Explaining unconventional monetary policy using the car/highway analogy

Economists love for using cars/highways as analogy is well-known. Whenever it is difficult to explain a concept they usually try and find an analogy in car/highway (see this for one example).

Adam Posen, now Bank of England MPC member uses the same analogy to explain unconventional monetary policy. A shortened version of the speech is also available in a eurointelligence article here.

He says:

I give the analogy that normal monetary policy by interest rate setting is like driving a new Range Rover down the M4 on a commute: one knows how long it will take to get to the  desired exit; the ride is smooth, well-marked and familiar; any particular causes of delays beyond normal traffic are clearly visible and swiftly cleared. Unconventional monetary policy, including QE, is like making the same trip but: doing so in an urgent hurry; driving a 10 year old used Vauxhall Vectra with a cranky transmission; down a rural road because the M4 is closed; without a good map or signage, and with all kinds of strange surprises blocking traffic. You will get where you are going using QE, but you are not sure how long it will take to get there, and you will not enjoy the ride. In other words, we can be confident that the coefficient of QE’s effect on nominal income is positive, and therefore that the British economy would have been stuck in a far worse place had QE not been implemented, but we cannot pretend to have precise knowledge of the size or timing of QE’s impact.

(In the article he replaces  class=”hiddenSpellError” pre=”replaces “>M4 with autobahn and Voxhall Vectra with Opel Vectra).

It is always humbling to read Posen’s excellent work and this speech is also a very good one. He says the real concern is not inflation but banks able to allocate funds to the economy. He actually rubbishes that high money now would lead to inflation later. He points to various charts showing episodes of high money growth have hardly led to inflation. High money only led to inflation in 1970s but there were other reasons for the rise in inflation then (see this St Louis Fed publication for a lot of details on the inflationary episode of 1970s)

 He then points to close parallels of UK economy with Japan’s in 1990s and says main worry is Banking system. It is not as bad as Japan as policies in UK have been better, but there is a parallel. So, the recovery is going to be weak and slow.

Excellent stuff as usual. Very good references at the end as well.

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Crisis of Capitalism or democatic system?

Lorenzo  class=”hiddenSpellError” pre=”Lorenzo “>Bini Smaghi keeps giving these speeches. In his recent speech he reviews the hot broad topic- Is this crisis the end of capitalism? He looks at the debate and towards the end says:

 The current crisis has been characterised by many as a crisis of capitalism. I wonder whether it might also be a crisis of our democratic system, a challenge to its ability to manage complex and global financial markets. Indeed, many parts of society benefited from the loose approach to supervision and regulation of the financial activities which took place in the run-up to the turmoil. Market participants have been short sighted, and so have the political authorities and institutions. Can this crisis convince them to look further ahead? Can we expect the longer-term interests of society to prevail once again over short-term incentives which led to instability?

The signals coming everyday from several financial market participants as well as political authorities do not seem so encouraging. The former are waiting for the dust to settle and for things to return to ‘normal’. The latter can only be as far-sighted as those they represent, i.e. those who elect them. What is really needed then, to quote that famous phrase, is somebody who will “ take the punch bowl away just as the party gets going” again; somebody who has the authority to slow the music down. I am fully aware that this is not easily done, but it is not impossible. It took the high inflation of the 1970s to convince the political authorities that monetary policy should be implemented by independent central banks. It would be better not to ‘waste’ another crisis to come to the same conclusion for financial stability.

The debate is happening at very basic level. Failure of democracy is another angle added by Bini Smaghi. And it is sad that as crisis has eased, the willingness to reform is just fading away. The Wall Street/Other financial streets elsewhere is again busy distributing bonuses and treating the crisis as a forgotten event. I firmly believe in what Spitzer says– you need people who want to regulate.

Economists are also coming out with new controversial ideas. Calomiris says you need big global banks to serve big global firms and too big to fail is not a big problem (debate between him and Simon Johnson here). Well what can one say?

Thinking about the crisis spiritually

Charles Calomiris has an interesting take on the crisis. I had just pointed to the peace connection with the crisis, and here Calomiris talks about spiritual response to the crisis. He gives a speech at Greek Orthodox Church of the Annunciation, Harvard Club and reflects on the crisis and its lessons.

When the Church of the Annunciation invited me to comment on the current financial crisis from a spiritual perspective I was hesitant. I am not a theologian, just a lay member of the Orthodox Church. I agreed partly because I was intrigued by the question and uncertain about what I would be able to say in response to it. I have studied financial crises most of my professional career, and since mid-2007 I have been busy researching, writing and speaking about the current crisis and the policy responses to it; but I had never considered the points of intersection between spirituality and financial crises. I see my attempt here as a starting point for exploring those points of intersection .

Does Globalisation lead to income inequality?

IMF Research Bulletin in September 2009 has an intereting discussion and short literature survey on the topic. It is written by Chris Papageorgiou. There is a lot of litearature on impact of globalisation on growth etc very little on income inequality. This one helps you understand a few papers on the topic. It also points to case studies of China, Mexico and India.

Political economy and a short history of global imbalances

Jeffry Frieden of Harvard Univ has a very interesting short paper on global imbalances. He gives a historical account and political perspective to it.

He tells you how in the globalisation era before World Wars, there were global imbalances as well. This time Germany was the deficit country and US was the surplus country. Currently we are in reverse and US is the deficit country and China, Germany etc are surplus countries. He also points that both US and Germany did not like them being part of global imbalances but because of political reasons carried on.The Great Depression led US to pass anti trade policies which then led Germany and other economies to turn protective and what followed was a complete chaos. All economies turned inwards and  we had formation of nationalistic sentiments and govt coalitions.

The same problems exist today and we need to be weary. The change from a consumption society to saving one and vicer versa is painful and couild easily lead to conflict.

Excellent stuff. A short paper with a lot of punch.

Addendum:
I have heard of Jeffry Frieden but never read much. I was glancing his working papers and is very very exciting stuff.

 

Central Banking and Vitamin D connection

I just came across this interesting press release from Bank of Finland. It says:

On 27 October 2009, the Bank of Finland Museum will launch its most recent seasonal exhibition, entitled ‘Vitamin D! The Devaluations of 1957 and 1967’. The exhibition will be on display until the end of 2010.

The purpose of the seasonal exhibition is to explain the background to the devaluations in Finland of 1957 and 1967, how the devaluations were brought about and their effect. The exhibitions at to enable the visitor of today to understand the monetary policy environment of a time when parliamentary turnover was so frequent that the average age of a government was only a year.

In the post-war years the Bank of Finland found it had to adjust the external value of the markka countless times. By joining the Exchange Rate Mechanism (ERM) in 1996, stability was brought to the Finnish currency’s value. The euro was adopted, initially as scriptural money in 1999, and subsequently the cash changeover was made at the beginning of 2002. 

Hmm. What I dont understand is this:

The title of the exhibition, with its reference to ‘Vitamin D’, does not seem to have been used to refer to the devaluations of the 1950s and 60s, but by the 1980s it had become a firm part of the economic jargon of the time. 

Now why was it named Vitamin D? Was it because as Vitamin D is crucial for our health so was Vitamin Devaluation necessary for Finnish economy? Or does it stand for something else? I tried doing google search but it was all over the place. Any ideas readers?

Anyways, all this may just sound trivia but it has a lesson for economic history as well. There have been many episodes where central banks have just failed to manage currency levels. Currency failed as a nominal anchor and then central banks moved to price stability/inflation. This includes Finland as well. It could be useful to study Finland’s experience with targeting currency levels.

Also, RBI could plan something like this as part of its Platinum Jubilee Celebrations. It has a museum and it could host such events to educate us more on Indian economic history.

 

Economic Stability and Peace

Nobel committee gave the Peace Prize in 2006 to Mohammed Yunus and Grameen Bank.

The Norwegian Nobel Committee has decided to award the Nobel Peace Prize for 2006, divided into two equal parts, to Muhammad Yunus and Grameen Bank for their efforts to create economic and social development from below. Lasting peace can not be achieved unless large population groups find ways in which to break out of poverty. Micro-credit is one such means. Development from below also serves to advance democracy and human rights. 

The linkage between economic prosperity and peace was always there but Nobel Committee made it more pronounced.

IMF chief Dominique Strauss-Kahn revisits the issue in his recent speech. He says economic instability leads to poverty which then leads to worsening of peace prospects

Let me stress that the crisis is by no means over, and many risks remain. Economic activity is still dependent on policy support, and a premature withdrawal of this support could kill the recovery. And even as growth recovers, it will take some time for jobs to follow suit. This economic instability will continue to threaten social stability.

The stakes are particularly high in the low-income countries. Our colleagues at the United Nations and World Bank think that up to 90 million people might be pushed into extreme poverty as a result of this crisis. In many areas of the world, what is at stake is not only higher unemployment or lower purchasing power, but life and death itself. Economic marginalization and destitution could lead to social unrest, political instability, a breakdown of democracy, or war. In a sense, our collective efforts to fight the crisis cannot be separated from our efforts guard social stability and to secure peace. This is particularly important in low-income countries.

He points just as Wars devastate economy, the reverse also follows. A declining economy could lead to wars, civil conflicts etc.

The causality also runs the other way. Just as wars devastate the economy, a weak economy makes a country more prone to war. The evidence is quite clear on this point—low income or slow economic growth increases the risk of a country falling into civil conflict. Poverty and economic stagnation lead people to become marginalized, without a stake in the productive economy. With little hope of employment or a decent standard of living, they might turn instead to violent activities. Dependence on natural resources is also a risk factor—competition for control over these resources can trigger conflict and income from natural resources can finance war.

And so we can see a vicious circle—war makes economic conditions and prospects worse, and weakens institutions, and this in turn increases the likelihood of war. Once a war has started, it’s hard to stop. And even if it stops, it’s easy to slip back into conflict. During the first decade after a war, there is a 50 percent chance of returning to violence, partly because of weakened institutions.

So what can IMF/policymakers do? Maintain economic stability at all costs.

Just a different perspective on the crisis.

Bank Capital regulation can learn from Inflation targeting

Hans Gersbach and Volker Hahn have an interesting article in voxeu. They say there are parallels between equity capital regulation and inflation targeting frameworks (ITF) of central banks. As we need to rethink about capital rule regulation, ITF could be of help.

What are the parallels?

Japan’s lost decade – how could it have been avoided?

I was just quick reading this interesting paper from Daniel Leigh of IMF. As it is quite technical, I just read the english bit. A paper on Bank of Japan and lost decade is just too tempting.

Bank of Japan has been hugely criticised for making a Japanese recession a prolonged slump or what is called as Japan’s lost decade.

A profile of Jurgen Stark – ECB Chief Economist

FT has an interesting profile of Jurgen Stark, chief economist of ECB. He is clearly not happy with US economists and is a highly conservative economists. He is also concerned with the massive monetary and fiscal stimuli which are leading to worsening of the moral hazard problem. He says intervene to minimise crisis but it should be cautious.

The profile is also very interesting as it gives you insights into German economics.

Stark cultivates a hardline image – his surname is the German word for “strong” – but that morning there were light, or at least sardonic, touches. In the US, he noted dryly, “everything is great”. There was the “Great Depression” of the 1930s and the “Great Inflation” of the 1970s. Stark paused. “I’m not so sure it was so great,” he said. Then there was the “Great Recession”, as some people are calling this period. Stark wanted to explain the ECB’s “exit strategy” – how the central bank would unwind “in a timely fashion” all the exceptional measures it has taken – and to warn governments of the perils of not quickly reining-in public sector debt. But pointed criticisms came quickly. He railed against economic growth “based on large and growing imbalances, reflected in asset prices and credit bubbles as well as global current account imbalances, which ultimately proved to be unsustainable”. And he attacked “potentially flawed indicators and concepts” used by US-trained economists

🙂 You often come across this grudge European economists (and elsewhere as well) have against US economists.

You get a glimpse of German School of Economic thought- Ordnungspolitik

His initial speciality was in labour markets, and the prevailing school of economic thought was Ordnungspolitik – the distinctly German tradition (without a real translation or equivalent in English) that allows markets to operate freely, but with clear rules and limits. The framework developed as a reaction to the brutal interventionism of the Nazi regime. Together with an abhorrence of inflation dating from the hyper-inflation of the 1920s, a reliance on exports stemming from postwar necessity and a long-established German industriousness, Ordnungspolitik helps explain how German policymakers have thought since 1945.

And yet the global economic crisis that erupted in August 2007 forced a policy reaction that appeared to have little to do with Ordnungspolitik.

Read on for more details…….

Comparing Fed, ECB and BoJ balance sheets in this crisis

I have been waiting to read something like this for a while now. We know enough about Fed Balance sheet and its expansion (see Bernanke’s recent excellent speech on the same; He is just too good at summarising complex ideas). But very little research etc is there on other central banks balance sheets.

ECB in its Oct Monthly Bulletin, has a nice analysis and comparison of Balance sheets of Fed, ECB and BoJ. Fed had the smallest balance sheet before the crisis and has the largest now.

A quick review of finance and growth

There was a time when I used to read a lot of this literature – Finance and Growth. It was mainly powered by Ross Levine of Brown University and you ended up reading quite a bit via the references he provides. Not anymore – one, these papers don’t include the crisis element and two, I just don’t get anytime. Most of the blogposts these days are referring only to some useful speeches (which i manage to read somehow).

John Lipsky of IMF in his new speech has given a useful review of Finance and Growth literature. What does research broadly imply? Three findings:

First, financial development is critical for both growth and development. There are few, if any, instances where the transition from a predominately agricultural economy through sustained and diversified growth has taken place without a well-functioning system of financial intermediation. While the details of national systems have varied, the broad principle has not.

Second, the presence of financial crises, even recurring crises, has not reversed the positive relationship between financial system development and economic growth.

And, third, financial crises and their impact can be suppressed completely only through severe financial sector repression and by autarkic policies—and at a clear cost to economic growth and development.

First and thrid points are ok. It is second point which needs to be expanded. The crises may not have reversed the relationship between fin system development and growth but has surely posed numerous question on the nature of financial development itself. There is still little clarity on what it means. Prior to the crisis all the fancy finance ideas were seen as advanced, sophisticated etc etc. We now know none of those words are true by a long way.

Addendum:

• The speech was given at this Bank of Mexico Conference

Why do politicians decide to delegate to central banks

Finally I found some paper which helps me understand why do politicians give up powers to Central banks? This one is a fairly technical one from Christopher Crowe of IMF. Though he backs it up with some interesting case studies. It is also focused on goal independent central banks and not central banks in general. There are two ways by which you check independence:

• Goal independent means central banks can decide what and how to operate mon policy. Some say ECB is goal independent and others add Fed as well.
• Instrument independent mens governemnt decides what to do and Central Bank decides how to do. Most Central Banks are instrument independent.

In nutshell politicians delegate monetary policy to goal independent central banks because it allows them to remove conflict amidst political parties. Otherwise political parties fight over what should the Central Bank do and try and influence it.

The motive for delegating the monetary policy decision to a fully (goal-) independent central bank is that it removes the intracoalition conflict over monetary policy from the political arena. I derive the conditions under which delegation will occur. In equilibrium, the cost of coalition formation depends upon the relative sizes of the factions within each coalition. Since e¤ective lobbying strength depends on faction size (because larger factions have lower per-member lobbying costs), equal-sized factions (with equal chances of winning) will invest heavily in lobbying for their preferred outcome. The contest will therefore be costly for the coalition as a whole, motivating both sides to take monetary off  the table. By contrast, if one faction dominates in terms of size, then lobbying strengths are clearly mismatched, the likely victor in the policy dispute is clear, and no faction will commit significant resources in the dispute. Incentives to delegate will be minimal.

And keeping mon pol off the table actually enhances powers as it helps them focus on other areas and not being worried about opposing parties trying to control mon policies .

One could argue that the independence enjoyed by goal-independent central banks (GICBs) is particularly striking given the political sensitivity of their core role . the conduct of monetary policy. However, this political sensitivity could explain the decision to delegate. Because monetary policy is contentious, it can split otherwise homogeneous political coalitions. Taking monetary policy off the table makes it easier for these political actors to effectively combine to control policy with respect to other key issues. Far from being constrained, politicians who decide to delegate may see their overall freedom of action enhanced.

It also points to case studies of Bundesbank, Netherlands Central Bank (how politicians formed a coalition as mon pol was off the table). Some parties even tried to gain more authority over Bundesbank as there was little conflict in economic policies with others. On the other hand in UK there was no difference amidst politicians over economic policy and as a result Bank of England was hardly independent. Only when differences arose it was decided to make it more independent (but again it is just instrument independent). Then there is experience of South Africa where the Bank was granted goal independence as there was conflict amidst politicians.

These are all very different and interesting insights. You have a goal independent central bank when politicians fight over economic policy. If politicians have similar econ policies you end up with a not-so independent central bank.

It is often said RBI is not as independent. Though there are many reasons one reason could be that our political parties hardly have any economic agenda. The elections are fought on all kinds of reasons and economics plays a very small role. Moreover, whichever party has used economics as the agenda, it has lost the elections (R’ber the BJP 2004 election campaign of India shining). Is RBI/Monetary policy ever a point of discussion amongst our political parties? Barring finance ministry I doubt it.

So would difference in economic policies lead to a more independent RBI? That is a research question worth exploring for sure.

Lessons from India’s post 1991 Banking/Financial Crises

RBI Dep Governor, Dr. Usha Thorat has given an excellent speech reviewing all the major/minor financial/banking crises in India since 1991. She adds the lessons learnt from each crisis.  

She covers following crises:

• The BOP crisis of 1991
• The Securities irregularities of 1992
• Imbroglio caused by dealings of Non-Banking Financial Companies in 1997
• Asian Crisis of 1997 – the first global contagion
• Urban Co-operative Banks – the Weak Link
• Failure of a fairly significant mid sized commercial bank in 2004

What is interesting is that each crisis the broad setting is the same, just that players change in each one. Whichever is the weakest link in financial system is soon exploited by players which poses risks to the entire system.

Mervyn King is really worried about Banks and their regulation

Mervyn King speeches used to be one of my favorite central banker speeches. He has not been talking regularly for a while now and the speeches have also been just ok types.

He makes a strong comeback  with his recent speech and I hope he returns to top form. He hits hard on banks and the damage they have created to the economy.

The United Kingdom faces two fundamental long-run challenges. First, to rebalance the economy, with more resources allocated to business investment and net exports and fewer to consumption. That is consistent with the need – now widely accepted – to eliminate the large structural fiscal deficit and to raise the national saving rate. It is part of a need for a wider rebalancing of domestic demand in the world economy away from those countries that borrowed and ran current account deficits towards those that lent and ran surpluses.

Second, both the structure and regulation of banking in the UK need reform. Banks increased both the size and leverage of their balance sheets to levels that threatened stability of the system as a whole. They remain extraordinarily dependent on the public sector for support. That was necessary in the immediate crisis, but is not sustainable in the medium term. 

Further he adds

Tonight I want to focus on the second of those challenges – reform of the structure and regulation of the banking system. Why were banks willing to take risks that proved so damaging both to themselves and the rest of the economy? One of the key reasons – mentioned by market participants in conversations before the crisis hit – is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as “too important to fail”. Such banks could raise funding more cheaply and expand faster than other institutions. They had less incentive than others to guard against tail risk. Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.

The sheer scale of support to the banking sector is breathtaking. In the UK, in the form of direct or guaranteed loans and equity investment, it is not far short of a trillion (that is, one thousand billion) pounds, close to two-thirds of the annual output of the entire economy. To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.

He points to 2 broad approaches to fix banks:

1. Accept some banks are too big to fail and limit the probability of them failing
2. Limit the size of the banks

He prefers the 2nd approach as first has limitations and we can never be sure. For 2nd he suggests 2 ways – Narrow Banks or separating commercial banking from other bank activities. He says banks are like utilities and like we do it for utilities (separating main activities from others), we should do it for banks. Then only regulation is possible.

These are quite different ideas from a Central banker based in UK. They have been pretty much shaken up by the low morals in banking/finance industry. 

EAC’s India Economic Outlook 2009-10 is out!

PM’s Economic Advisory Council has released the growth outlook for FY 2009-10. The report is here. It is end of October and we have crossed half of the FY 2009-10. It should have come earlier. But anyways, it is a useful policy document.

I will post my comments later.

Revisting Keynes idea of International Clearing Union

It is actually surprising that so much focus is given on one of Keynes many ideas- whether fiscal stimulus works or not. Very little is known of Keynes ideas on economic institutions/organisations. He had some grand ideas wrt international economic institutions and as a result we have World Bank, IMF, GATT (now WTO).

I came across this excellent paper by Nadia Piffaretti of World Bank who looks at another Keynes international institution idea which got lost – International Clearing Union.

As the global economy undergoes profound changes, it is becoming apparent that the so-called “Revived Bretton Woods System” has increased the overall vulnerability of the global financial architecture. Therefore, it is worth revisiting the origins of the Bretton Woods conference, and pointing out the relevance for today’s framework of Keynes’ original 1942 plan for an International Clearing Union. This note explores the main characteristics of Keynes’ original plan, by revisiting his original writings between 1940 and 1944, and outlining its relevance to the current debate on the international financial architecture. The note suggests that reforms of the international financial architecture should include anchoring the international monetary system on sounder institutional ground.

Hmmm. What was this ICU??

Keynes’ proposal for the establishment of a new World Order went beyond the need to suggest a framework for managing post-war relations. It originated from Keynes’ realization that the use of money in international trade had, as Keynes put it, only “worked” for about “two periods of about fifty years each” in the past 500 years (Keynes 1940, p. 21). Hence, contrary to common wisdom, Keynes’ work did not stem only from the desire to overcome the limitations of the inter-war periods of unrestrained exchange rate flexibility. In the final breakup during the War of the “international currency laissezfaire,”  Keynes saw not only a problem, but – in his own words – an address the fundamental question of the institutional weaknesses of the first era of globalization, which had been brought to an end by the two World Wars and the Depression. Keynes saw the absence of an organized system of international payments as a key institutional weakness amid a disorderly international system.

His response was first and foremost aimed at institution-building. By suggesting the introduction of an “opportunity” to  international clearing union (among national central banks), he proposed to apply to international payments the same institutional arrangement governing payments within nations, centered around a system of banking clearing.

The author then looks at more eco history and why it was not accepted. US Treasury had alternate plans and was more acceptable to the Bretton Woods participating public. She also tells you in detail what the plan was and how would it work.

She then suggests the need to look at the plan now as we go through a deep global crisis next to the Great Depression. Just like then, we are talking about many proposals and need to look at Keynes ICU plan as well.

Excellent stuff. Drawing lessons from Eco History to suggest some reform/proposals ahead.

Using matchboxes to spread awareness in rural markets

IDB has an insightful post on how match boxes are available across India despite being made mostly in South India. It is a case study of amazing logistics and has potential to tap untapped markets (of information dissemination).

Wish visitors a very happy diwali

Wishing all the visitors and a very happy diwali. Blogging will resume on Tuesday.

Diwali has brought some good news for ME visitors. As per Palgrave econ blog rankings, Mostly Economics is back in the top 50 eco blog ranks.

Thanks for all the visits and comments. Keep them flowing.

Financial literacy in times of crisis

Jeff Lacker has an interesting speech on financial literacy in times of crisis. He discusses whether we need more regulation or more efforts to increase literacy and consumer disclosures. His comparison of consumer goods with financial goods is also very interesting.