I sportsed all over Prague

On Sunday the 3rd of May, 2015 (two weeks before I officially turn old), I finally achieved a life-long ambition of running a marathon. I ran in the Prague Marathon organised by RunCzech. My official race time was 4:08:02, but since it took me over five minutes to cross the start line, my actual time was 4:02:24.

My training was not particularly rigorous — the longest I had run beforehand was 27km (about 16.5 miles) — and I was really only aiming to finish, so to finish so close to four hours is incredibly gratifying. I spent the vast majority of the race ahead of the 4-hour pace setters, but hit my own version of the wall in the 38th kilometre. These two charts summarise my experience. The first chart lists my times for each kilometre, with the red line being the rate needed to achieve four hours (the peak in the 21st km is a pee break). The second gives my time relative to that 4-hour target (in seconds). At the 34km mark, I was 244 seconds (4 minutes, 4 seconds) ahead of the 4-hour pace, meaning that I lost roughly six and a half minutes in the last 8.2 km.

PragueMarathon

The biggest thing I learned from the experience is that there is no such thing as “the” wall — there are at least three walls!

The first wall is simple glycogen depletion, possibly combined with dehydration. I’m pretty sure this was not an issue for me, although I am starting to wonder (see below). I had stuffed my face with pasta (and protein) for days beforehand, I downed a Clif Bar immediately prior to the race and I was munching on a Clif Shot Blok every 5km. I was also drinking water regularly, to the point of needing to stop to pee at the half-way mark. Having said that, I now realise that I was only consuming about 20g of carbs per hour, which is considerably less than the commonly recommended 40-60g. I never experienced any of the usual glycogen depletion symptoms, like a brain fade, though. I always felt like I had energy.

The second wall is psychological. Since my longest ever run beforehand was only 27 km, I was acutely aware of the distance once I headed north of 25km and had to talk my way through it in the 28-30 km range. Certainly once I’d gotten to 32 km and was able to tell myself “10 km to go”, this issue seemed to pass completely.

The third wall, which I had not considered at all beforehand, was a dramatic emergence of muscle pain in my quads from about 35km onwards. At first, it just felt like muscle burn from doing hill sprints, but it got worse and just after the 37km mark it became so bad that I had to stop and walk. I tried stretching, but that somehow only made it worse, into a blinding pain that shut out almost all other sensory experience.

I walked and occasionally shuffle-jogged for the next 2km before the pain started to ease and I was able, with a grit-the-teeth-and-focus-like-a-goddamn-laser sort of effort, to keep myself jogging constantly for the final 3 km. Watching the 4-hour pace setters run past me while I was walking was not a pleasant experience.

It was not a pulled muscle (a muscle strain) — it was in both legs and it eased over the next couple of days as I recovered in ways that a strain would not. I also do not think it was glycogen depletion, as I (believe that I) remained lucid and had energy throughout. Instead, I think it was “dead quads”, of the sort described here and here. If I’m correct, then it amounted to insufficient training and, in particular, insufficient strength training. Weirdly enough, it also suggests that if I had stopped and stretched my hamstrings halfway through the event, it might not have been so bad.

You can see how poor my form was at the end here (notice how robotic the leg movements are, and how I’m just lifting my feet and then dropping them like bricks):

If that makes it seem like I’m disappointed, I promise that I’m not! It was an incredible experience that I enjoyed immensely and would encourage anybody to try. I’m already scoping out my second …

Digital currencies, including Bitcoin

Back in 2011, I wrote a post about Bitcoin.

In March 2013 I started employment at the Bank of England and this blog went into dormancy.

My view evolved somewhat since then. Interested readers might care to read two new articles in the Bank’s Quarterly Bulletin on digital currencies. I was a co-author on both of them.

http://www.bankofengland.co.uk/publications/Pages/quarterlybulletin/2014/qb14q3prereleasedigitalcurrenciesbitcoin.aspx

That link also includes two videos (hosted on YouTube), one of which features my head talking awkwardly.

Now dormant

Since March 2013 I have been employed by the Bank of England and, as such, am unable to offer public comment on matters that might relate to the work of the Bank or politics in the UK.

I may, at some point, return to blogging here on matters outside the domain of my work; but for now, this blog will remain dormant.

The Tesla vs. John Broder (of the NY Times) fiasco

(Updated to include all of Broder’s published pieces on the matter)

After their 2011 cock-up with their Top Gear review, you might be forgiven for thinking that Tesla had learned a valuable lesson.  Nope.

Here (10 Feb 2013) is the review by John Broder of the NY Times, in which he roundly disparages the Tesla Model S.  Elon Musk — Chairman, Product Architect and CEO of Tesla — firmly disputed Broder’s account of what happened.

Here (12 Feb 2013) is Broder’s second piece on the matter, in which he defends the allegations he made in the review.

Here (13 Feb 2013) is Tesla’s public response, including detailed logs of what the car was actually doing.  On the face of it, this appears to completely vindicate Musk (not to mention raise questions about Broder’s approach to journalism).

Here (14 Feb 2013) is Broder’s third piece, with a point-by-point reply to Tesla’s blog entry.  Many, if not all, of his points sound reasonable.

At this point, the whole thing is a he-said-she-said debacle.

None of that matters, though.

Tesla screwed up here, and badly. Not technically (i.e. from an engineering perspective), but definitely on the marketing side.

It might be cynical, but looking into the past work of the dude assigned to evaluate your product is just basic PR management. What kind of marketing director doesn’t sit down and think about what prior biases any given reviewer might have? I suppose I can understand failing to think about it the first time, but twice is just plain stupid.

Especially because of the fiasco with Top Gear and Broder’s (apparently) demonstrated prior beliefs, but fundamentally just as a basic courtesy, why didn’t Tesla tell Broder and the NY Times up front that everything would be logged? Heck, why not ask (or even insist) beforehand that the log data be made publicly available alongside the article? Isn’t a near endless supply of data about the car a selling point?

Tesla is a near perfect example of the simple fact that good engineering and good design are not sufficient to produce a successful product.

Nobody approaches a new thing (product, topic, event, whatever) with a completely open mind. Everybody has pre-conceived notions that shape (i.e. bias) their experiences.  It’s called “being human.” Failure to recognise and work with that simple fact demonstrates an almost child-like naivety. Seriously, does everybody at Tesla think that Apple is successful only because of their design and engineering?

Tesla fans are going to feel smug over this whole affair.  Telsa itself is going to lose potential customers.

 

Hate too-big-to-fail banks? Then you should love CDOs …

A random thought, presented without much serious consideration behind it:

The more we do away with too-big-to-fail banks, the more we need CDOs and the like to provide risk and liquidity transformation.

Suppose we replace one giant, global bank with many hundreds of small banks. Each small bank will end up specialising in specific industries or geographic regions for reasons of localised economies of scale. There exists idiosyncratic risk — individual industries or geographic regions may boom or go belly up. A giant, global bank automatically diversifies away all that idiosyncratic risk and is left with only aggregate (i.e. common-to-all) risk. Individually and in the absence of CDOs and the like, idiosyncratic risk will kill off individual banks. With CDOs and their ilk, individual banks can share their idiosyncratic risk without having to merge into a single behemoth.

In the event of a true aggregate shock, the government will end up needing to bail out the financial industry no matter what the average bank size because of the too many to fail problem.

There are problems with allowing banks to become TBTF.  They end up being able to raise funding at a subsidised rate and their monopoly position allows them to charge borrowers higher rates, both contributing to rent extraction which is both economically inefficient (the financial industry will attract the best and the brightest out of proportion to the economic value they contribute) and fundamentally unfair. Worse, the situation creates incentives for them to take excessive risks in their lending, leading to a greater probability of an aggregate shock actually occurring.

But we are now trying to kill off TBTF in a world in which credit derivatives have either vanished altogether or are greatly impaired. On the one hand, that reduces aggregate risk because we take away the perverse incentives offered to TBTF banks, but on the other hand, it also reduces our ability to tolerate idiosyncratic risk because we take away the last remaining means of diversification.

Calm down people. Kocherlakota is still a hawk.

A certain kind of nerd is excited about this recent speech by Narayana Kocherlakota, the president of the Minneapolis arm of the Federal Reserve.  Watching him speak, some people think they saw a leopard not only change its spots, but but paint stripes on as well.

The reason?  Well, Kocherlakota is famously an inflation hawk (we do like our animal analogies, don’t we?), but in the speech he argued that the Fed should commit to keeping interest rates at “exceptionally low levels” until unemployment in America falls to 5.5% (it’s currently 8.3% and was last at 5.5% around May 2008) and, as a general rule, inflation hawks are not meant to care about unemployment.  They’re meant to focus, like a hawk, on inflation.  Here are Bloomberg, Joe Weisenthal, Neil Irwin, FT Alphaville, Felix Salmon, Tim Duy, Scott Sumner, Aki Ito and Brad DeLong (I don’t mean to suggest that these guys are all suggesting that Kocherlakota has become a dove — they’re just all worth reading).

Let’s look at his speech (I’m mixing his words up a little, but the words and their meaning are the same):

As long as longer-term inflation expectations are stable and that the Committee’s medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent, [the FMOC] should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

This is not the statement that a dove would make.  A dove would be speaking about giving weight to both unemployment and inflation in any decision rule.  A NGDP-targetter, if forced against their will to speak in this language, would speak of something close to a 50-50 weighting, for example.  But that’s not what Kocherlakota is saying here.  He is instead saying that the Fed should keep long-term expectations of inflation stable (presumably at 2%) and, in any event, freak out if inflation over the coming year is likely to be any higher than 2.25% and only then, when as an inflation hawk he has nothing to worry about, should the Fed be willing to look at unemployment.

These are still lexicographic preferences.  “Fight inflation first and ignore unemployment while you’re doing it,” he is saying.  “Then look at unemployment (but be prepared to ditch it if inflation so much as twitches).”

As I say, these are not the ideas of an inflation dove.

It does represent at least a slight shift, though.  As Tim Duy makes clear, last year he thought a core PCE inflation rate of 1.5% would be enough to trigger an increase in interest rates, whereas now he appears to be focusing on 2.25% in headline CPI inflation.  Those are different objects, though, so it’s not always apples-to-apples.

Instead, I perceive two main shifts in Kocherlakota’s viewpoint:

First, and most importantly, he has been convinced that much of America’s currently-high unemployment is because of deficient demand and not, as he used to hold, because of structural (i.e. supply-side) factors.  Here is a snippet from an interview he did with the FT:

“I’m putting less weight on the structural damage story,” said Mr Kocherlakota, arguing that recent research on unemployment pointed more towards “persistent demand shortfalls”. Either way, he said, “the inflation outlook is going to be pretty crucial in telling the difference between the two”.

The recent research he mentions, at least in part, will be this paper by Edward Lazear and James Spletzer presented recently at Jackson Hole.  Here’s the abstract:

The recession of 2007-09 witnessed high rates of unemployment that have been slow to recede. This has led many to conclude that structural changes have occurred in the labor market and that the economy will not return to the low rates of unemployment that prevailed in the recent past. Is this true? The question is important because central banks may be able to reduce unemployment that is cyclic in nature, but not that which is structural. An analysis of labor market data suggests that there are no structural changes that can explain movements in unemployment rates over recent years. Neither industrial nor demographic shifts nor a mismatch of skills with job vacancies is behind the increased rates of unemployment. Although mismatch increased during the recession, it retreated at the same rate. The patterns observed are consistent with unemployment being caused by cyclic phenomena that are more pronounced during the current recession than in prior recessions.

Second (and to some extent, this is just a corollary of the first), Kocherlakota is now emphasising that conditional on inflation being tightly restrained, he is happy to deploy (almost) any amount of stimulus to help improve the employment situation, whereas previously his emphasis was on how additional stimulus would lead to more inflation.

In other words, I read this speech as evidence that Kocherlakota’s underlying philosophy remains unchanged, but his perception of the problems to which he needs to apply that philosophy has changed.  That doesn’t make him a leopard changing it’s spots, that makes him principled, intelligent and open minded.

Naturally, Mark Thoma said all of this before me, and better than I could have.

Update:

Ryan Advent, over at the Economist’s Free Exchange, also has a comment worth reading. He expands a little on the two points I mention:

As Mr Kocherlakota points out, one advantage of the threshold approach (an advantage shared by NGDP targeting) is that it allows members to remain agnostic about the extent of structural unemployment in the economy. If unemployment is mostly structural, the inflation threshold will be crossed first; if not, the unemployment threshold will. Either way, the Fed has set its tolerances and adopted a policy to get there.

… which is something that I had originally meant to highlight in this post (honest!). Ryan continues:

(I will point out, however, that the threshold approach implies contracting in the fact of negative structural shocks and easing in the face of positive productivity shocks while NGDP targeting will generally pull in the opposite direction, more sensibly in my view.)

That’s the real debate, right there. Generally everyone agrees on what to do when faced with a demand shock, but how to deal with supply shocks continues to be a matter of considerable disagreement, no doubt to the frustration of both sides. That and how best to disentangle the data to identify whether a shock, or more correctly an assortment of shocks is, on net, mostly supply or mostly demand.

Monetary policy, fear of commitment and the power of infinity

This is a fascinating time to be thinking about monetary policy…

Like everybody else, central banks can do two things:  they can talk, or they can act.

Some people say that talk is cheap and, in any event, discretion implies bias.

Other people point out that things like central bankers’ concern for their reputation mean that it’s perfectly possible to promise today to implement history-dependent policy tomorrow. Some cheeky people like to point out that this amounts to saying that, when in a slump, a central bank should “credibly commit to being irresponsible” in the future.

In fact, some people argue (pdf) that, in my words, “all monetary policy is, fundamentally, about expectations of the future.”  But if that’s the case, why act at all? Why not just talk and stay away from being a distorting influence in the markets?

There are two reasons: First, since since talk is cheap, credibility requires that people know that you can and, if necessary, will act to back it up (talk softly and carry a big stick). Second, because if you can convince people with actions today, you don’t need to explicitly tell them what your policy rule will be tomorrow and central bankers love discretion because no rule can ever capture what to do in every situation and well, hey … a sense of mystery is sexy.

OMO stands for “Open Market Operation”. It’s how a central bank acts.  Some scallywags like to say that when a central bank talks, it’s an “Open Mouth Operation.” Where it gets fun (i.e. complicated) is that often a central bank’s action can be just a statement if the stick they’re carrying to back it up is big enough.

In regular times, a typical central bank action will be to announce an interest rate and a narrow band on either side of it. In theory, it could be any interest rate at all, but in practice they choose the interest rate for overnight loans between banks. They then commit to accepting in or lending out infinite amounts of money if the interest rate leaves that narrow band. Infinity is a very big stick indeed, so people go along with them.

So what should a central bank do when overnight interest rates are at (or close to) zero and the central bank doesn’t want to take them lower, but more stimulus is needed?

Woodford-ites say that you’ve got to commit, baby. Drop down to one knee, look up into the economy’s eye and give the speech of your life. Tell ’em what you promise to do tomorrow. Tell ’em that you’ll never cheat.  Pinky-swear it … and pray that they believe you.

Monetarists, on the other hand, cough politely and point out that the interest rate on overnight inter-bank loans is just a price and there are plenty of other prices out there. The choice of the overnight rate was an arbitrary one to start with, so arbitrarily pick another one!

Of course, the overnight rate wasn’t chosen arbitrarily. It was chosen because it’s the price that is the furthest away from the real economy and, generally speaking, central bankers hate the idea of being involved in the real economy almost as much as they love discretion. They watch it, of course. They’re obsessed by it. They’re guided by it and, by definition, they’re trying to influence it, but they don’t want to be directly involved. A cynic might say that they just don’t want to get their hands dirty, but a realist would point out that no matter the pain and joy involved in individual decisions in the economy, a cool head and an air of abstraction are needed for policy work and, in any event, a central banker is hardly an industrialist and is therefore entirely unqualified to make decisions at the coalface.

But as every single person knows, commitment is scary, even when you want it, so the whole monetarist thing is tempting. Quantitative Easing (QE) is a step along that monetarist approach, but the way it’s been done is different to the way that OMOs usually work. There has been no target price announced and while the quantities involved have been big (even huge), they have most definitely been finite. The result? Well, it’s impossible to really tell because we don’t know how bad things would have been without the QE. But it certainly doesn’t feel like a recovery.

Some transmission-mechanism plumbers think that the pipes are clogged (see also me).

Woodford-ites say that it’s because there’s no love, baby. Where’s the commitment?

Monetarists say that infinity is fundamentally different to just a really big number.

Market monetarists, on the other hand (yes, I’m sure you were wondering when I’d get to them), like to argue that the truth lies in between those last two. They say that it’s all about commitment (and without commitment it’s all worthless), but sometimes you need an infinitely big stick to convince people. They generally don’t get worked up about how close the central bank’s actions are to the real economy and they’re not particularly bothered with concrete steps.

So now we’ve got some really interesting stuff going on:

The Swiss National Bank (a year ago) announced a price and is continuing to deploy the power of infinity.

The European Central Bank has switched to infinity, but is not giving a price and is not giving any forward guidance.

The Federal Reserve has switched to infinity and is giving some forward guidance on their policy decision rule.

The Bank of England is trying to fix the plumbing.

It really is a fascinating time to be thinking about this stuff.

More on Woodford and QE

Continuing on from my previous post, I note that James Hamilton has also written a piece on Woodford’s paper [pdf here].  He expands on another way in which QE in the form of long-dated asset purchases could have an effect on the real economy:  the pricing kernel is almost certainly not constant.  Before I get to him, though, recall Woodford’s argument:

But it is important to note that such “portfolio-balance effects” do not exist in a modern, general-equilibrium theory of asset prices — in which assets are assumed to be valued for their state-contingent payoffs in different states of the world, and investors are assumed to correctly anticipate the consequences of their portfolio choices for their wealth in different future states — at least to the extent that financial markets are modeled as frictionless. It is clearly inconsistent with a representative-household asset pricing theory (even though the argument sketched above, and many classic expositions of portfolio-balance theory, make no reference to any heterogeneity on the part of private investors). In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, where the present value is calculated using an asset pricing kernel (stochastic discount factor) derived from the representative household’s marginal utility of income in different future states of the world. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, the representative household’s marginal utility of income in different states of the world should not change. Hence the pricing kernel should not change, and the market price of one unit of a given asset should not change, either, assuming that the risky returns to which the asset represents a claim have not changed.

Given that context, here’s Hamilton:

In a recent paper with University of Chicago Professor Cynthia Wu, I discussed this theory. We noted that 3-month and 10-year Treasury securities are treated by the private market as very different investments. Based on a very long historical record we can say with some confidence that, if the U.S. Treasury were to borrow $10 B in the form of 3-month T-bills and roll these over each quarter for a decade, it would end up on average paying a substantially lower total borrowing cost than if it were to issue $10 B in 10-year bonds. If it’s really true that nothing in the world would change if the Treasury did more of its borrowing short-term, the natural question is why does the Treasury issue any 10-year bonds at all?

I think if you ask that question at a practical, institutional level, the answer is pretty obvious– the Treasury believes that if all of its debt were in the form of 3-month T-bills, then in some states of the world it would end up being exposed to a risk that it would rather not face. And what is the nature of that risk? I think again the obvious answer is that, with exclusive reliance on short-term debt, there would be some circumstances in which the government would be forced to raise taxes or cut spending at a time when it would rather not, and at a time that it would not be forced to act if it instead owed long-term debt with a known coupon payment due.

The implication of that answer is that the assumption underlying Woodford’s analysis — that changing the maturity structure would not change the real quantity of resources available for private consumption in any state of the world — is not correct.

Hamilton goes on to point out that a similar risk-aversion story may be at play at the Federal Reserve:

I think the Fed’s reluctance to do more has to do with the same kind of risk aversion exhibited by the Treasury, namely, large-scale asset purchases tie the Fed into a situation in which, under some possible future scenarios, the Fed would be forced to allow a larger amount of cash in circulation than it would otherwise have chosen.

Which is funny, if only for a specialised sub-set of humanity, because it translates into the Fed being worried that by engaging in stimulus whose effect ranges from weak to uncertain, they may be forced to engage in stimulus that will absolutely work.

Woodford, QE and the BoE’s FLS

I’ve been thinking a bit about the efficacy of QE, the potential benefits of the Bank of England’s Funding for Lending Scheme (FLS) [BoE, HM Treasury] and the new paper Michael Woodfoord presented at Jackson Hole [pdf here] (it’s a classic Woodford paper, by the way, even if it is is almost entirely equation free: a little difficult to wrap your head around, but ultimately very, very insightful).  Woodford’s conclusion starts with an excellent statement of the problem:

Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit.

The interest-rate lower bound here is not necessarily zero, but rather whatever rate is paid on excess reserves, which may indeed be equal to zero, but need not be.  In the US, interest on reserves for depository institutions has been 0.25% since Oct 2008; in the UK it has been Bank Rate, currently 0.5%, since Mar 2009.  In principle, one might push the interest rate paid on reserves into negative territory, but such an action would come at the cost of destroying a subset of the money market and with a very real risk that economic agents (banks or, worse, businesses and households) would instead choose to hold their money in the form of physical currency.

Woodford advocates a strong form of forward guidance — that is, the abandonment of restriction (i) — as the optimal policy at the present time, on the basis that all monetary policy is, fundamentally, about expectations of the future.  In particular, he uses the paper to make an argument for nominal GDP level targeting.

This is vitally important stuff, but in this post I want to talk about quantitative easing, in the general sense of the phrase, or what Woodford far more accurately refers to as “balance sheet policies.”

First up is the purchase of short-dated safe assets, paid for with the creation of new reserves.  For the financial sector, this means giving up a safe, liquid asset with a steady revenue stream in return for money.  In normal times, the financial sector might then seek to increase their lending, providing a multiplier effect, but with interest rates on short-dated safe assets at the same level as interest paid on reserves, the financial position of the bank does not change with the purchase, so their incentive to lend can’t increase.  In this case, the short-dated safe asset has become a perfect substitute for money and, absent any forward guidance, such a policy can have no effect on the real economy.  Krugman (1998) and Eggertson and Woodford (2003) provide two-period and infinite-horizon treatments respectively.  Forward guidance in this setting might be anything from the private sector observing the purchases and inferring a more accommodative policy stance in the future (and the central bank doing nothing to disabuse them of that belief) to an outright statement from the central bank that the increase in reserves will be permanent.

Next up is the idea of purchasing long-dated safe assets, or even long-dated risky assets.  Woodford stresses that this can be decomposed into two distinct parts:  An initial expansion of the central bank’s balance sheet via the purchase of short-dated, safe assets and then an adjustment of the composition of the balance sheet by selling short-dated safe assets and buying long-dated assets.  Since the first step is thought to be ineffective (by non-Monetarists, at least), any traction should be obtained in the second step.

But because the second step represents either an adjustment in the relative supply of short- and long-dated government debt (in the case of limiting oneself to safe assets) or an allocation of capital directly to the real economy (in the case of purchasing risky assets), this is arguably fiscal policy rather than monetary and should perhaps be better done by the Treasury department.  Putting that concern to one side, I want to consider why it might, or might not, work.

The standard argument in favour is that of portfolio rebalancing: now holding extra cash and facing low yields on long-dated safe assets, a financial actor seeking to equate their risk-adjusted returns across assets should choose to invest at least some of the extra cash in risky assets (i.e. lending to the real economy).  Woodford emphasises that this story implicitly requires heterogeneity across market participants:

But it is important to note that such “portfolio-balance effects” do not exist in a modern, general-equilibrium theory of asset prices — in which assets are assumed to be valued for their state-contingent payoffs in different states of the world, and investors are assumed to correctly anticipate the consequences of their portfolio choices for their wealth in different future states — at least to the extent that financial markets are modeled as frictionless. It is clearly inconsistent with a representative-household asset pricing theory (even though the argument sketched above, and many classic expositions of portfolio-balance theory, make no reference to any heterogeneity on the part of private investors). In the representative-household theory, the market price of any asset should be determined by the present value of the random returns to which it is a claim, where the present value is calculated using an asset pricing kernel (stochastic discount factor) derived from the representative household’s marginal utility of income in different future states of the world. Insofar as a mere re-shuffling of assets between the central bank and the private sector should not change the real quantity of resources available for consumption in each state of the world, the representative household’s marginal utility of income in different states of the world should not change. Hence the pricing kernel should not change, and the market price of one unit of a given asset should not change, either, assuming that the risky returns to which the asset represents a claim have not changed.

He goes on to stress that if the central bank were to take some risk off the private sector, the risk still remains and, in the event of a loss, the reduction in central bank profits to the treasury would require a subsequent increase in taxes. Consequently, a representative household would experience the loss no matter whether it was formally held by itself or the central bank.  Crucially, too …

The irrelevance result is easiest to derive in the context of a representative-household model, but in fact it does not depend on the existence of a representative household, nor upon the existence of a complete set of financial markets. All that one needs for the argument are the assumptions that (i) the assets in question are valued only for their pecuniary returns [John here: i.e. their flow of revenue and their expected future resale value] — they may not be perfect substitutes from the standpoint of investors, owing to different risk characteristics, but not for any other reason — and that (ii) all investors can purchase arbitrary quantities of the same assets at the same (market) prices, with no binding constraints on the positions that any investor can take, other than her overall budget constraint. Under these assumptions, the irrelevance of central-bank open-market operations is essentially a Modigliani-Miller result.

[…]

Summing over all households, the private sector chooses trades that in aggregate precisely cancel the central bank’s trade. The result obtains even if different households have very different attitudes toward risk, different time profiles of income, different types of non-tradeable income risk that they need to hedge, and so on, and regardless of how large or small the set of marketed securities may be. One can easily introduce heterogeneity of the kind that is often invoked as an explanation of time-varying risk premia without this implying that any “portfolio-balance” effects of central-bank transactions should exist.

Of the two requirements for this irrelevance result, the second is clearly not true in practice, so large-scale asset purchases should, in principle, work even in the absence of any forward guidance, although the magnitude of the efficacy would be in doubt.

On the first, Woodford does acknowledge some work by Krishnamurthy and Vissing-Jorgensen (2012) which shows that US government debt possesses non-pecuniary qualities that are valued by the financial sector.  In particular, safe government debt is often required as collateral in repo transactions and this requirement should give such assets value above that implied by their pure pecuniary returns.  However, as pointed out by Krishnamurthy and Vissing-Jorgensen in a discussion note (pdf), to the extent that this channel is important, it implies that central bank purchases of long-dated safe assets can even be welfare reducing.

To see why this is so, I think it best to divide the universe of financial intermediaries into two groups:  regular banks and pure investment shops.  Pure investment shops have, collectively, particularly stable funding (think pension funds) although the funds might swoosh around between individual investment shops.  Regular banks have some stable funding (from retail deposits), but also rely on wholesale funding.

Up until the financial crisis of 2008, regular banks’ wholesale funding was done on an unsecured basis.  There was no collateral required.  There was very little asset encumbrance.  But since the crisis (and, indeed, arguably because of it), regular banks have had essentially no access to unsecured lending.  Instead, banks have been forced to rely almost entirely on secured borrowing (e.g. through covered bonds at the long end or repos at the short end) for their wholesale funding.  In addition to this, new regulations have been (or are being) put in place that increase their need to hold safe assets (i.e. government debt) even if unsecured borrowing is available.

QE has therefore acted through two, broad channels.  In the first, portfolio rebalancing may still have worked through the pure investment shops.  Having sold their government bonds and now holding cash, they reinvested the money but since the yields on government bonds were now lower relative to other asset classes, they put a larger fraction of that money into equity and corporate bond markets.  To the extent that such investment shops are not able to perfectly offset the central bank’s trade, or are unable to full recognise their need to bear any potential losses from any risk the central bank takes on, large non-financial companies (NFCs) with access to stock and bond markets should therefore have seen a reduction in the price of credit and, in principle, should have been more willing to undertake investment.

On the other hand, QE has also served to lower the supply of eligible collateral at precisely the time when demand for it among regular banks has shot up.  The banks have then been faced with an awful choice:  either pay the extra high cost to get the required collateral (buying it off the pure investment shops), or deleverage so that they don’t need the funding any more.  As a result, their funding costs will have gone up as a direct result of QE and if they have any pricing power at all (and they do), then interest rates available to households and small-to-medium sized enterprises (SMEs) will be forced to be higher than they would otherwise have been.  No matter which option banks choose (and most likely they would choose a combination of the two), a negative supply (of credit) shock to the real economy would occur as a result.

If this second broad channel (through regular banks) were to outweigh the first (through pure investment shops), then QE focused on the purchase of long-dated safe assets would, in aggregate, have a negative effect on the economy.  I believe it is this very possibility that has given both the Federal Reserve and the Bank of England pause in their consideration of additional asset purchases.

Of course, if the central bank were not to buy long-dated safe assets but were instead to purchase long-dated risky assets (bundles of corporate bonds, MBS, etc), the supply of safe assets needed for collateral purposes would not be artificially reduced and, to the extent that portfolio rebalancing helps at all, the full efficacy would be obtained.   However, such a strategy would go against the principle that central banks ought to stay away from the decisions regarding the allocation of credit.

All of which is why, I suspect, that the Bank of England has decided to go for their Funding for Lending Scheme.  At it’s heart, the FLS is a collateral swap.  The BoE gives banks gilts and the banks give the BoE bundles of their mortgages and SME loans, plus interest.  The banks can then use the gilts to obtain funding on the wholesale market, while the interest that banks pay the BoE is a decreasing function of how much additional lending the banks make to the real economy.  The mortgages and SME loans that the banks give the BoE will have a haircut applied for safety.  It’ll be pretty tricky to get just right, but in principle it should be able to offset any increase in funding costs that QE may have imposed.

A clear majority of credit creation in Britain takes place via regular banks, so this has the potential to have quite a dramatic effect.  We’ll just have to wait and see …