rates. Why can’t we show the picture as it is?

The high growth rates are important as Growth Commission report shows, but clearly we need to do a lot more than just smile at the growth rates. For instance, can the idea of India as an economic superpower be achieved on high growth rates alone? That is why it is important to do a reality check on just the relevance of  GDP growth concept in India. The Stiglitz commission idea needs to become mainstream sooner.

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