Monetary policy and inflation in times of war (and How Eli Heckscher caused a bank run at the Riksbank in 1920)

Riksbank Deputy Governor Henry Ohlsson in this speech discusses inflation in Sweden in 4 wars: WWI, WWII, Korean War in 1960s and Middle East War in 1970s.

Inflation rose in all the four wars but overall outcomes etc were different:

“When major and unusual events such as the war in Ukraine occur, there is no ‘manual’ for how to act as an economic policy decision-maker. All wars are different – in terms of their scale and duration, their location and their impact on the world around them.”

This is how Henry Ohlsson began his speech at Uppsala University, where he described what research literature has to say about the connection between war and inflation. He also looked back at earlier episodes of war being associated with rising inflation in Sweden.

He highlighted four episodes: the First World War, the Second World War and the Korean War, and, starting in the mid-70s, a more prolonged episode of war in the Middle East. The first three wars were marked by a more short-term inflation, while inflation became more persistently high during the latter period, largely because economic policy became too expansionary.

What about inflation today:

Henry Ohlsson said that Sweden now has better conditions for coping with the balancing act that rising inflation entails for monetary policy, compared with when inflation began to rise in the 1970s. He highlighted three factors behind this: the inflation target, the wage-formation model and the fact that today there is a more robust fiscal policy framework in place.

So what can we learn from history with regard to our current situation? asked Mr Ohlsson. During many of the periods of high inflation in connection with war, the effects of monetary policy have been heavily dependent on the expectations of companies and households regarding future economic developments.

“The price increases we have seen in recent months are not something that monetary policy can affect. But the high inflation risks setting off a spiral of price increases, wage drift, price increases, wage drift and so on. It is essential to ward off these tendencies in time. It was therefore time to change the direction of monetary policy and start raising the repo rate” concluded Mr Ohlsson.

Ohlsson also discusses this interesting economic history episode in Sweden related to Eli Heckscher. The eminent economist of Heckscher-Ohline mode caused a run on the central bank in 1920s:

An interesting, but perhaps not so well-known, event during this period was that Eli Heckscher, professor at the Stockholm School of Economics and internationally renowned economist, actually caused a bank run at the Riksbank in 1920.  Although the inflation peak had passed, inflation at the beginning of 1920 was still so high that Heckscher thought that the Riksbank should raise the discount rate significantly. When the Riksbank did not want to do this, Heckscher decided to do something about it.

The right to exchange notes for gold had ceased in connection with the outbreak of the war in 1914, but was reintroduced in 1916. However, since an export ban on gold had been introduced in 1914, this did not mean in practice that the gold standard had been re-established. The export ban allowed the gold price to differ between countries and the value of the krona to change against other currencies. This was also the case as the krona depreciated against the dollar.

At the US Federal Reserve, the price of one kilogram of gold in the depreciated Swedish currency was SEK 3,600 at the beginning of 1920. At the Riksbank, the price of one kilo of gold was instead SEK 2,480. If the export ban were to be lifted, then a considerable arbitrage gain could be made.

Heckscher decided to draw the general public’s attention to this fact and did so through an article entitled “The new price revolution” (Den nya prisrevolutionen), published in the daily newspaper Stockholms Dagblad on 11 March 1920. The article was more or less an explicit encouragement to readers to withdraw their money from the bank and go to the Riksbank to redeem it for gold: “Anyone who brings SEK 1,000 in banknotes to the Riksbank has the legal right to receive 50 SEK 20 [gold coins] and these currently have a value of SEK 1,450 – 45%
profit on the most risk-free of investments”

The final results were indeed an onslaught of people who wanted to redeem their banknotes at the Riksbank, who were therefore forced to raise the discount rate in order to defend the gold reserve. In connection with this, the Riksbank requested release from the obligation to redeem banknotes for gold, which was subsequently also granted.

Hmm..

Irrigation Management for Sustainable Agriculture

Rishabh Kumar, Jobin Sebastian and Arun Vishnu Kumar in RBI’s May-22 Bulletin analyse irrigation in 19 States:

In the backdrop of recurrent episodes of drought and declining ground water table, ensuring irrigation efficiency is of paramount importance for sustainable agriculture. This article analyses the trends in the area-weighted cost and efficiency of irrigation across 19 agriculturally important Indian states using the Comprehensive Cost of Cultivation data published by the Ministry of Agriculture and Farmers’ Welfare, Government of India for the period from 2002-03 to 2017-18.

Highlights:

• • The area-weighted cost of irrigation declined during the study period perhaps reflecting the impact of increased access to subsidised power in most of the states. However, the costs are still high in some states.
  • The estimated technical efficiency of irrigation suggests that majority of the states lie far from the efficiency frontier and have also recorded declining trends over the study period.
  • The inefficiency appears to be driven by the energy consumption in the farm sector and ground water accessibility.
  • The findings call for policy focus on energy and water efficient irrigation technologies, particularly in states where irrigation efficiency is declining.

How Economics Found Science …and Lost its Subject Matter

Nicholas Gruen in this INET article questions the often quoted trade off between efficiency and equality by economics:

My point has simply been to show one theoretical framing of the relationship between efficiency and equality that proceeds from careful, critical observation of and abstraction from reality. If this is well-judged, our understanding of reality improves as do our prospects of improving it. The textbook approach couldn’t be more different. Turns out that it is metaphysical fairy-floss. The “efficiency-equality” trade-off exists as a particular case of the general one that if you wish to achieve one thing, doing something else could get in your way. That applies whether the things in question are apples, oranges, efficiency, spelling prowess, bananas, Nobel Prizes, stop signs, or fortune cookies. Oh — I nearly forgot — and equality. Who knew?

Disciplines like economics can be worse than useless without proper attention to what Mary Midgely called their ‘philosophical plumbing’ — the way their organizing ideas are brought into relation to get us closer to reality — like the philosophical plumbing I’ve offered in this essay. Without it, the ideas and techniques economists use are unmoored from any wider accountability for actually helping us understand the world. Yet that kind of close-grained reflectiveness about the way ideas are used in situ is completely absent, both from learned journal literature and from the core economics curriculum. (Indeed, in my experience, it barely makes its way into the “philosophy/methodology of economics” literature and pedagogy preoccupied as they have been with various more ponderous set pieces — for instance, Popper’s falsificationism and Milton Friedman’s call to judge theory by the quality of its predictions rather than the realism of its assumptions).

Finally, note how frequently the kind of thinking I’ve been critiquing in this essay perpetrates the fallacy of the excluded middle — and how much damage this has done to the fabric of economic and political debate, and therefore to our economy and polity. Thus, Friedrich Hayek compellingly demonstrated the impracticability of managing a complex economy entirely from the center. But he took this demonstration of the impracticality of one extreme to justify a lurch towards the other and the general principle that less government was in principle preferable to more. This piece of motivated impatience in going from arguments to practical conclusions — so typical of intellectuals — was a spectacular non-sequitur from which many economists have still not freed themselves and from which the world has still not recovered.

 

NSDL@25: Ushering India’s stock market through the digital era for 25 years

National Securities Depository Limited (NSDL) recently celebrated its 25th anniversary.

My article in Moneycontrol on how this organisation silently paved way for digitalisation of equity markets.

Differences between foreign state-owned banks and foreign private-owned banks..

Marcin Borsuk, Oskar Kowalewski and Pawel Pisany in this ECB paper study differences in foreign state-owned banks vs foreign private owned banks:

In this study, we reassess the links between commercial bank ownership and lending growth during the 1996–2019 period. We !nd evidence that the lending activities of foreign state-controlled and foreign privately owned banks differ, particularly during different crisis type periods and origins. Foreign state-controlled banks’ loan growth rates are higher than those of foreign private owned banks during host banking crises. By contrast, foreign state-controlled banks reduce their credit growth during a home banking crisis, while foreign private-owned banks increase lending in the host countries. Moreover, we find evidence that bank-specific characteristics were more important determinants of credit growth than ownership structure during the global financial crisis of 2008 and gain in importance in the post-crisis period.

How easy is it to understand central bank publications?

I wrote about RBI’s communications last week asking whether people/markets understand what RBI says?

Timothy Munday of Bank of England in this Bank Underground post asks similar question related to Bank of England:

How easy is it to understand this sentence you are currently reading? How easy it is to understand this sentence that has dependency arcs that are longer that make it more difficult to read? How about if my writing is magniloquent? Or what if I use normal words? Writing style matters for how easy it is to read text. This post asks if writing style can influence how long markets take to digest Bank of England monetary policy information. I find that Bank of England publications that summarise their content in the first sentence, and use less unexpected vocabulary, are associated with a faster time for swap markets to reach a new equilibrium price following the publication release.

The Monetary Policy Report (MPR), Minutes and other publications have material effects on asset prices (Hansen, McMahon and Tong (2019). But these moves in asset prices may take hours (or days) to materialise. The November 2021 MPR was 56 pages long. That publication was released simultaneously with the Minutes, which was 15 pages long. Subsequently, there was an hour long Q&A, the text of which was 14 pages long when transcribed. In other words, markets received a deluge of information. That information will only be fully reflected in asset prices when market participants have had time to read and digest the publications.

A discussion of what the Bank of England’s Monetary Policy Committee (MPC) chooses to say in these documents is well above this author’s pay grade. It is the result of a long process of deliberation by the MPC and staff. The content of that discussion, the outcome of the MPC’s decision, and the reasons behind it, are taken as fixed.

How the MPC chooses to communicate is a different issue (and indeed has been discussed on this blog before). This post asks if writing style can influence how long markets take to digest Bank of England monetary policy information. In other words, if the Bank of England writes more clearly, does that lead to a faster time for market prices to move to a new equilibrium?

His analysis shows simpler communications do help:

There are two features that are significant at the 5% level and two at the 10% level.

Documents with higher contextual expectancy, first lines that summarise the entire document, words that are more prevalent, and are published on days without a monetary policy decision are associated with a shorter time for the market to reach a new equilibrium.

The length of dependency arcs, the initial market reaction, and, interestingly, the length of the document, do not display any association with the time taken for the market to digest the Bank’s information.

….

The above analysis comes with several caveats, and so our results should be read in with them in mind.

Only correlations between some (handpicked) textual features and how long it takes for the market to settle have been presented. And, of course, correlation doesn’t imply causation. Indeed, there are plausible omitted variables: one could argue that if the Bank of England has a more complicated message to convey, it must write in a more complicated style.

Furthermore, the estimates of how long it takes the market to digest communication are simple, and influenced by news releases that occur after the publications (although these should only add noise to the estimates, not bias them).

Finally, the small sample does mean that the regression lacks power. Coefficients that just dip under a 5% or 10% significant level should not be over-interpreted.

These caveats notwithstanding this is initial evidence that writing style matters, adding to the existing body of work on this topic from the Bank of England (Haldane and McMahon (2018); Bholat et al (2018). Of course content matters, and the Bank of England’s message is of paramount concern when drafting communication. But, at the margin, when that message’s substance has been formed, the style it is presented in can help the market to understand it quicker.

There is one central lesson behind writing: write as simply as possible. This lesson applies to central banks too.

Bridging regulatory gaps for NBFCs

My new article in Financial Express on the recent policies by RBI to bridge regulatory gaps between NBFCs and Banks.

 

Joan Robinson on Karl Marx: “His Sense of Reality Is Far Stronger”

Carolina Alves in the recent issue Journal of Economic Perspectives on Joan Robinson’s turn to Marxism:

This paper revisits why Joan Robinson turned to Karl Marx in 1942 and which insights from Marxian economics she sought to incorporate into her later works, while commenting on how her encounter with Marx was received by some her of contemporaries. By the end of the 1930s, Robinson wanted to bring academic and Marxian economics together in a search for a more realist theory of the rate of profit and income distribution, along with clarifications on Keynes’s concept of full employment and the nature of technical progress and a long-period theory within the Keynesian framework. The result, An Essay on Marxian Economics (1942), was her most important work in terms of laying the foundations of her enduring challenge to the orthodox economics. Here she relied on Marxian insights to escape Marshallian orthodoxy. It is the story of how the originator of imperfect competition pushed further into a theory of exploitation.

Robinson’s essay on Marxism here

 

The digital economy, privacy, and CBDC

Toni Ahnert, Peter Hoffmann and Cyril Monnet in this ECB paper ask the question of privacy issues with rising digital economy and how CBDC can help:

We study a model of financial intermediation, payment choice, and privacy in the digital economy. Cash preserves anonymity but cannot be
used for more efficient online transactions. By contrast, bank deposits can be used online but do not preserve anonymity. Banks use the information contained in deposit flows to extract rents from merchants in need of financing. Payment tokens issued by digital platforms allow
merchants to hide from banks but enable platforms to stifle competition. An independent digital payment instrument (a CBDC) that
allows agents to share their payment data with selected parties can overcome all frictions and achieves the efficient allocation.

It is interesting to think of several scenarios around payments between players and types of transactions. Then see how cash, bank deposits and CBDC help in these transactions.

The Demand for Money, Near-Money, and Treasury Bonds

Arvind Krishnamurthy & Wenhao Li in the new NBER paper:

Bank-created money, shadow-bank money, and Treasury bonds all satisfy investors’ demand for a liquid transaction medium and safe store of value. We measure the quantity of these three forms of liquidity and their corresponding liquidity premium over a sample from 1934 to 2016.

We empirically examine the links between these different assets, estimating the extent to which they are substitutes, and the amount of liquidity per unit delivered by each asset. Treasury bonds and bank deposits are imperfect substitutes, in contrast to the findings of perfect substitutes of Nagel (2016). This result is directly relevant to the monetary transmission mechanism running through shifts in asset supplies, such as quantitative easing policies.

Our results on the imperfect substitutability of bank and shadow-bank money also inform analyses of the coexistence of the shadow-banking and regulated banking system. We construct a new broad monetary aggregate based on our estimates and show that it helps resolve the money-demand instability and missing-money puzzles of the monetary economics literature.

Capital Flow management measures in the digital age

Group of IMF economists (Dong He, Annamaria Kokenyne, Xavier Lavayssière, Inutu Lukonga, Nadine Schwarz, Nobuyasu Sugimoto and Jeanne Verrier) in this IMF FinTech notes raise concerns about cryptos and capital flow management:

Capital flow management measures (CFMs) can be part of the broader policy toolkit to help countries reap the benefits of capital flows while managing the associated risks. Their implementation typically requires that financial intermediaries verify the nature of transactions and the identities of transacting parties but is facing the rising challenge of crypto assets.

Indeed, crypto assets have become a significant instrument for payments and speculative investments in some countries. They can be traded pseudonymously and held without identification of the residency of the asset holder. Many crypto service providers operate across borders, making supervision and enforcement by national authorities more difficult. The challenges posed by the attributes of crypto assets are compounded by gaps in the legal and regulatory frameworks.

This paper aims to discuss how crypto assets could impact the effectiveness of CFMs from a structural and longer-term perspective. To preserve the effectiveness of CFMs against crypto-related challenges, policymakers need to consider a multifaceted strategy whose essential elements include clarifying the legal status of crypto assets and ensuring that CFM laws and regulations cover them; devising a comprehensive, consistent, and coordinated regulatory approach to crypto assets and applying it effectively to CFMs; establishing international collaborative arrangements for supervision of crypto assets; addressing data gaps and leveraging technology (regtech and suptech) to create anomaly-detection models and red-flag indicators that will allow for timely risk monitoring and CFM implementation.

Cyberattacks and Financial Stability: Evidence from a Natural Experiment

Antonis Kotidis and Stacey L. Schreft in this Federal Reserve working paper use a natural experiment to study the impact of cyberattacks on financial stability:

This paper studies the effects of a unique multi-day cyberattack on a technology service provider (TSP). Using several confidential daily datasets, we identify and quantify first- and second-round effects of the event. For banks using relevant services of the TSP, the attack impaired their ability to send payments over Fedwire, even though the Federal Reserve extended the time they had to submit payments.

This impairment (first-round effect) caused other banks to receive fewer payments (second-round effect), leaving them at risk of having too few reserves to send their own payments (a potential third-round effect).

These innocent-bystander banks responded differently depending on their size and reserve holdings. Those with sufficient reserves drew down their reserves. Of the others, smaller banks borrowed from the discount window, while larger banks borrowed in the federal funds market.  These significant adjustments to operations and funding prevented the second-round effect from spilling over into third-round effect and broader financial instability.

These findings highlight the important role for bank contingency planning, liquidity buffers, and the Federal Reserve in supporting the financial system’s recovery from a cyberattack.

Instinctive versus reflective trust in the European Central Bank

Siria Angino and Stefania Secola in this research paper look at two kinds of trusts:

Political science research has established that trust in institutions, including central banks, is shaped by socio-economic and demographic factors, as well as by the assessment of institutional features and by slow-moving components such as culture. However, the role of cognitive processes has largely been neglected, especially in the analysis of central bank trust. In this paper we aim to address this gap focusing on the case of the European Central Bank (ECB).

We introduce the concepts of “instinctive trust”, which captures an on-the-spot judgement on the institution’s trustworthiness, and of “reflective trust”, which refers to a more pondered opinion on the matter. Using a survey experiment, we find that deeper consideration about the ECB promotes less trust in the institution compared to an on-the-spot judgement. This result is mainly driven by women, and in particular by those who say they possess a low understanding of the central bank’s policies.

 

RBI communications: Do you understand what I say?

My new piece on moneycontrol:

Central bank communications have come a long way from being an ignored tool to an important one of monetary policy. RBI clearly can do better 

Made in Russia? Assessing Russia’s potential for import substitution

Heli Simola of Bank of Finland in this paper analyses Russian choices amidst stiff sanctions. Can Russia rely on import substitution?:

Russia’s brutal military aggression on Ukraine has led to extensive economic sanctions by Western countries and the withdrawal of many foreign companies from Russian markets. The isolation of Russia from the international community has substantially restricted its access to advanced technologies and eroded the country’s economic growth potential. Our analysis suggests that Russia has fairly limited possibilities for import substitution in high-technology sectors. China, which could play a key role as an alternative source for inputs, has seen its share of Russian imports, including high-tech inputs, increase substantially in recent years. The extent to which China is willing to support Russia in the current situation remains unclear, however.

 

A tale of two global monetary policies: Federal Reserve and ECB

Silvia Miranda-Agrippino and Tsvetelina Nenova in this Bank of England WP:

We compare the macroeconomic and financial spillovers of the unconventional monetary policies of the Fed and the ECB. Monetary policy tightenings in the two areas are followed by a contraction in global activity and trade, a retrenchment in global capital flows, a fall in global stock markets, and a rise in risk aversion. Bilateral spillovers are also powerful. Fed and ECB monetary policies propagate internationally through the same channels – trade and risk-taking – but the magnitude of ECB spillovers is smaller. We postulate that the relative importance of the euro and the US dollar in the international financial system can help to explain such asymmetries, and produce tentative evidence that links the strength of the ECB spillovers to € exposure in trade invoicing and the pricing of financial transactions.

Not surprised to read the results. Federal Reserve monetary policy has become a global monetary policy due to the role of US Dollar in international financial system and transactions.

Responsibility for Emissions: the Case of the Swiss National Bank’s Foreign Exchange Reserves and the Norwegian Oil Fund

Interesting Banque de France paper by Naef Alain, Klooster Jens van’t compares the two public investment companies: Norway’s sovereign fund and Switzerland’s foreign exchange reserve:

Should public investors take responsibility for the greenhouse gas emissions of the firms that they invest in? This paper answers this question through a comparative study of two very different investors: the Swiss National Bank (SNB)’s foreign exchange portfolio and the world’s largest sovereign wealth fund, the Norges Bank Investment Management (NBIM), the Norwegian sovereign wealth fund.

Although both funds target positive returns, the SNB presents itself as a market neutral investor, whereas the NBIM is one of the world’s leading public ethical investment vehicles.

Despite having a carbon footprint 10 times higher than the SNB, the NBIM potentially has a more positive impact to stop climate change. The NBIM uses divestment, shareholder engagement and moral leadership to try to mitigate the impact of its portfolio. The SNB on the other hand has a mainly passive approach, with only some minor exclusions.

Comparing the impact of their strategies, the paper provides the first detailed study of the powers available to public investors in pursuing environmental objectives.

 

Big techs, QR code payments and financial inclusion

Thorsten Beck, Leonardo Gambacorta, Yiping Huang, Zhenhua Li and Han Qiu in this BIS paper point to spillovers from digital payment footprints:

Using a unique dataset of around half a million Chinese firms that use a QR code-based mobile payment system, we find that (i) the creation of a digital payment footprint allows firms to access credit provided by the same big tech company; (ii) transaction data generated via QR code generate spillover effects on access to bank credit; and (iii) there are positive effects of access to big tech credit on sales, including during the Covid-19 shock. The findings suggest that access to innovative payment methods helps micro firms build up credit history, and that using big tech credit can ease access to bank credit.

Are major advanced economies on the verge of a wage-price spiral?

Frederic Boissay, Fiorella De Fiore, Deniz Igan, Albert Pierres Tejada and Daniel Rees in this BIS Bulletin article:

• Inflation has returned, reaching levels not seen in decades. Whether inflation enters a persistently higher regime will depend on labour market developments, and on whether a wage-price spiral emerges.
• To date, evidence for a broad acceleration in wage growth is mixed. Wage growth has picked up significantly in the United States, but remains moderate in most other advanced economies, despite tentative signs of a renewed sensitivity of wages to inflation in some segments of the labour market and a pickup in inflation expectations.
• But extrapolating behaviour from low-inflation periods is problematic. If inflation remains high, households may ask for higher wages to make up for lost purchasing power and firms may raise prices to protect profit margins. And stubbornly high inflation may lead to institutional changes such as automatic indexation and cost-of-living adjustment clauses.

 

Warming Arctic to prompt new trade routes and new cold war

William Coningsby-Brown in this OMFIF article:

The Arctic is warming faster than anywhere else on the planet and could be free of summer sea ice by 2035. This would open up a region with vast natural resources and unrealised trade routes.

Trans-Arctic trade routes create opportunities for the control of new global shipping lanes, including the northern sea route, northwest passage and northeast passage (see map). The NSR has the most potential, shortening the traditional Suez canal route between northern Europe and China by 40%. With sea ice already retreating, the route has been tested not only in the warmer months, around September, when the sea ice is at its minimum. In the summer of 2018, Danish shipping company Maersk sent a container freighter through for the first time, while in February 2021 a large commercial cargo ship completed the route for the first time in the middle of winter.

Trade is already on the rise. In 2020, 33m tons of goods were shipped on the NSR, up from 1.5m in 2019. Countries around the NSR are investing in trade infrastructure, with Russia leading the way, showing a long-term commitment to the route.

But this is not just a battle for commercial sea lanes. Melting ice allows greater access to oil and mineral reserves, with estimates that nearly 25% of the earth’s undiscovered, recoverable petroleum resources lie in the region. Add to that the vast number of fish that live in the plankton-rich waters and this could drive a new gold rush among northern nations competing to get their hands on these valuable resources.

I have no idea about Arctic but shouldn’t we worry more about the impact of Arctic’s warming on sea-life, water flow and so on?