Archive for the 'Economics' Category

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.

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

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.


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.