Research Economist at the Bank of England
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.
That link also includes two videos (hosted on YouTube), one of which features my head talking awkwardly.
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.
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.
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.
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.
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 …
Alan Kohler has a piece on Crikey talking about electricity prices in Australia. It’s an interesting piece and well worth a read, but it’s got a crucial economics mistake. After talking about the politics and such, Alan gets down to brass tacks, telling us that:
He finishes by explaining:
That’s because the increase in power prices has been almost entirely offset by the high Australian dollar, which has produced tradeable goods deflation of 1.4% over the past year. In other words, thanks to the high Australian dollar we are getting a big improvement in energy infrastructure without an overall drop in living standards.
And thank goodness for fast rising power prices — without that, we’d have deflation. It’s true!
But it’s not true, and it’s not true for a very important reason.
Back in 1997, in the guts of of the Great Moderation (the time from the mid ’80s to the start of 2007 when US aggregate volatility was low) and before the real estate boom that presaged the financial crisis of 2007/2008, Paul Krugman famously wrote (this Economist piece is the best reference I could find in the two minutes I spent looking on Google) that unemployment was whatever Alan Greenspan wanted it to be, “plus or minus a random error reflecting the fact that he is not quite God.”
It’s popular to argue that Ben Bernanke lacks that power now that America has interest rates at zero. I disagree (see here and here), but I appreciate the argument.
Australia has no such problem. Interest rates are still strictly positive and the RBA has plenty of room to lower them if they wish.
So I have no qualms at all in saying that inflation in Australia is whatever Glenn Stevens (the governor of the RBA) wants it to be, plus or minus a random error to reflect the fact that he’s not quite God.
If the various state grids had all been upgraded a decade ago and electricity prices were currently stable, then interest rates would currently be lower too. They would be lower because that would ensure faster growth in general and a lower exchange rate, both of which would lead to higher inflation, thereby offsetting the lower inflation in electricity prices.
There’s a famous argument in economics called the Lucas Critique, named for the man that came up with it, that points out simply that if you change your policy, economic agents will change their actions in response. It applies in reverse, too, though. If economic agents change their actions, policy will change!
Alan Kohler ought to know this. Indeed, I suspect that Alan Kohler does know this, but it’s a slippery concept to keep at the front of your mind all the time and, besides, it would make it hard to write exciting opinion pieces. 🙂
In case anybody was wondering, monetary policy definitely still has an effect at the zero lower bound. In the UK, the banks have unwittingly (and certainly unwillingly) been part of a demonstration of a so-called helicopter-drop of money. In a country of 60 million people, by mid 2008 there were over 20 million Payment Production Insurance (PPI) policies in effect and that number was growing fast. In early 2011, they were ruled to have been mis-sold (customers were deemed, in general, to have been pressured or deceived into buying insurance they didn’t need) and banks were ordered to offer compensation. Wikipedia has a summary here. From a pair of articles in the FT ([1], [2]):
[Article 1] About £4.8bn had already been paid out by the end of May – effectively acting as “helicopter money” dropped into the hands of those people who may be among the most likely to spend it.
[Article 2] The independent Office for Budget Responsibility, relying on estimates that PPI refunds would deliver £6bn over the year, revised up its estimate of the growth rate of real disposable household income by 0.5 percentage points in March from its November figure … the amounts set aside for PPI redress by the five biggest banks have now soared to almost £9bn.
[Article 2] The FSA said it does not know the average payout per claimant. But some of the “complaints management” companies, which have been making aggressive pitches to help consumers get their money back, say these average £2,000 to £3,000 per applicant.
[Article 1] “When I heard I was going to get over £2,000 in compensation I hired builders to fix a long-overdue problem with the eaves in my roof and put the rest of the money towards a holiday to Greece in September,” said Elaine Overten, a retired nurse from Derbyshire, who received compensation for PPI payments made on her NatWest mortgage over 10 years.
I just love the little (and not remotely subtle) hint from the FT that monetary stimulus would help Greece out of their hole.
Anyway, the point is simple. If you put money in people’s hands, especially if those people are “credit constrained,” they will spend it. That was the point of my “Monetary policy for 10 year olds” post a while ago. It remains the point today. It will always be the point.
The problem, of course, is that while PPI compensation payouts are acting as a positive stimulus, the corresponding hit to the banks will be causing them to hold back in their lending and so provide a negative stimulus at the same time. If I had to guess, I’d say that the net effect of PPI compensation is to provide a positive stimulus because of the broad distribution and, I assume, the fact that a large fraction of the recipients really are currently credit constrained.
I hereby present John’s Not Particularly Innovative Taxonomy Of Bank Failures ™. In increasing order of severity:
Category 1) A pure liquidity crunch — traditionally a bank run — when, by any measure, the bank remains entirely solvent and cash-flow positive;
Category 2) A liquidity crunch and insolvent (assets minus liabilities excluding shareholder equity is negative) according to market prices, but solvent according to hold-to-maturity modeling and cash-flow positive;
Category 3) A liquidity crunch and insolvent according to both market prices and hold-to-maturity modeling, but still cash-flow positive;
Category 4) A liquidity crunch, insolvent and cash-flow negative, but likely to be cash-flow positive in the near future and remain so thereafter; and, finally,
Category 5) A liquidity crunch, insolvent and permanently cash-flow negative.
A category 1 failure is easily contained by a lender of last resort and should be contained: the bank, after all, remains solvent and profitable. Furthermore, a pure liquidity crunch, left unchecked, will eventually push a bank through each category in turn and, more broadly, can spill over to other banks. There need be no cost to society of bailing out a category 1 failure. Indeed, the lender of last resort can make a profit by offering that liquidity at Bagehot‘s famous penalty rate.
A category 2 failure occurs when the market is panicking and prices are not reflecting fundamentals. A calm head and temporarily deep pockets should be enough to save the day. A bank suffering a category 2 failure should probably be bailed out and that bailout should again be profitable for whoever is providing it, but the authority doing to bailing needs be very, very careful about that modeling.
For category 1 and 2 failures, the ideal would be for a calm-headed and deep-pocketed private individual or institution to do the bailing out. In principle, they ought to want to anyway as there is profit to be made and a private-sector bailout is a strong signal of confidence in the bank (recall Warren Buffett’s assistance to Goldman Sachs and Bank of America), but there are not many Buffetts in the world.
Categories 3, 4 and 5 are zombie banks. Absent government support, the private sector would kill them, swallow the juicy bits and let the junior creditors cry. If the bank is small enough and isolated enough, the social optimum is still to have an authority step in, but only to coordinate the feast so the scavengers don’t hurt each other in the scramble. On the other hand, if the bank is sufficiently important to the economy as a whole, it may be socially optimal to keep them up and running.
Holding up a zombie bank should optimally involve hosing the bank’s stakeholders, the shareholders and the recipients of big bonuses. Whether you hose them a little (by restricting dividends and limiting bonuses) or a lot (by nationalising the bank and demonising the bonus recipients) will depend on your politics and how long the bank is likely to need the support.
For a category 3 failure, assuming that you hold them up, it’s just a matter of time before they can stand on their own feet again. Being cash-flow positive, they can service all their debts and still increase their assets. Eventually, those assets will grow back above their liabilities and they’ll be fine.
For a category 4 failure, holding them up is taking a real risk, because you don’t know for certain that they’ll be cash-flow positive in the future, you’re only assuming it. At first, it’s going to look and feel like you’re throwing good money after bad.
A category 5 failure is beyond redemption, even by the most optimistic of central authorities. Propping this bank up really *is* throwing good money after bad, but it may theoretically be necessary for a short period while you organise a replacement if they are truly indispensable to the economy.
Note that a steep yield curve (surface) will improve the cash-flow position of all banks in the economy, potentially pushing a category 5 bank failure to a category 4 or a 4 back to a 3, and lowering the time a bank suffering a category 3 failure will take to recover to category 2.
A very smart three year old asked me what would happen if we gave everybody 20 dollars. Now, this is a deep and difficult question and no less important for having come from a three year old. Anybody who tells you it’s easy has not thought about it properly. As it turns out, I am not smart enough to explain this to a three year old, so I instead decided to give my answer to their parents and trust them to translate for me. I also decided to pretend the question was:
What would happen if we gave every 10-year-old kid on the planet 20 dollars (or its local equivalent)?
Here’s my answer:
If we were to give every 10 year old on the planet the equivalent of 20 dollars in their local currency, they’d immediately spend all of it, because 10-year-old kids do not care about savings and have no debts to pay down.
***
If this all came as a complete surprise, the shops would immediately be emptied of all lollies (candy if you’re American, sweets if you’re British) before the shop owners knew what was happening. Some of them might have put up their prices part-way through the day, but not many. If it’s a small one-person shop it’s hard to go around changing the price on everything when you’ve got a queue 20 people long that you need to serve. If it’s a big shop, the owner probably isn’t on site and flunkies aren’t paid to think, they’re paid to just take the customers’ money. It’s a bit more complicated through, because each shop selling out of their lollies would happen in a cascade through the day. The kids would first swarm to the shop that everybody knows about and when it sold out, they’d move on to to more obscure shops. They’d repeat the process until every shop sold out of stock or the kids ran out of money.
At the end of the day, faced with empty shops and tills overflowing with money, the shop owners would then order more lollies and put up their prices for next week when those lollies actually arrive. They’d also go home and celebrate with their family over the windfall profits. They’d order new cars, book holidays and increase the pocket money they give to their own 10-year-old kids. So as well as clearing out existing inventory, the shower of money will lead to more demand for new stuff and a future increase in prices. Eventually, once everything had settled down, the price of everything (including cars and holidays) would have gone up, but along the way they will have collectively produced and consumed more stuff than they would have otherwise.
***
Alternatively, if all the purveyors of lollies had one day’s advance warning that this avalanche of disease and bad manners was going to descend on their shops, they would face a problem (the good kind of problem). If they’re a popular and well-known shop, they would know they were going to sell out. Ideally, they’d have ordered more stock to sell in advance, but it’s not going to come in time (it takes a week). So instead, they order more lollies (and beg their supplier to be quick about it) and put up their prices immediately to suck some more money out of the kids. When the shop opens, the flood of kids turn up and buys all the lollies at the higher prices and swarms on to the next shop. But because of the higher prices, the kids will run out of money sooner and so the really obscure shops may not get much extra business at all. Knowing that this is going to happen, the obscure shops may not increase their prices, hoping to tempt some of the kids to come to them.
At the end of the day, the owner of the popular shop is positively giddy with excitement. They’ve sold all their lollies and gotten even more money than they would have if they’d sold them all last week. When they go home and celebrate, they order two new cars, one of them a Lexus, and the holiday they book is at a 5 star resort. Their kid doesn’t just get an increase in pocket money, they get sent to a private school. The owners of the obscure shops are also happy, because they’ve had a really profitable day, but it’s not been as good as it would have been without the advance notice. They just get their existing car repaired and buy a book about travelling through interesting countries. Their kid gets an extra scoop of ice cream for dessert. In the end, prices have generally gone up, although not necessarily everywhere (more popular and more fancy stuff will have increased their prices more) and, in aggregate, we will have produced and consumed more stuff.
***
If the whole thing was announced two weeks in advance, then some really interesting stuff would happen. The most popular shop would place an advance order for extra lollies so as to have more stock on the day and they’d increase their prices. They’d need to judge it carefully to decide how much of each to do, but their goal would be to make even more profit than they would with just one day’s notice. But that order for extra lollies will need to be placed and delivered and paid for before the kids ever get their 20 dollars. That means that the popular shop will need to borrow against the upcoming profit. On top of that, with all that advance notice, it’s not only the popular shop owner that will change their plans. The lolly manufacturers themselves would be putting up their prices, so the cost of ordering those extra lollies is higher. The normally obscure shops might try to do something to remind kids that they’re there. The really smart kids might even spend the two weeks looking for obscure shops that are less likely to put their prices up. Because the obscure shops might therefore be more likely to be visited on the big day, they’ll generally be able to put up their prices a little bit. But on the other hand, that will be offset by the fact that kids will know that the popular shop will have twice as many lollies as usual, so even knowing about the obscure shop, maybe they’re better off just going to the popular one.
When the big day comes, the popular shop will have a huge day. They’ll sell squillions of lollies at higher prices, but the really obscure shops will make more money, too. But they can’t all get more money than they would under the one-day-notice or no-notice scenarios. Exactly who will win and who will lose relative to the first two scenarios will depend on who managed to convince the kids to come to them on the day. At the end of the day, the popular shop will pay off their loan to the bank and will almost certainly have made an excellent profit. The owner of the popular shop and the owners of the obscure shops that made good profits will go home and celebrate, buy cars and holidays and try to figure out how to better compete with each other next time.
Overall, this case leads to an increase in demand and production of stuff before the money gets given to people (it temporarily sits in the popular shop’s inventory). The lolly manufacturer gets their money before the new money is even printed. In the end, prices are a bit higher and real quantities were higher than they would have been, but the distribution of that demand is once again different. Some of the extra money will go first (before it even exists!) to the manufacturer. Some of it will go on the big day to shop owners and some of it will go on the big day to the bank owner.
***
Now we start to get sneaky. If it’s announced two weeks in advance, but then cancelled the day before the big day, then the popular shop will have already ordered, received and paid for their extra lollies with a loan they took out from the bank. The manufacturer will already have started spending their share of the money. Obscure shops will already have put effort into reminding kids that they’re there, and smart kids would already have spent time looking for really obscure shops. In this case, the manufacturer is happy; they got their money and so still celebrate with their family, but they’ll put their price back down because everything has gone back to normal. The obscure shop owners are a little bit annoyed but don’t really mind because at least now more kids know about them. The bank owner is sort-of happy, but worried about getting their money back so instead of celebrating they go to see the popular shop owner and have a difficult conversation about complicated stuff like loan covenants.
The popular shop owner is the only person who’s really annoyed, because they’re the only one that’s out of pocket. They’ve got twice their normal inventory and a big loan to pay off. Now, if the lollies will last for a while and the bank is patient, they might be able to just go about their normal business, selling them to the kids as they get their weekly pocket money and paying off the loan bit by bit. But if the lollies are going to go bad if they’re not sold quickly, the popular shop may have to lower their prices temporarily to tempt kids to buy them even without the extra 20 dollars. If that’s the case, the popular shop will make a loss and just be trying to minimise it. They’ll hope they make enough money to at least pay back the bank.
Overall, real things happened and real stuff was produced and consumed, a fair bit of it before the big day was ever meant to happen. While prices jumped around a little bit — some up, some down — they generally returned to where they were beforehand.
***
Finally, we get to the scenario where it’s announced two weeks in advance, but people think it’s going to be cancelled before the big day. In this case, the obscure shops probably won’t bother to remind kids that they exist and only the most bored of the smart kids will ride around looking for obscure shops that they probably won’t have a chance to spend money in anyway. The popular shop, worried that they’ll be stuck with a big loan and inventory they can’t sell without making a loss, either won’t order anything in advance at all or will only make a small order. The manufacturer won’t blame the popular shop for only making such a small order and won’t bother to put up their price.
If the big day does get cancelled as people suspect, then nobody gets hurt and nothing happens, while if it really does happen, it’ll be a fantastic surprise and everybody will be happy (well, at least the kids and the shop owners). But, importantly, nothing much will happen at all until people believe the big day is really going to go ahead.
***
This last scenario is a bit like America and the UK today. The central banks have engaged in tremendous efforts to stimulate their economies, but for a bunch of boring reasons, the benefits of those efforts will only appear in most people’s pockets at some point in the future. On top of that, every time the shops start to think the shower of money will actually come through and place orders with the manufacturers, the manufacturers get excited and raise their prices a little. But because that means some prices are going up even before people get the new money, some central bankers worry that they’re planning to give away too much of the stuff and so talk very loudly about how they’re going to cancel most of the stimulus before it gets into people’s hands. That makes the shops worried again and so they cancel their orders.
The problem is one of commitment and credibility. Some people think that when the central banks talk about their exit strategies they’re doing it to defend their hard-won credibility in controlling inflation. That’s all well and good as a long-run strategy, but it also erodes a different type of credibility because, from the perspective of the public at large, they’re committing to do something and then going back on that commitment. It’s the boy who cried wolf in reverse. Imagine trying this strategy with your own kid:
Yes, on the face of it, this whole essay goes against my previous thoughts on monetary policy at the moment. What? A guy can’t have multiple, contradictory opinions at once?