Romer compares Great Depression and Current Crisis

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

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

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

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….