Dr YV Reddy special- S. Guhan Memorial Lecture

Dr Subbarao in his recent speech provided refernce to a recent speech Dr Reddy gave in memory of S. Guhan.

I just searched and found the text of the speech here. He sets the agenda for the financial system right:

Currently, there are several responses to this question of what next for India’s financial sector? I will state a few of them and briefly comment on each of them.

First, some say that India has been saved from the financial crisis only because the policy was conservative and did not act to improve the efficiency of the system. Hence, the prescription is to act now.

This view is not right simply because India was active in policy interventions in both monetary and financial sector. RBI adopted active countercyclical policy; while many others failed to intervene. There is another problem with acting rapidly or comprehensively now for reform; because there is no agreement on right model for financial sector.

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Central banks from the view point of law and economics

I just posted a while back on the importance of knowing law while understanding central banking. It isn’t just about economics alone as you need a proper legal framework under which central bank has to operate. The success of central banks as an institution isn’t about economics alone, is a success of law as well.

 

Masaaki Shirakawa, Governor of the Bank of Japan gives a super speech to Faculty of Law, Tokyo University on this issue. He says knowledge of law is as critical as knowledge of economics.

 

He discusses three aspects of law that influence central banking:

 

• Democracy and central bank independence: issues from the viewpoint of public law: Law grants independence to central banks which allows them to achieve their objectives properly.  
• Innovation in central banking business: issues from the viewpoint of private law: There were couple of innovations in this crisis. Like BoJ accepted foreign bonds as collateral. This has legal implications as which law would apply and how? There were innovations in payments and  settlement system that allowed the acceptance of foreign collateral
• Financial system stability and international legal issues: Financial system is global and failure of firms leads to international legal issues. The Lehman Bros collapse is a useful case study on the issues

Very useful insights. He also adds a few points on life as a central banker.

 

In the end he says:

 

All of you have been studying law and might be hoping to utilize law to contribute to the world. There are many jobs such as the legal profession and legal departments where knowledge of the law can be utilized. While all of those jobs are no doubt important, it would be more than I can dream of if you also recognize the challenging and unique workplace that is a central bank.

 

 

 

 

 

 

 

 

 

 

Checking Financial Health vs Physical Health

Anna Lusardi in her post compares getting regular checkups of one’s health with doctors and of financial health with financial advisors. We do the first quite a bit and forget about the others.

Investmentless recovery ahead?

Fatas-Mihov Blog post rarely but whenever they do, it is full of insights. The duo have written some super papers and make a mark in the blogposts as well.

In the recent post, they point that recoveries post-recessions in 1991 and 2001 were investmentless.

What is interesting in this chart is that the last two recoveries were also special when it comes to the behavior of investment. In fact, the behavior of investment seems to mimic what we see above in the employment chart. While during the 1975 and 1982 recoveries investment grew faster than GDP (so the ratio increased), during the 1991 and 2001 recessions, investment grew at the same pace as GDP (so the ratio is flat). And this is more of a surprise if we take into account the fact that real interest rates remained very low during these two recoveries (more so in 2001).

 

 

We know that investment is the most volatile component of GDP so the V-shape that we see in 1975 and 1982 is what we would normally expect. By definition, it has to be that other components of GDP played a stronger role (relative to previous recessions) in 1991 and 2001 (consumption, exports). What was the exact role of those components will (hopefully) be the subject of a future post in this blog. What is interesting so far is the similarity in the behavior of employment and investment across the most recent recessions.

 

I am waiting for subsequent posts but I think the recovery is going to be mainly driven by consumption and exports. Going by reading the various crisis episodes exports rebound the fast. And as stimulus measures target consumption, it should also be a part of the story.

However, I was pretty perplexed by this finding. If recovery is jobless and investmentless is it a recovery at all? We usually associate growth pick-ups with growth in jobs and investment. I mean I can understand both are low, but not contributing at all?

Just too bugging all this.

Addendum:

for more on jobless recovery, see previous posts

Boring Banking vs Exciting Banking

I was reading this recent speech by RBI Gov Dr Subbarao.

He says there are calls to make banks boring. He cites works of Krugman, Volcker, Mervyn King and Dr. Reddy who in their own way have advocated the call to make banks boring.

Blogonomics makes an entry in world of Economics

Menzie Chinn of Econbrowser points that in wone of the economics workshops held at Bank of Canada, Blogonomics (Economics of Blogs) was discussed. This is like wow. Earlier, there was a pointer that blogposts helped in research paper writing and bloggers were invited to US Treasury. And now a panel discussion at Bank of Canada on blogonomics.

Chinn says:

Some questions posed by the panel chair were:

• Why do you blog?
• To what extent has your experience blogging matched your expectations going in? Has the response been surprising on any dimension? Has it taken up more (or less) of your time than you’d thought? Has the process of blogging had an unforeseen impact on your work and thinking?
• What effect do you think the emergence of economics blogs such as your own has had on the economics profession? On academia? Policy? Markets? The public? Any specific examples you can share from your own blogging experience?
• What is the most ‘trouble’ you’ve ever gotten into from something you’ve written on your blog?

Read Chinn’s views here.  My answers:

• I blog as it helps me remember and keep track of the work and readings I do. It has been just an amazing tool that way.
• For me blogging has been an amazing experience.  It has exceeded much beyond expectations. I never expected the kind of comments and rankings the blog got. I relaised I could write a bit. It has surely helped me review my thoughts. Whenever I write on my topic a quick search tells me what my thoughts were earlier on the issue
• This question does not apply to me as my blog nowhere has impacted public policy  or on the economics profession or On academia or on Markets. It is afterall Mostly Harmless Economics 🙂 But yeah I get comments requesting for some information, data etc which if I have I try and give. So I guess there is some marginal impact on very  few people
•  I have not got into any trouble but there have been some nasty comments sometime. If useful, I try and reason out. Otherwise I just plain delete it.

What about the other bloggers?

 

 

Finmin committee on Foreign Investment in India

Finance Ministry has floated a new committee to study foreign investment in India.

• To review the existing policy on foreign inflows, other than Foreign Direct Investment (FDI), such as foreign portfolio investments by Foreign institutional investors (FIIs)/ Non Resident Indians (NRIs) and other foreign investments like Foreign Venture Capital Investor (FVCI) and Private equity entities and suggesting rationalisation of the same with a view to encourage foreign investment and reducing policy hurdles in this regard while maintaining the Know Your Customer (KYC) requirements. 
• To identify challenges in meeting the financing needs of the lndian economy through the foreign investment. Foreign investment for this purpose to be understood broadly and can include investment in listed and unlisted equity, derivatives and debt including the markets for government bonds, corporate bonds and external commercial borrowings. 
• To study the arrangements relating to the use of Participatory Notes and suggest any change in the policy if required from KYC and other point of view. 
• To reexamine the rationale of taxation of transactions through the STT and stamp duty. 
• To review the legal and regulatory framework of foreign investment in order to identify specific bottlenecks impeding the servicing of these financing needs. 
• To suggest specific short, medium and long term legal, regulatory and other policy change; in respect to foreign investment keeping in view of the suggestions expert committee reports such as the Committee on Fuller Capital Account Convertibility, the Committee on Financial Sector Reforms and the High Powered Expert Committee on Making Mumbai an lnternational Financial Centre.

I don’t understand but there is no member from RBI. Why should this be? I think I already know the recommendations of the committee (don’t ask me why). There would be 2 scenarios:

1. The committee would go all out on opening India’s shores to all kinds of capital, remove all restrictions, remove RBI’s supervision over financial markets, RBI should adopt inflation targeting framework, Mumbai should become an international finance centre (like Iceland, London) etc. It would be centred on how bad our financial system regulation is and we need to adopt these changes else we are doomed. It would add it is a mistake to think since we have largely avoided the financial crisis, that we don’t revamp the financial system. Let’s do it all real fast. The criticism would be mainly on RBI for keeping such a tight control on financial system.
2. The committee report is going to be cautious about the volume of capital inflows in the country. India should invite capital flows but should but with some checks in place. It would say we should learn lessons from the ongoing crisis and not think all capital flows are necessarily good. It would instead suggest incremental changes.

Some people would ask, so what is different and what is new? This is the nature of all committee reports w.r.t. capital flows. Well, nothing is new. But this is how things usually are.

If the second version goes through, it is likely to be followed by dissent notes from a few members who would vote for the first version. The dissent notes are going to be highlighted by the media as somehow most people in media feel the first version is the only model.  

So let’s see how it goes. It is going to be tabled in 4 months from now. I hope I am all  wrong about this one. And we see some progress.

Microfinance helps or not?

Well, there has been a lot of debate recently on the issue- whether microfinance helps or not?

Two studies, both by Poverty Action Lab researchers have been in heavy controversy since they have been published. First – The miracle of microfinance? Evidence from a randomized evaluation by Abhijit Banerjee,  Esther Duflo,  Rachel Glennerster and Cynthia Kinnan (May, 2009). Second by Expanding Microenterprise Credit Access: Using Randomized Supply Decisions to Estimate the Impacts in Manila by Dean Karlan (July, 2009). First based in India, second in Philipines. Both studies show limited impact of microfinance on people’s lives.

Creating jobs in US – Lessons from Europe?

Recently Paul Krugman pointed to the differences in recovery of US and Germany. US is recovering with unemployment still rising and Germany recovering with hardly any increase in unemployment levels.

Jacob Funk Kirkegaard has a superb post in Peterson Institute’s Real Time Economics Issues Watch Blog. He compares the unemployment levels in Euro area economies and says:

While the US unemployment rate has more than doubled since early 2008 to 10.2 percent in October 2009, increases in Europe have so far been more muted. In France, supposedly the core eurozone country and labor market overregulator, unemployment has risen by only about 2 percentage points to 10.0 percent, according to the latest available data. Meanwhile, in Germany the essentially flat unemployment rate still at less than 8 percent really stands out, both among other EU countries and obviously when compared to the United States.

For the first time in decades therefore the unthinkable—at least among labor economists—has happened and US unemployment rates are today above those of the core eurozone countries. It is hard to imagine a better reason than that for the Obama administration to reconsider its domestic employment policy response to the crisis.

Superficially of course, it would seem that core-Europe’s labor markets have been far better able to cope with the economic crisis than the US labor market. However, one caveat must immediately be highlighted.

Any relatively better labor market performance in core Europe is countered by a collapse of eurozone labor productivity relative to the US, especially in manufacturing.

How did European economies manage this?

It is further important to realize that the benign recent core-European labor market trend represents an explicit social choice in the countries in question. Not only did France and Germany let their existing extensive social safety nets play their intended role as automatic stabilizers after the fall of 2008, but both countries have further moved aggressively to financially support temporary flexible working-time arrangements—the so-called “work sharing programs.” Increasing the flexibility of working hours for individual workers at the outset of the crisis, so that fluctuations in labor needs are distributed across all workers rather than selectively among them (which would have resulted in some layoffs) has clearly been instrumental in containing unemployment rates.⁷

In many ways, the core-European policy response is a welcome improvement on the disastrous European labor market policies of the 1980s where the “lump of labor fallacy” led governments to facilitate workers’ early retirement or other premature exits from the labor market in the false hope that more people leaving the workforce would free up additional job opportunities for younger workers. Similarly, it is clear that in core Europe’s generally still highly regulated labor market, attempts to combat hysteresis effects by maintaining people in employment even at reduced hours is likely to be a sensible policy, as many core-European workers would otherwise have invariably slipped into long-term unemployment.

So what are the policy options/choices for Obama?

With the US unemployment rate at 10.2 percent, it may be too late to expand “work sharing programs” from the current 17 state-level programs. Government-supported “work sharing programs” similar to those in core Europe work to preserve existing employment rather than to create new jobs. Hence such programs disproportionately benefit skilled workers, whom companies will prefer to “hoard,” as they are more likely to find employment elsewhere if laid off. This type of insider-outsider dynamic has been very prevalent in Europe during the crisis, where increases in unemployment despite work sharing programs have been heavily concentrated among people on temporary work contracts. Additional protection for “insiders” is clearly not what the US labor market needs at the moment.

Instead, in the short term, Congress should implement a temporary holiday for Social Security and Medicare payroll taxes for new hires. This could provide an urgently needed, powerful broad-based and immediately implementable job creation stimulus for the US labor market.

For the long term, Congress needs to get serious about multi-year funding for broad-based workforce skills improvement and retraining programs. The one-off funding for the Workforce Investment Act (WIA) included in the stimulus bill and the long-warranted expansion of Trade Adjustment Assistance (TAA) to services sector workers are welcome, but must be prolonged. Only sustained funding will insure that the relevant skills-enhancing programs are in place when US workers need them. With job losses in the current recession increasingly of a structural nature (meaning that workers will need to seek new jobs in a new industry), such programs will be more needed to avoid another jobless US recovery.

Interesting insights from European Labour markets and policies.

The times have changed. US  has always criticised Europe for its labor policies. Europe’s labor market has always been seen as a factor that has lowered the regions’ growth, productivity etc. Now, US might have to take some lessons from Europe’s  weakness.

Exit strategies – an international dimension

Lorenzo Bini Smaghi of ECB gives an international dimension to the exit strategies in his speech. Each economy would be weary of exiting first as there is uncertainty and it could damage its economy’s prospects

He says looking at the current economic conditions the ideal international exit strategy would be first Asia, then Latin America and then US and advanced economies.

This ‘optimal’ sequence would mean that Emerging Asia tightens its policies as the economy gets back on track, thus avoiding domestic overheating and financial instability. The exit would be accompanied by an appreciation of Asian currencies, and that in turn would favour a rebalancing of growth towards domestic demand, thereby avoiding a large build-up of foreign exchange reserves and excess domestic liquidity.

It would also entail a progressive reduction of liquidity flows to the US, which were probably useful as the crisis escalated but are becoming less so as financial markets stabilise in the US.

Latin American countries would be the next to exit, as their economies recover gradually, thanks also to exports to Emerging Asia and to stronger domestic demand. In Latin America too, some appreciation of the exchange rates would be expected to accompany the recovery and stem excessive capital inflows.

The US and other advanced countries would exit last, as their economies are proving to be the slowest to recover. This would be the ideal sequence.

However this is not happening

Unfortunately, the reality appears to be quite different. Emerging Asian economies have not yet exited and do not seem to be in the mood to exit first, despite the stronger pace of their recovery, at least compared with that of the US. They continue to maintain strongly accommodative monetary policies and steadily accumulate foreign exchange reserves.

In all Emerging Asia, except Malaysia, foreign reserves are now higher than before the Lehman collapse (see attached table). As a result of these interventions, the strong domestic demand for credit is being met, fuelling potential financial market instability in these countries. Just to give an example, the year-on-year growth rate of domestic credit has reached 32% in China.

Delayed exit in Asia is posing problems for Latam as well as the capital flows are moving to Latam as well leading to appreciation. They are also likely to respond and manage capital flows. Brazil has already responded.

Why is this happening? He points to three possible reasons:

• Philosophical: When advanced economies want to delay exits why should emerging exit now?
• Tactical: The emerging economies need to be sure that advanced econs would also exit if their economies recover. As they are not sure now, they are not exiting
• Prudential: Need to be sure that crisis is over before exiting

Interesting dimensions to the international exit strategy problem. He summarises it as:

Let me conclude. An optimal exit strategy from the extraordinary monetary, fiscal and financial policies implemented by advanced and emerging market economies has several elements. It has to be timed properly, in all countries. This is difficult: not all countries are in the same cyclical position, so some should exit earlier than others. However, those who should exit earlier can do so if they are confident that those who are supposed to exit later will do so in the same timely fashion. Furthermore, they want to be sure that the worst of the crisis is over and that concrete actions are being taken to overhaul the financial system. To make such commitments credible and to build up that confidence, we need a stronger system of international cooperation than the current one, with the major countries undertaking to bear in mind the external implications of their actions. Without a stronger multilateral system we might end up repeating the mistakes of the past, with one difference. The impact on each of us will be greater.

International cooperation…we always look to it but is disappointing. This crisis we have moved a bit forward on the crisis. As the crisis is easing we are again seeing a scramble for world supremacy.

Useful stuff from Smaghi. He usually is quite good.

 

A look at Bank of England Balance Sheet

Paul Fisher of Bank of England explains in details about Bank of England balance sheet.

Paul Fisher notes that the Bank of England’s support for the economy had been “truly, historically massive – both in terms of liquidity insurance and operations and monetary policy.” The balance sheet had expanded to as large a size as at any time in the past two hundred years, and the pace of change had been “unprecedented”.

At some point, he says, the Bank’s balance sheet will return to something approaching its former composition, and perhaps size, with the temporary operations being time-limited, or have price disincentives for use in normal conditions. But the innovations introduced during the crisis will leave the Bank better prepared to deal with stresses in future. Paul Fisher notes that the Sterling Monetary Framework is used to set monetary policy and to provide liquidity insurance to the banking sector but it “…cannot provide medium-term funding for banks to carry out lending.”

What was once an esoteric topic meant for academicians, has become so important. Central Bankers are taking a lot of pains to explain the idea to the public.

I had earlier pointed to a comparison of Fed, Euroarea and Bank of Japan balance sheets. Add this speech to get a feel of Bank of England as well.

International Monetary System – a quick view

Mark Carney, Governor of the Bank of Canada talks on international monetary system (IMS) in his recent speech.

The international monetary system consists of (i) exchange rate arrangements; (ii) capital flows; and (iii) a collection of institutions, rules, and conventions that govern its operation. Domestic monetary policy frameworks dovetail, and are essential to, the global system. A well-functioning system promotes economic growth and prosperity through the efficient allocation of resources, increased specialization in production based on comparative advantage, and the diversification of risk. It also encourages macroeconomic and financial stability by adjusting real exchange rates to shifts in trade and capital flows.

Carney then provides a snapshot of 3 IMS we have had – Gold Standard, Bretton Woods and current hybrid system. On th present system he says:

After the breakdown of the Bretton Woods system, the international monetary system reverted to a more decentralized, market-based model. Major countries floated their exchange rates, made their currencies convertible, and gradually liberalized capital flows. In recent years, several major emerging markets adopted similar policies after experiencing the difficulties of managing pegged exchange rate regimes with increasingly open capital accounts. The move to more market-determined exchange rates has increased control of domestic monetary policy and inflation, accelerated the development of financial sectors, and, ultimately, boosted economic growth.

Unfortunately, this trend has been far from universal. In many respects, the recent crisis represents a classic example of asymmetric adjustment. Some major economies have frustrated real exchange rate adjustments by accumulating enormous foreign reserves and sterilizing the inflows. While their initial objective was to self-insure against future crises, reserve accumulation soon outstripped these requirements.  some cases, persistent exchange rate intervention has served primarily to maintain undervalued exchange rates and promote export-led growth. Indeed, given the scale of its economic miracle, it is remarkable that China’s real effective exchange rate has not appreciated since 1990.

In each major global crisis we have had to reform our IMS. We cannot continue with the current IMS as well. Changes need to be made as we would end up in similar problems later on as well.

So what is the way forward? He suggests some options:

The first is to reduce overall demand for reserves. Alternatives include regional reserve pooling mechanisms and enhanced lending and insurance facilities at the IMF. While there is merit in exploring IMF reforms, their effect on those systemic countries that already appear substantially overinsured would likely be marginal. As I will touch on in a moment, the G-20 process may have a greater impact.

He explains these in details.

A nice short note on IMS.

Using economics to ease airport congestion

It is once in a while you come across such papers which refresh you completely. These days most research is focused around crisis and recessions which is very good but gets onto you after a while. You need a change. 

I came across this fascinating paper by econ trio – Jeffrey P. Cohen, Cletus C. Coughlin, and Lesli S. Ott. The paper tells you about how economics can help reduce congestion at airports. 

We all know that airports are congested at peak hours. How do airport regulators decongest the same. The authors tell us how economics can help. 

Risk management lessons from Philippe Jorion

One cannot skip Philippe Jorion, if he has taken a course in finance/MBA in finance. Atleast that seems to be the case in Indian schools. The moment your professor teaches about risk and moves to Value at Risk, he/she would most likely ask you to read Jorion’s famed book on VAR.

The Academy of Behavioral Finance & Economics

I got an email from Prof Rassoul Yazdipour of Academy of Entrepreneurial Finance:

Dear Amol,
 
I very much enjoyed your blog on interview with professor Malkiel; esp. the part on Behavioral Finance/Econ. So I thought to drop a line and let you know about The Academy of Behavioral Finance & Economics www.aobf.org and its 2010 Annual Meeting in Chicago.
 
Appreciate spreading the word via your blogs/sites.
 
Best,
Rassoul
www.aobf.org

I was just checking the Annual meeting details and one can send papers by May 15, 2010. The meeting will be held on Sep 15-17 2009. The tentative topic list for papers is as follows:

Theoretical and empirical/experimental works that involve the application of psychology and neuroscience to all areas of financial decision-making and practice will be considered for presentation at the meeting. This includes, but is not limited to, the following areas:

1.  Investment and the Working of Financial Markets at all levels of functionality and capital  allocation—including both public and private aspects; 
2.  Financial Management of Companies—both public and private entities;
3.  Firm Entry and Exit Process—ranging from startup ventures to mature businesses;
4.  Entrepreneurship, Innovation, and Venture Capital;
5.  All other Business and Economic Endeavors that Involve Human Decision Making and Choice Under Conditions of Risk and Uncertainly; 
6.  Teaching and Learning—ranging from case development to other pedagogical issues. 

As it is tentative, one can send other behavioral finance/economics papers as well.

The 2009 meeting details are here. It was held on Sep 23-25 2009. They have not uploaded the papers till now.

So, I thought I would just share this information with the visitors of this blog. Please spread the word.

I would wait for the papers.

Addendum:

BTW, the Burton Malkiel post is here.

Lessons from East Asian Crisis

San Fransisco Fed organised a conference on Asia and the Global Financial Crisis. All biggies – Bernanke, Rogoff, Obstfeld, Eichengreen etc  – discussed on variety of topics – Asian crisis of 1997, Asian economies in this crisis, global imbalances etc.

 

I was reading this paper by Anne Krueger on lessons from East Asian crisis. More specifically, on Korea’s 1997 crisis and Japan’s crisis. The paper is very easy to read and tells you many lessons on the way.

 

Lessons from Japan:

• A first, and perhaps the most important, one is that an undercapitalized banking system can retard, if not entirely stifle, an incipient recovery even when fiscal policy is expansionary.
• Second, efforts by banks (and acquiescence by the government) to hide their difficulties not only delay recovery but create uncertainty about the financial system as a whole
• Third, unless measures to restore healthy banks are sufficiently large, they do not significantly contribute to the resolution of the problem.
• Fourth and finally, when banks continue to roll over NPLs, they are starving the potential new entrants (especially small and medium enterprises) of credit, and hence reducing growth.

 

The same lessons could be drawn from Korean as well:

The Korean experience reinforces the Japanese lessons. Although the crisis was triggered by difficulties within the banks that were intensified by the exchange rate regime, the crisis was financial once the exchange rate had been allowed to depreciate and float. It was already seen that the underlying  problem had been a failure of the financial system to develop commensurately with the needs of an increasingly complex modern economy. This was connected to the problems of the chaebol. They had been heroes of Korea’s hugely successful growth experience, but had accepted government restrictions and had had their own banks each financing much of the needs of the individual groups.

 However, the actions taken by Korean policymakers was faster than Japanese. Krueger points this was also because Japan’s much of the problems was becasue of domestic issues. So Japan just chugged on hoping small policymeasures would be enough. Despite hope, the economy kept slipping.

Whereas in Korea, they owed a large foreign debt and hence there was a lot of attention. The politiicians initially said no to IMF aid but had tioe eventually take it. I had earlier pointed to an interesting angle on why US came forward to help Korea so quickly. But other East- Asian economies also had huge foreign liabilities but were much slower and had much bigger crisis as well.

Lessons for today:

 

 

• Perhaps the most important conclusion that can be drawn from crises in many countries is that delays in recognizing and confronting the difficulties in the financial sector are costly. Denial by officials may be understandable, but when the measures taken are timid relative to the magnitude of the problem, or when they are undertaken after significant delays, the costs of the cleanup mount
• Both the credibility of the authorities and the transparency of both the situation and the measures taken are also crucial.
• Moreover, in almost all crisis situations, the crisis happens because of underlying weaknesses in the economic policy framework and economic  structure.
• It is also notable that growth can resume fairly quickly when strong measures are taken. Most forecasts of post-crisis growth in the Asian countries were unduly pessimistic.
• For emerging markets, further lessons derive from the necessity to maintain consistency between policies toward exchange rates and monetary and fiscal policies.
• But perhaps the strongest lesson from all of the crisis situations is the urgent necessity of restoring the financial system by recapitalizing the banks, removing the NPL from bank portfolios, and enabling the resumption of the flow of credit.

All well known ideas. Nicely put though.

 

Lack of Fiscal expectations could undermine Taylor rule

I had said earlier we should read Eric Leeper. He brings really interesting interactions between fiscal and monetary policy. His research centres on the idea that managing and anchoring fiscal expectations is as crucial. We usually worry about inflation and central bank expectations and never really look at fiscal policies. This is not surprising as much of research has focused on monetary policy. The mon pol research has looked at DSGE models (see this as well) which do not have any role of fiscal policy.

Nevertheless, times are changing and we are seeing some research on fiscal policy. Much of the fight is between fiscal multipliers.  It is high time we start to engage in research like we do for central banks- rules, institutions, frameworks etc.

Econs like Leeper are helping us think through these ideas.

In a new paper Leeper says:

Slow moving demographics are aging populations around the world and  pushing many countries into an extended period of heightened fiscal stress. In some countries, taxes alone cannot or likely will not fully fund projected pension and health care expenditures. If economic agents place sufficient probability on the economy hitting its ”fiscal limit” at some point in the future–after which further tax revenues are not forthcoming–it may no longer be possible for “good” monetary policy—behavior that obeys the Taylor principle—to control inflation or anchor inflation expectations. In the period leading up to the fiscal limit, the more aggressively that monetary policy leans against inflationary winds, the more expected inflation becomes unhinged from the inflation target. Problems confronting monetary policy are exacerbated when policy institutions leave fiscal objectives and targets unspecified and, therefore, fiscal expectations unanchored. In light of this theory, the paper contrasts monetary fiscal policy frameworks in the United States and Chile.

The paper is fairly technical and needs a patient reading. It would have been better if he explained the broad ideas in English and put the technical details in appendix. For instance he gives you scenarios of active fiscal policy vs monetary policy and vice versa. One does not get a proper idea on what the analysis actually show.

But one gets a broad idea on what the paper implies. Anchoring fiscal expectations is important as it undermines monetary policy as well. The idea that at some point of time taxes will not be able to fund the growing expenditures and pension liabilities is a threat. So, we need some clarity on how governments plan to manage their public finances. With no clarity, monetary policy would also suffer. There have been many instances in the past when  fiscal policy mess has resulted in a monetary policy mess as well.

The case studies of US and Chile are contrasting and interesting stuff.

Euroarea in Recessions- a comparison

ECB’s November monthly bulletin (heavy pdf file) has a short research note comparing the performance of Euroarea in previous recessions. To do a comparison of recessions in Euroarea is always a mighty job.

• The decline in investments, consumption, employment, wages is much the same as in previous recessions. The wages actually don’t decline as much.
• The decline is much sharper in exports which reflects in a much sharper decline in GDP

Useful stuff.

Fed’s role in Payments systems

Thomas Hoenig of Kansas Fed has an interesting speech on payments system in US. He points that much of the growth in payments system  is happening in private sector with no regulatory oversight. The payment system is also being run by a few large players and there is little competition. So far it is all good as there are no sisks. But as the crisis tells us we cannot take anything for granted. Hence time to move and reform this section. He argues for Fed’s increased role in oversight of payments system.

I can’t extract contents from the speech as there are security issues. So, just read on.

Lessons from New Deal

Lee Ohanian summarises the broad lessons from Great Depression and his huge research in this speech. He says the depression was mainly because of the New Deal.

The failure to recover is puzzling, because economic fundamentals improved considerably after 1933. Productivity growth was rapid, liquidity was plentiful, deflation was eliminated, and the banking system was stabilized. With these fundamentals in place, the normal forces of supply, demand, and competition should have produced a robust recovery from the Depression. Figure 3 shows the recovery in productivity, real bank deposits, and the level of the GNP deflator, which stops falling after 1933, and rises modestly afterwards. Why wasn’t the recovery stronger?

My research shows that one policy that delayed recovery was the National Industrial Recovery Act (NIRA), which was the centerpiece of New Deal recovery policy. The NIRA prevented market forces from working by permitting industry to collude, including allowing firms within an industry to set minimum prices, restrict expansion of capacity, and adopt other collusive arrangements, provided that firms raised wages considerably. These policies worked. Following government approval of an industry’s “code of fair competition”, industry prices and wages rose significantly.

Promoting collusion reduces employment and output, while setting the wage above its market-clearing level depresses employment by making labor expensive. Employers respond to high wages by reducing employment relative to the market-clearing level that is jointly determined by supply and demand. Figure 2 shows hours worked and the real manufacturing wage. The most striking feature of the graph is that the continuation of the Depression coincides with rising real wages. This fact stands in sharp contrast to standard economic reasoning, which indicates that normal competitive forces should have reduced industry wage levels and increased employment and output. This coincidence of high industry wages and low hours worked is one of the most telling signs that the market process was considerably distorted.

The broad lessons are that policies that are supposed to ease recession should not distort market incentives. This was a lesson from works of Prescott et al as well.