Foreign Aid: Beneficial or not?

Jagdish Bhagwati has written a fascinating historical review of foreign aid. Zambian born Goldman Sachs economist Dambisa Moyo has recently criticized aid severely. She has said aid does not get any desired benefits for Africa and only goes into the purses of the politicians. What is worse is that there are hardly any suggestions from any African leaders on what should be done. The suggestions mostly come from Western economists/policymakers who are usually not aware of the local situation.

 Bhagwati reviews the broad economic rationale behind aid and how it was seen as beneficial. Foreign aid is based on two principles- moral duty and should yield beneficial results. The second principle has never rally worked which has weakened the first one as well. The early works of  Gunnar Myrdal, Paul Rosenstein-Rodan and Arthur Lewis led to some support for foreign aid. This led to rich countries  being asked to fix a target for giving s1% of aid every year.

 Bhagwati tracks where did 1% come from? Arthur Lewis had a student working in a French colony who said French spent 1% of GNP on the colony. The same was explained by Lewis to a UK MP and the term caought on.

 Bhagwati also explaisn how Rosenstein-Rodan got this aid idea popular within US congress. It was the time of Cold war and aid was seen as a way to prevent communism from spreading to the world. Soviets had helped Egypt construct a dam and this was used as a way to show USSR ideas are gaining grounds. So obviously it caught on with US congress!!!

 As Cold War became over, Aid was seen as something that would help the developed countries. As poor become more developed because of aid, they would demand more goods and services from developed and would lead latter to grow as well. This was superfluous as spending the same amount in developed countries itself would lead to more prosperity. Another idea was aid would lower illegal immigration. Bhagwati says this was also not right as illiegal immigration would actually increase as people will have more money to bribe on the borders.

 All this frustrated Lewis and he said in jest that development econs should hand over iad to Madison Avenue. And this became true after 20 years as we have rockstars, concerts asking to give aid!

 Bhagwati also looks at the fame Harrod Domer model which justified aid. The model says there are two ways for a country to grow. One, how much it saves and invests. Two, how much returns it got from investments. The broad idea for foreign aid was it would supplement domestic savings and help in growth. Then as an add on, the domestic savings will also increase over a period of time. However, the recepiuent countries politicians were smart and realized shortfalls in domestic savings would be taken care of. And actually domestic savings went down!!

 Overall, the foreign aid failed to pick up. Every year targets are missed.

 Bhagwati adds China and India did not grow based on foreign aid but based on reforms. Development basically comes down to how the citizens and poliymakers make proper choices and reform their economies. Foreign aid is unlikely to help.

 A great article by Bhagwati. In just about 5 pages, explains so much about foreign aid and its basics.

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Ross Levine vs Joseph Stiglitz : A debate on financial innovation

Ross Levine and Joseph Stiglitz debate on merits of financial innovation in this Economist Forum. Overall the broad ideas are the same. Ross Levine who says financial innovation is useful looks at history and says how i-banks came up to finance rail roads in 19 century, how liquid bond market came up in 17 and 18 century to finance oceanic expeditions and how venture capital helped fund biotech and information tech industry.

 Stiglitz says finance is useful but not in the current form. It is not an end but a means to an end. Financial services should be done at low cost but has become too expensive. The recent wave of so called financial innovation has actually worsened economic outcomes with benefits flowing to financial firms and losses going to taxpayers.

 Overall both say the same point in different ways.  But the examples shown by Levine is what finance should be doing and Stiglitz would agree to. It is the current form of financial innovation where the problems are. Infact there is no real innovation here. It is just herding to make profits from whatever possible ways.

 Another thing which I don’t understand is Levine comparing finance to other sectors. He says in other sectors also we have problems – information tech eases identity theft, drugs are abused etc. We don’t say stop innovating in them so why should we say the same for finance? Even they have risks. Well said but finance is very different. The amount of damage caused by badly created financial products is far more. Moreover, it affects the people involved in creating these products the least.  Just look at the bonuses being distributed by financial sector now. And most of the population still reels under unemployment problems. It is both funny and sad. We still have not managed to understand the issues despite such a big crisis.

Am not saying financial innovation is not useful. But we must understand the implications as well

Searching for a defunct economist

Lorenzo Bini Smaghi of ECB gives another super speech turning Keynes’ dictum on its head. And no, it is not the usual criticising Keynes idea but revisiting what Keynes said and read him carefully :

From Basicland to Sorrowland

Charles Munger of Berkshire Hathaway has an article tracing the US economic history calling it Basicland and how it has become Sorrowland.

In the early 1700s, Europeans discovered in the Pacific Ocean a large, unpopulated island with a temperate climate, rich in all nature’s bounty except coal, oil, and natural gas. Reflecting its lack of civilization, they named this island “Basicland.”

The Europeans rapidly repopulated Basicland, creating a new nation. They installed a system of government like that of the early United States. There was much encouragement of trade, and no internal tariff or other impediment to such trade. Property rights were greatly respected and strongly enforced. The banking system was simple. It adapted to a national ethos that sought to provide a sound currency, efficient trade, and ample loans for credit-worthy businesses while strongly discouraging loans to the incompetent or for ordinary daily purchases.

The performance of basic land was very good.

In its first 150 years, the government of Basicland spent no more than 7 percent of its gross domestic product in providing its citizens with essential services such as fire protection, water, sewage and garbage removal, some education, defense forces, courts, and immigration control. A strong family-oriented culture emphasizing duty to relatives, plus considerable private charity, provided the only social safety net.

The tax system was also simple. In the early years, governmental revenues came almost entirely from import duties, and taxes received matched government expenditures. There was never much debt outstanding in the form of government bonds.

As Adam Smith would have expected, GDP per person grew steadily. Indeed, in the modern area it grew in real terms at 3 percent per year, decade after decade, until Basicland led the world in GDP per person.

And then came the danger…

But even a country as cautious, sound, and generous as Basicland could come to ruin if it failed to address the dangers that can be caused by the ordinary accidents of life. These dangers were significant by 2012, when the extreme prosperity of Basicland had created a peculiar outcome: As their affluence and leisure time grew, Basicland’s citizens more and more whiled away their time in the excitement of casino gambling. Most casino revenue now came from bets on security prices under a system used in the 1920s in the United States and called “the bucket shop system.”

Has a nice reference to Paul Volcker and his rule:

How was Basicland to adjust to this brutal new reality? This problem so stumped Basicland’s politicians that they asked for advice from Benfranklin Leekwanyou Vokker, an old man who was considered so virtuous and wise that he was often called the “Good Father.” Such consultations were rare. Politicians usually ignored the Good Father because he made no campaign contributions.

Among the suggestions of the Good Father were the following. First, he suggested that Basicland change its laws. It should strongly discourage casino gambling, partly through a complete ban on the trading in financial derivatives, and it should encourage former casino employees—and former casino patrons—to produce and sell items that foreigners were willing to buy. Second, as this change was sure to be painful, he suggested that Basicland’s citizens cheerfully embrace their fate. After all, he observed, a man diagnosed with lung cancer is willing to quit smoking and undergo surgery because it is likely to prolong his life.

Finally Basicland become sorrowland…

As it worked out, the politicians ignored the Good Father one more time, and the Basicland banks were allowed to open bucket shops and to finance the purchase and carry of real securities with extreme financial leverage. A couple of economic messes followed, during which every constituency tried to avoid hardship by deflecting it to others. Much counterproductive governmental action was taken, and the country’s credit was reduced to tatters. Basicland is now under new management, using a new governmental system. It also has a new nickname: Sorrowland

Very interesting….

Economic Survey 2009-10…not impressive at all

A lot was expected from this year’s Economic Survey. It was expected to be simpler to read and more analytical. The size (number of pages) was expected to decline  just like what RBI did. There was a new Chief Economic Adviser to Ministry of Finance – Mr Kaushik Bas) (Cornell University) – who was expected to drive some change.

The final outcome has been disappointing. It is the same style with more and more tables and data. It is not even organised properly. Nearly 294 pages report with not much value addition. One can read RBI’s quarterly survey which is much shorter and provides the same kind of analysis.

How did inflation targeting economies fare in this crisis?

Filho Carvalho and E. Irineu of IMF evaluate performance of Inflation targeting economies vs non-inflation targeting economies in this crisis. 

First J-PAL Bihar Development Conference

This is exciting. MIT’s Poverty Action Lab conducted its first conference for Bihar’s development. They shared findings of the research work on various programs conducted in different Indian states with the politicians of Bihar.

Behavioral economics lessons for marketers

Ned Welch of Mckinsey provides 4 lessons (free subscription required) from behavioral economics for marketers.

Long before behavioral economics had a name, marketers were using it. “Three for the price of two” offers and extended-payment layaway plans became widespread because they worked—not because marketers had run scientific studies showing that people prefer a supposedly free incentive to an equivalent price discount or that people often behave irrationally when thinking about future consequences. Yet despite marketing’s inadvertent leadership in using principles of behavioral economics, few companies use them in a systematic way. In this article, we highlight four practical techniques that should be part of every marketer’s tool kit. 

This is so true. I think one field where behavioral economics can contribute extensively is marketing. It is a natural fit. But we don’t see many examples.

What are the lessons?

1. Make a product’s cost less painful
2. Harness the power of a default option
3. Don’t overwhelm consumers with choice
4. Position your preferred option carefully

Read the article for more details. Nicely put.

Robinhood tax!!

Dani Rodrik points to this tax on a very rare blog post – Robinhood tax. It is an initiative started by many organisations that work to reduce poverty in the UK and overseas, and campaign to tackle climate change.

They plan to raise funds for poverty and climate change actions by taxing financial firms:

How it works

The Robin Hood Tax is a tiny tax on bankers that would raise billions to tackle poverty and climate change, at home and abroad.

By taking an average of 0.05% from speculative banking transactions, hundreds of billions of pounds would be raised every year.

That’s easily enough to stop cuts in crucial public services in the UK, and to help fight global poverty and climate change.

Why now?

Because of the financial crisis, frontline services at home – like the NHS and our schools – are under fire.

At the same time, poor communities and the environment are being hit hard – as aid and green budgets are slashed by rich countries.

So it’s time for the people who caused this mess to pay to clean it up.

Who’s in?

Gordon Brown, Angela Merkel (the German Chancellor) and Nicolas Sarkozy (the French President) have all spoken out in support of a tax on financial transactions.

Plenty of business bigwigs are on-board too. Like Lord Turner (from the Financial Services Authority), George Soros (the philanthropist) and Warren Buffet (US businessman extraordinaire). And then there are the hundreds of economists who have backed the idea, too.

This isn’t some crazy pipedream. It’s a simple and brilliant idea which transcends party politics and which – with your support – can become a reality.

Hmmm. Lord Turner’s initial idea has found many takers in UK.

I like the name Robinhood tax. Like Robinhood who passed the riches to poor, the tax plans to do the same. Actually because of the name and the broad idea, it might be pushed by politicians and the public as well. As Blinder says in this superb piece for economists advising governments – Getting a good name for a proposal/reform is  as critical as the proposal/reform itself. 

I was also thinking about the Obama’s proposal to seperate commecial banking from speculative finance. By calling it Volcker rule, it could go either way. Some politicians/economists might associate the proposal as a very good one as it has the name of Paul Volcker who is highly respected. Some might not as they may not like Volcker. Atleastb the financial lobby does not like him. You know it can go eitherway. But with something like a Robinhood tax…you make an impact immediately.

Addendum:

Rodrik has not been blogging for a while now. He says somethings suddenly ignite his urge to blog.  Well it is a real loss for not getting to read his blogposts regularly. Hope he gets ignited more frequently.

Teaching financial literacy is not for all

Anna Lusardi in a post says:

I regularly receive e-mails from people who recognize the terrible need for improving financial literacy among young people. Most of the people who write say they want to volunteer their time and teach financial literacy in high school. I am very impressed by how strongly people feel about financial literacy and I have been thinking of ways of harnessing that willingness to help and the generosity of volunteers. Financial literacy is much in need of promoters and organizers. It is a very important issue and we need to work for it.

While I want to encourage everyone to get involved with the schools, I am reluctant to recommend that individual volunteers teach financial literacy in schools, for three main reasons.

1. Contrary to popular belief, it is very hard to teach

2. Individuals seem to have many different ideas about how to approach the instruction of financial literacy. As I have mentioned in previous blogs, financial literacy is a topic grounded in economic and finance theory and it should be taught accordingly. But what I often hear suggested are topics like how to balance a checkbook or how to buy stocks. We need to stay away from these narrow “how to” lessons of financial literacy, as the objective here is to prepare people to understand and navigate a world of complex and changing financial markets.

3. It’s not always clear how well qualified individuals are to teach financial literacy. In several cases, I have found that college freshmen have set up web pages to teach financial literacy and are eager to go to high schools to offer some classes, even though they may have taken only one introductory course in economics. This is the curse of economics. I have found that many people feel very confident about their views of how the economy works even if they have never read an economics textbook.

Very well said Prof Lusardi. Pick up a newspaper, magazine etc and you see so many people telling you about vitues of financial planning etc. Especially at the year end you have tons of advice on what to do to save taxes etc. And buying stocks advice comes from all kinds of people all across the year.

So what is the way:

I do not want to discourage anyone who is interested in the pursuit of improving financial literacy in schools. Quite the opposite! Please be involved; do not let the school in your own district not pursue financial literacy, not teach these courses! But perhaps the best role is to be an “ambassador of financial literacy”; be an advocate for financial literacy without going directly to the blackboard. We normally do not let strangers into the classroom, in any course, not just financial literacy. In my view, teaching financial literacy requires a deep knowledge of economics, solid training, and a fair dose of humility.

An analysis of Fed exit strategies from previous recessions

Michael Bordo and John Landon Lane have written a super paper looking at how Fed has exited from various recessions.  They look at all the US recessions from 1920-2007. They first look at what Fed did in all those recessions and then how it exited from recessions.  The exit is basically when Fed started raising rates and looking at what macroeconomic variables. In exit policies they use both narrative evidence and econometric exercises.

The findings are quite amazing:

Mankiw on US political system

Wellesley Weston Magazine has a good interview of Greg Mankiw (HT: Mankiw himself):

Why an economist?

WellesleyWeston Magazine: You have had a remarkable career both in the public and private sector. What is it about economics that piqued your interest?

Greg Mankiw: I first became interested in economics during my freshman year at Princeton. One of my friends was taking a microeconomics class; I started reading her textbook and found that I like economics, a lot. In many ways I am a prototypical economist. Economists share a couple of characteristics: they tend to be naturally better in math and science—economics is fairly quantitative—and they are generally more interested in public policy and social issues than in the substance of science. I have always been interested in politics—dinner conversation in my home often centered on what was happening locally and in Washington. But politics by itself seemed vague, random, and subjective. Economics appealed to me because it brought an analytic perspective to social policy questions.

On complexity of US political system:

WW: In your experience heading the Council of Economic Advisors, how much does economics really affect public policy?

GM: The Council has only an advisory function. It has no decision-making power over anything. My day started with a 7:30 am meeting every morning in the Roosevelt Room, the conference room right next to the Oval Office, with members of the White House senior staff. Everyone was fully prepared for the meeting, having already read the news of the day. This was quite a shock for an academic—no one at Harvard would ever dream of calling a meeting at 7:30 am!

I also met regularly with the Administration’s economic policy team—the head of the National Economic Council, the Secretary of the Treasury, the Commerce Secretary, and the Head of the Office of Management and Budget. We coordinated the economic policy effort with a goal of providing either a recommendation or a menu of options for the President to consider regarding the economic policy issues of the day. Several times a week we would meet with the President to discuss the pros and cons of our recommendations. Ultimately, he was the decision maker.

But that’s not the end of the story. When I went down to Washington, I thought the political constraints [on economic policy] would come through political advisors, people like Karl Rove, but they usually came from Legislative Affairs, the group that acts as a liaison between the President and Congress. Congress provides powerful political constraints. From the outside it often seems like there are only two teams in Washington: Republicans and Democrats. But it is really far more nuanced that. There is the Administration and the Congress; and within Congress, there is the Senate and the House; and there are coalitions within each of them. Everyone is looking over their shoulder trying to figure out what they can get passed; everyone is promoting their own agenda. It is very easy to get frustrated, thinking, “Gosh, it’s really terrible we can’t get our economic agenda through and we have all these great ideas.” But then you realize that these checks and balances are precisely the system for which the founding fathers were aiming.

It is the same everywhere. That is why all economists must read this note from Blinder before advising governments/taking up policy roles.

Profile of Paul Krugman

Larissa MacFarquhar has a wonderful profile of PaulKrugman (HT: Krugman’s blog)  . The title of the article – The Deflationist How Paul Krugman found politics. The article is a kind of short bio on Paul Krugman.

In particular how he started being interested and writing on politics. He wasn’t interested much till George Bush became President.

A behavioral perspective to causes of global imbalances

David Laibson and Johanna Mollerstrom provide an alternative explanation to the reason for surge in global imbalances. The paper is here. (It is a NBER version. The free version is not yet available).

Germany and Greece…history repeats itself

Tyler Cowen has a superb post :

…the Greek Finance Ministry had warned of “complete collapse” if the whole system…was not rethought…”Prices and value move in an atmosphere of imminent catastrophe,” he wrote.  “In Greece for a while now all the foundations of a healthy economy have been overturned.  There can be no stability, neither in economic equilibrium nor in monetary or financial affairs.”

…While the Italians…were genuinely worried by Greece’s financial crisis, it was the Germans who needed to be persuaded.  Initially, Altenburg’s advocacy of the Greek position was not well received even in his own Ministry.  But then the political stakes were suddenly raised…

…In Athens people expected the Finance Minister to win substantial concessions from the Germans.  In actual fact he was in a very weak position.

…It was not that the Greek financial crisis could be ignored; nor that the Greek Finance Minister lacked the wit or intelligence to present his case.  It was simply that no Greek politician carried enough weight to be heard seriously in Berlin.

That’s from yesterday’s Financial Times, no…whoops, sorry!  That’s from Mark Mazower’s Inside Hitler’s Greece: The Experience of Occupation, 1941-44.  It’s a good book

Just amazing isn’t it. As Cowen says, you are reading the same lines everywhere now. So, again knowing history is very important. THose who say, this is the first time this has happened etc are mostly wrong. Dig up history and you find parallels.

Reinhart-Rogoff recently said:

Since independence in the 1830s, Greece has been in a state of default about 50% of the time

Given this frequency, Greece should have many such cases in the past as well. The question that comes to my mind is why was Greece allowed to be a part of EMU with such a poor track record? And then allowed to carry on despite having debt levels over 60% for so many years after joining EMU.

Another worry is a financial crisis strikes, govts are asked to bail out. The revenues and expenditure of govts decline and deficit looms. As financial crisis eases, the govt goes into a debt crisis. And now the financial firms start penalising the govt asking for higher interest rates, credit rating agencies lower ratings etc. Eitherways , govt is pushed into a corner. How do we end all this?

It is surprising that most reports now say the govt needs to have better public finances in order to manage future financial crisis. Fair point. But why not some criticism for the way financial firms operate?

I had also pointed out to the financial jugglery used by Goldman Sachs and Greek govt to lower latter’s debt levels. Robert Peston of BBC looks at Goldman Sachs’ defense. GS says the impact was marginal. Moreover, financial firms will always look for business opportunities and there needs to be a stricter code to prevent govts from using financial jugglery. This is sad really. There is no corporate conscience anymore.

Using nudge to simplify banking services in Italy

Mario Draghi, Governor of the Bank of Italy in his speech says:

Old vs Young members of Central bank’s MPC

Maral Shamloo of IMF has written an interesting paper. Shamloo models how monetary policy committee delivers on its objective with older and younger generation of MPC members:

In this paper I study the effect of imperfect central bank commitment on inflationary outcomes. I present a model in which the monetary authority is a committee that consists of members who serve overlapping, finite terms.

Older and younger generations of Monetary Policy Committee (MPC) members decide on policy by engaging in a bargaining process. I show that this setup gives rise to a continuous measure of the degree of monetary authority’s commitment. The model suggests that the lower the churning rate or the longer the tenure time, the closer social welfare will be to that under optimal commitment policy.

Hmmm….very intresting idea and equally interesting findings.  It says older MPC members give better overall results. You come across many papers on monetary policy committee thanks to Alan Blinder. But they are mostly on the lines of how it is organised, how decisions are taken etc. This paper takes a step forward and looks at the age profiles in the MPC.  

Though, much of the paper is technical and based on a model. It would be interesting to put these findings with real examples – modelling young and old generation MPC members at say Fed, Bank of England, Riksbank, ECB etc.

It is amazing to see

Argentina’s Central Bank is not alone

I had pointed out to the interesting case study of Argentina’s central bank. The post shows how Argentina’s central bank has lost its credibility and received a shock on its independence. The Central bank governor was fired for not agreeing to Argentine President on an economic issue.

This crisis has led to a severe strain on the idea of central bank independence. Most central banks have ended up intervening in financial markets saving financial firms. They have done work which belongs to finance ministry etc. And now this political pressure.

Charles Plosser, Philadelphia Fed President points Central Bank of Argentina is not alone here:

Another way independence is currently threatened arises from efforts to make political appointees out of the Reserve Bank presidents or members of their boards of directors. Both the threat of “policy audits” and the political appointment of presidents or directors are not-so subtle efforts to politicize the Federal Reserve.

These changes run counter to history and the principles of sound and responsible central banking. Over the past 30 years, many countries have acted to increase the degree of independence of monetary policymaking from short-term political influences. These moves reflect empirical research that generally shows that developed countries whose central banks have greater independence tend to have lower and more stable inflation without sacrificing employment or output, thus benefiting from more stable economies and better economic performance.

The assault on central banks is not confined to the U.S. It is showing up in a number of countries and in different ways. Just since January 1, 2010, here is a sampling from recent news reports of what central bankers have faced in other countries:¹

Argentina’s president fired the governor of the central bank when he refused to transfer $6.6 billion in foreign-exchange reserves to the government’s coffers to meet fiscal expenses ahead of next year’s election.

South Korea’s president, not surprisingly, has urged the Bank of Korea to go slow on its exit strategy from accommodative monetary policy. However, to underscore the point, he sent a vice minister to attend a Monetary Policy Committee meeting for the first time in a decade.

Japan’s new administration has put increasing pressure on the Bank of Japan to increase lending. This month, the new finance minister said he was looking for even more cooperation from Japan’s central bank.

Mexico’s president has appointed a new governor for the Bank of Mexico, after clashing with its former governor over the central bank’s reluctance to cut interest rates.

This is worrisome. Two of these – Mexico and South Korea are inflation targeting central banks which are deemed as more independent than other central banks.

Plosser reviews importance of central bank independence. He criticises politicians move to audit Fed’s monetary policy as it would compromise central bank independence.

Ideas also matter for catch up growth

Paul Romer in his new paper (HT: Charter cities blog) points to the importance of ideas in emerging economies’ catch up growth phase.

Economists devote too much attention to international flows of goods and services and not enough to international flows of ideas. Traditional trade flows are an imperfect substitute for flows of the underlying ideas. The simplest textbook trade model shows that a welfare-enhancing move toward freer flows of ideas should be associated with a reduction in conventional trade. The large quantitative effect from the flow of ideas is evident in the second half of the 20th century as the life expectancies in poor and rich countries began to converge.

Another example comes from China, where authorities dramatically reduced accident rates by adopting rules of civil aviation that were developed in the United States.

All economists, including trade economists, would be better equipped to talk about international flows of technologies and rules if they adopted a consistent vocabulary based on the concepts of nonrivalry and excludability. An analysis of the interaction between rules and technologies may help explain important puzzles such as why private firms have successfully diffused some technologies (mobile telephony) but not others (safe municipal water.)

A very interesting paper which partitions ideas into rules and technologies. It then shows how incentives matter in flow of both rules and technologies to developing economies. Where incentives are well-defined and known, the adaptation of rules and technologies work and vice versa. So, it not just about trade of goods, services etc but about ideas as well.

These papers take you to a different level of thinking. You are pushed to think on so many things.

An exit rule from John Taylor

John Taylor likes everything in monetary policy to be based on some rules. He has been a big critique of Fed’s policies which has not followed his Taylor rule and has intervened in financial markets in an adhoc manner. Then he has called most of Fed’s policies as Mondustrial – a monetary policy which is actually like an industrial policy favoring certain markets/sectors. He has been saying the various Fed programs should have been part of fiscal policy.

In his new paper he says Fed needs an exit rule to get out of its remaning programs (r’ber most of liquidity facilities have ended already).

An exit strategy to take the Fed to this monetary framework must focus on three things: (1) the federal funds rate, (2) the level of reserve balances (or the size of the Fed’s balance sheet), and (3) the composition of the Fed’s portfolio of assets. In order to achieve this goal the direction of change of all three is clear: The interest rate must rise above its current abnormally dedicated to the extraordinary programs such as TALF, MBS, and the Bear-Stearns-AIG facilities must be reduced. The timing and the amount by which these changes are made should depend on economic conditions.

Federal Reserve Board Chair Ben Bernanke (2009) has clearly described the instruments that are available to the Fed during an exit strategy, including paying interest on reserve balances, borrowing by the Fed to finance its extraordinary measures, and reducing reserve balances further by unwinding the extraordinary measures.

An exit strategy, however, is more than a list of instruments. It is a policy describing how the instruments will be adjusted over time until the monetary framework is reached. It is analogous to a policy rule for the interest rate in a monetary framework except that it also describes the level of reserves and the composition of the balance sheet. Hence, an exit strategy for monetary policy is essentially an  exit rule.

And what could the rule be?

One possible rule would link the FOMC’s decisions about the interest rate with its decisions about the level of reserves. In other words, when the FOMC decides to start increasing the federal funds rate target, it would also reduce reserve balances. One reasonable exit rule would reduce reserve balances by $100 billion for each 25 basis point increase in the federal funds rate. By the time the funds rate hits 2 percent, the level of reserves would be reduced by $800 billion and would likely be near the range needed for supply and demand equilibrium in the money market. The Trading Desk at the New York Fed would then be in a position to carry out the interest rate decisions of the FOMC as it has in the past, and the exit would be complete. Of course, at the start of this process, the FOMC is likely to need the assistance of increases in interest rates on reserves because of the high current level of reserves. And it might be wise to start reducing reserves by $100 billion or $200 billion before interest rates start to rise, because reserves are well above $800 billion now.

Where does the “$100 billion per quarter point” come from? We do not know much about the reserve-interest rate relationship, but $100bn per 25bps is close to what was observed when the Fed started increasing reserves in the fall of 2008. As shown in Figure 5 the funds rate fell from 2 percent to 0 percent as the Fed increased the supply of reserves by $800 billion.  Of course we do not know if this relationship will hold now with changed circumstances in the  banking sector, but it is a reasonable place to begin.

Interesting thought and quite a different one as well. +

Addendum:
You know I keep thinking if Taylor had been at Fed. Would he have run the monetary policy as he has been saying based on rules etc. It is a good theoretical idea but is it easy to implement?  Don Kohn has already looked at limitations of Taylor rule in real time policymaking.