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April 18, 2011

Can Keynesians be anti-Keynesian?

Follow any policy debate, and you are sure to find a list of economists who support or inspire those on both sides of the issue. In The Economist, we find some of those on the roster for the new Republican leadership in the House of Representatives, and why:

"When Republicans proposed slashing billions of dollars from federal spending this year, Democrats circulated predictions by economists that jobs and growth would be hit. John Boehner, the Republican speaker in the House of Representatives, countered with an economic expert of his own: John Taylor of Stanford University. 'Nothing could be more contrary to basic economics, experience and facts,' Mr. Taylor asserted on his blog, which Mr. Boehner cited. By cutting government spending, he said, the Republicans would 'crowd in' private investment and create jobs.

"… if there is one ideology that unites today's Republicans, it is Keynesianism, whose nefarious influence they are determined to stamp out. 'Young Guns,' the book-sized manifesto of Eric Cantor, Kevin McCarthy and Paul Ryan, leading Republican House members, devotes several pages to the evils of Keynesian activism and its exponents in the administration."

One of the interesting things about the article is that among the economists cited as being among the critics of "Keynesianism," you find the names John Taylor, Robert Mundell, and Kenneth Rogoff. I find that list interesting because if you follow the links I attached to those names you will find work with models that are decidedly Keynesian in structure. Works by Taylor and Rogoff are, in fact, seminal contributions to the "New Keynesian" paradigm that dominates macroeconomics today.

As far as I know, none of these men have repudiated the basic worldview that motivates the referenced work. In fact, as recently as last year John Taylor approvingly described, as he has many times, a key characteristic of the paradigm for monetary policy that was in place the decades before the financial crisis:

"… the central bank has a strategy, or rule, to adjust the interest rate depending on economic conditions: In general, the interest rate rises by a certain amount when inflation increases above its target and the interest rate falls when by a certain amount when the economy goes into a recession."

I added the emphasis to the last part of that passage as it is a feature of the so-called Taylor rule that is entirely built on the foundation of the New Keynesian model.

How, then, to explain the Keynesian predilections of the economists mentioned as presumed carriers of the anti-Keynesian mantle? The source of the confusion, I think, goes back to the historical, but somewhat obsolete, distinction between so-called Keynesianism and monetarism. The latter was, of course, personified in Milton Friedman and his dispute with what was the orthodoxy in the three decades following the Great Depression. Lost in the early-days labeling, however, was the fact that the disputes were more about the empirical details of theory rather than the theory itself.

In particular, Friedman did not deny the effectiveness of policy in principle but rather its wisdom or impact in practice. This sentiment is exactly the one he expressed in his prescient and transformative 1968 presidential address to the American Economics Association:

"In the United States the revival of belief in the potency of monetary policy was strengthened also by the increasing disillusionment with fiscal policy, not so much by its potential to increase aggregate demand as with the practical and political feasibility of so using it."

In a recent essay on Friedman's views about the ineffectiveness of fiscal policy, Tim Congdon notes Friedman's views on the issue:

"Friedman offered two informal theoretical arguments for the virtual irrelevance of fiscal policy, as he saw it. The second was that fiscal policy is much harder to adjust in a sensitive short-term way than monetary policy. But the first was the more telling and deserves detailed discussion.… In Friedman's words, 'I believe it to be true… that the Keynesian view that a government deficit is stimulating is simply wrong.' The explanation was the wider effects of the way the budget deficit is financed. To quote again, 'A deficit is not stimulating because it has to be financed, and the negative effects of financing it counterbalance the positive effects, if there are any, on spending.' "

Though Congdon emphasizes different channels (associated with the mix of monetary and fiscal policy associated with deficit spending), those who follow such things may recognize in Friedman's remarks the notion of Ricardian equivalence:

"This is the idea that increased government borrowing may have no impact on consumer spending because consumers predict tax cuts or higher spending will lead to future tax increases to pay back the debt.

"If this theory is true, it would mean a tax cut financed by higher borrowing would have no impact on increasing aggregate demand because consumers would save the tax cut to pay the future tax increases."

My point is not to dispute or defend the truth of the Ricardian proposition. My point is that it has absolutely nothing to do with whether one believes (or does not believe) that the New Keynesian framework is the right way to view the world. The essential policy implications of the New Keynesian idea (like the old Keynesian idea) is that changes in gross domestic product can be driven by changes in desired spending by households, businesses, foreigners, and the government in sum. You can believe that and still believe in fiscal policy ineffectiveness, as long as you believe that total spending is unaltered by a particular policy intervention.

There are, of course, plenty of arguments against fiscal policy activism that do not require adherence to Ricardian equivalence, in total or in part. The most obvious would be the position that any short-term rush from stimulative policies is more than reversed in the long run by the negative consequences of higher tax rates on productive activity, or the redirection of private investment to lower return public spending. Again, the point is that a self-professed adherent to a Keynesian reality need suffer no doubts about the coherence of his or her intellectual framework if he or she objects to fiscal policies aimed at juicing the economy through greater government spending.

This whole discussion may seem like a bit of inside baseball, and perhaps it is. But the stakes in this debate are high, as clearly illustrated by today's announcement from rating agency Standard & Poor's that it reduced its outlook to negative on the triple-A credit rating of the United States. In my view, productive discussions about the truly pressing issues of our day are unlikely unless we understand where the disagreements lie—and where they do not.

Photo of Dave Altig By Dave Altig
senior vice president and research director at the Atlanta Fed



April 18, 2011 in Deficits, Federal Debt and Deficits, Fiscal Policy | Permalink

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I'm a rank amateur, so please let me know where I go wrong.

Fiscal stimulus is government spending, and government spending comes from either taxes or borrowing (bonds). Since raising taxes is pretty much the worst possible policy in a recession, let's assume the stimulus is entirely borrowed.

Bonds are repaid via future taxes, hence the idea of Ricardian equivalence. However there's always uncertainty in the future. To the extent the public believes the recession is due to a temporary market failure which the stimulus can repair ("nothing to fear but fear itself")... to the extent they believe the stimulus may be offset by future spending cuts... Ricardian equivalence will fail. So 0 < R < 1.

Now let's compare to monetary stimulus. It's also funded by the sale of bonds* but this time the public sells them to the Fed. Except all bonds originate at the Treasury, and additional demand from the Fed must ultimately cause additional supply. This is especially likely since recessions often cause a flight to safety, sending organic bond demand high. And, primary dealers are required to sell.

So the only difference is whether the Treasury sells bonds to the public or to the Fed. The Fed destroys bonds and even refunds the coupons, so R = 0. The cost of the procedure is inflationary pressure. And inflation... also stimulates the economy,** by spurring investors to renew existing contracts and seek higher nominal returns. So Friedman was right, though maybe not as right as he thought or for the reasons he gave.

That's the financing issue. What about Taylor's crowding out? Here I think there are more teeth: http://lumma.org/microwave/#2010.07.18

-Carl

* Unless the Fed has been doing something weird, like you know, buying MBS. Those are money-quantity neutral if the payments are destroyed. So I don't get all the talk about an exit strategy. The Fed can simply hold its MBS to maturity, alternatively destroying or reinvesting the payments as part of its overall operations.

** Provided inflation expectations remain anchored. I think.

Posted by: Carl Lumma | April 18, 2011 at 11:03 PM

Essentially there is no difference between Keynesianism and its opponents like monetarism. They all agree on the basic notion that money is equivalent to cash balances (though how you can define money as something that is not spent and then try to relate it to total income or total expenditure is beyond me).

Keynes argued about the tension between bonds and cash balances. Friedman added stuff like equity and consumer durables and Keynesians like Tobin did not disagree.

Keynes's classic money equation
M = M1 + M2 = L1(Y) + L2(r)
where M2 is the speculative demand for money
simply reduces to monetarism if speculative demand is zero.

Posted by: Philip George | April 19, 2011 at 04:59 AM

Both Carl and Philip make good points. Carl's contribution is noting "uncertainty". Ricardian equivalence doesn't hold for, at least, two reasons: 1) the future is irreducibly uncertain, and 2) most people outside of finance and economics recognize this basic fact and thus heavily weight the present observable economic activity from employment-producing fiscal stimulus and assign very little weight to the distribution of possible future tax rates. Thus they don’t save their current earnings to pay the tax man. If you believe that people use future tax rates in their present consumption calculus, please provide me the probability distribution and parameters that they are using for their calculations.

Technically, Keynes posited that inflation stimulates the economy by increasing people's expectations of the marginal efficiency of capital (i.e., the return on invested capital). When capital is plentiful the marginal efficiency is low and people are not motivated to invest it in new capital projects that employ people and resources. This leads to the similarity with Friedman. People compare the marginal efficiency of capital to the schedule of interest rates when they decide to invest (notice that marginal efficiency of capital is not always equal to the interest rate as Classical, Neo-Classical, Monetarists, Neo-Classical Keynesian Synthesis [in the long run] schools all assume). Thus, when the marginal efficiency of capital (return on invested capital) is greater than the interest rate people invest, when it's not they don't.

So, there are 2 options, in general: raise the marginal efficiency of capital through boosting confidence ("animal spirits") and/or use an “exogenous” force to employ people to build capital (e.g., fiscal stimulus). Keynes also believed that you could lower the interest rate below the schedule of the marginal efficiency of capital by increasing the money supply as Friedman would advocate. However, Keynes believed this was inefficient because there is no substitute for money so as people demand more and more in uncertain times as they struggle to build a security blanket made of dollars big enough and they just let them sit in bank accounts, under mattresses, or in Treasuries (Keynes’s used the word “hoard”). This idle money cannot increase employment (Keynes's main goal for moral and economic reasons).

This is exactly what we have seen--corporations haven't really invested and banks haven't lent (due to lack of willingness and now they claim lack of demand) thus it's left to the government to spend and increase employment. One might point to increases in the equity markets as a mechanism for saved money to go towards employment producing investment. But, remember that an overwhelming amount of money that has flowed to asset markets post the crisis was in the secondary markets and not primary issuance (e.g., IPOs). Thus, the money is simply trading hands based on past investments that employed people to build the products or provide the services of the businesses represented by the ownership stakes provided by stocks. Outside of employing people in the financial community, this “spending” doesn’t employ many people. This is why you see a tight labor market for people in finance and a weak market for construction workers.

Posted by: Joshua Packwood | April 19, 2011 at 07:14 PM

Keynesians are anti-keynesian. Monetarists are keynesian. What a confusion!
Have any of you ever tried marxist economic theory for a change?

Posted by: wskarma | April 20, 2011 at 04:56 AM


Thanks, Dave for a thought-provoking and brave post. A few comments. First, neo-Keynesianism dominates the world of applied macroeconomics because it has empirical content. The theory can be tested and implications for policy made based on parameters derived from experience. True tests come when events occur outside the historical norms, such as what has occurred in the past few years, and in general the theory has stood up well.

As a result, this paradigm dominates the applied world, where there are quantitative benchmarks for performance. Unfortunately in other realms the theory does not dominate, and in fact is ridiculed. The first such realm is academia. Here, neoclassical theory has all but squeezed the neo-Keynesian paradigm from the classroom. The grip of the neoclassicals is such that one can barely find a neo-Keynesian article in a major journal. The benchmark in this world now is model elegance. Abstract optimization is prized far over empirical validity. The fact that these models rely on unfounded assumptions such as rational expectations and efficient markets and that recessions are the result of productivity shocks are not subjects for discussion. No $100 bills on the sidewalk, but trillions in losses.

The second realm is policy. If we give conservatives the benefit of the doubt as to their motives (a significant assumption), then what they feel is a strong aversion to government action of nearly any type. This explains the mental gymnastics of the economists you cite whose research has been based on an empirically valid theory, but whose implications run into their ideology. The resulting cognitive dissonance is an embarrassment to them and to the profession. I put it this way: a Keynesian would say that the government should pull the Chilean miners out of the mine, while a conservative would say it's not effective because either it would encourage future miners to be relaxed on the job or because the cost would imply that the private sector would be crowded out and less money would be spent on safety.

One last point: your last line on S&P and the US debt rating. Of course, the problem is serious and needs attention. But please do not encourage these guys by citing them as a source of authority on these matters. Their track record on sovereign debt is abysmal, to say nothing of securitized products. Their incentives are highly questionable and their use by investors as a crutch is a key factor behind the financial collapse we have just gone through. Please devote your efforts to unwinding them and encouraging independent analysis.


Posted by: Rich888 | April 20, 2011 at 09:56 AM

I believe the concept that, with a Federal deficit, one would spend less now because taxes are going to be higher in the future is just not in the American conciousness.

Indeed, I see as the other way around: people pulling income into these low tax years, and then increasing spending now, rather than have the income in what might be higher tax years in the future.

But this is an empirical question. Surely polls have been done: "Are you spending less now, because taxes might be higher in the future?" To which the answer, "What are you talking about?" should be a possible choice.

[this comment occured because of a Krugman link]

Posted by: David Fields | April 20, 2011 at 09:59 AM

David Fields has it correct. The future for 70% of Americans is the bill due at the end of the month, not the marginal efficiency of capital.

Posted by: DR | April 20, 2011 at 11:34 AM

I would think that David Field's comments on testing Ricardian equivalences with the American public might be applied to corporations as well. If corporations were concerned about future taxes, we would see that factored into the tax rate used in DCF analysis for longer-term projects. There would be increased tax-rate assumptions in later years, or at least future tax rates would be factored into the sensitivity analysis.

It would be easy enough to poll corporate finance managers to find out if this was in fact happening, and then try to calculate what impact that had on the acceptance of business projects. My suspicion is that it might have an impact, but at much less than Ricardian equivalence.

John

Posted by: Ragweed | April 21, 2011 at 03:06 PM

"If we give conservatives the benefit of the doubt as to their motives (a significant assumption), then ..."

If you are going to claim to give conservatives the benefit of doubt as to their motives, then you should do so. You do no such thing. It would be as if a conservative said: "If we give liberals the benefit of doubt as to their motives, then we should assume [the same exact things we already assume without giving them the benefit of doubt]." If you are unable to accurately or objectively describe the positions and motives without your own biases, try not to claim that you are in fact doing so.

Posted by: sparky | April 22, 2011 at 07:36 AM

Keynes did not ponder what drove the economies of the world in order to get published or to achieve tenure. He eschewed elaborate mathematical economics, even though his intellect and mathematical skill fully permitted him to engage in such analysis. Rather, he was practical, and looked for an explanation in the Great Depression of why what he observed was as it was. A highly successful investor, he spent the first hour of every day doing the equivalent now of reading the WSJ and the Financial Times. He also had worked for the British treasury. He was directly responsible for financing the First World War for Britain. From these practical, real life experiences, he arrived at economic conclusions that are indeed the paradigm by which most operate today, including Mr. Taylor. So, the Young Guns have cited economists who have stood on the shoulders of Keynes.

Last, we make a grave policy error if we fail to recognize that the steps of governmental intervention taken by Chairman Bernanke, the Congress, and Secretary Paulson, in the early fall of 2008, are the chief reason that we did not see in late 2009 and early 2010 unemployment go to 20%. Forgotten, for example, in the current discussion of cutting government spending, is the effect the stimulus package had on state governments, which would otherwise have severely curtailed expenditure. The federal government used its collective strength to avoid the kind of reamplification of recessionary tendencies that would have been the inevitable result of such state layoffs.

Finally, it does not help to analyze these economic issues in terms of conservative and liberal, or Republican and Democrat. As the collapse of communism demonstrates, rigid adherence to a purely ideological notion of economics is doomed to fail. Rather, the policy issues should be addressed in a practical way, avoiding dogma and with a keen eye to the demonstrable.

Posted by: Michael Egan | May 24, 2011 at 10:14 PM

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April 13, 2011

How has the financial system changed? (And what to do about it)

The subject of this post's title was, in essence, the centerpiece of the most recent edition of the Atlanta Fed's annual Financial Markets Conference, convened this year in Stone Mountain, Ga. (just outside Atlanta). In terms of formal papers, the conference was bookended by work that came to very similar conclusions but from very different angles. From the vantage point of recent developments in micro banking structure, Arnoud Boot offered this diagnosis:

"A fundamental feature of more recent financial innovations is their focus on augmenting marketability. Marketability has led to a strong growth of transaction-oriented banking (trading and financial market activities). This is at least in part facilitated by the scalability of this activity (contrary to relationship banking activities). It is argued that the more intertwined nature of banks and financial markets induces opportunistic decision making and herding behavior. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability."

Taking the very long view, Moritz Schularick presented (from a paper co-authored with Alan Taylor) pretty compelling evidence that the ongoing shift from relationship banking to transactions-based banking has fundamentally altered the nature of financial developments on real activity in modern economies:

"We first document and discuss our newly assembled dataset on money and credit, aligned with various macroeconomic indicators, covering 14 developed countries and the years from 1870 to 2008. This new dataset allows us to establish a number of important stylized facts about what we shall refer to as the 'two eras of finance capitalism.' The first financial era runs from 1870 to 1939. In this era, money and credit were volatile but over the long run they maintained a roughly stable relationship to each other, and to the size of the economy measured by GDP. The only exception to this rule was the Great Depression period: in the 1930s money and credit aggregates collapsed. In this first era, the one studied by Friedman and Schwartz, the 'money view' of the world looks entirely plausible. However, the second financial era, starting in 1945, looks very different. With the banking sector progressively more leveraged in the second financial era, particularly towards the end, the divergence between credit supply and money supply offers prima facie support for the credit view as against a pure money view; we have entered an age of unprecedented financial risk and leverage, a new global stylized fact that is not fully appreciated."

If there was agreement on increasing threats to financial stability, what to do about it (unsurprisingly) was somewhat more controversial. On the microprudential front, several conference participants—Viral Acharya, for example—looked to greater capital buffers as a key to greater financial stability. Others—George Kaufman commenting on Boot's paper, for instance—were more inclined to rely on market solutions. Boot, for his part, was highly skeptical of the self-correcting market forces and, while sympathetic to greater reliance on bank capital, believes much more is required:

"What we have also argued is that market discipline might be rather ineffective. We described this as a paradox. When particular strategies have momentum in financial markets, the market as a whole may underestimate the risks that these entail. How then can we expect market discipline to work? It appears to us that market discipline might not be present when banks follow financial market inspired strategies. Things are even worse because these strategies will lead to a high correlation in actual exposures between financial institutions because all see the same opportunities and hence herding occurs. Systemic risk would then be considerable and not checked by market discipline."

Earlier in the paper, Boot puts forward:

"We believe that heavy handed intervention in the structure of the banking industry—building on the Volcker Rule—might ultimately be an inevitable part of the restructuring of the industry. It could address complexity but also help in containing market forces that might run orthogonal to what prudential concerns would dictate (as the insights on market discipline in section 6 suggest). For now, the structural interventions in the banking industry are rather tentative. Other measures such as higher capital and liquidity requirements are clearly needed. But these primarily focus on individual institutions while a more system-orientation is crucial to identify externalities and interlinkages (Goodhart, 2009; and Calomiris, 2009). Anti-cyclical capital surcharges and other measures and surcharges depending on the degree of interconnectedness are needed as well to add some further comfort. We tend to subscribe to John Kay's (2009) notion of redundancy: having comfort in the stability of the financial sector dictates building redundancy into the regulatory and supervisory structures of banking."

With respect to "system-oriented" signals, Schularick was clear where he and his co-author think their research leads:

"These new results from long-run data, if they pass scrutiny, inform the current controversy over macroeconomic policy practices in developed countries. Specifically, the pre-2008 consensus argued that monetary policy should follow a 'rule' based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst."

Credit and bank capital—along with sound fiscal policy and a little good luck—do appear to have been key to how well different economies fared during the recent financial crisis. At least that is the conclusion reached in a study by Stephen Cecchetti and his co-authors from the Bank of International Settlements:

"The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis.… Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part."

As we seek to shore up our financial timber to avoid a repeat of recent history, it is appropriate to remember that, while it is good to be lucky, fortune is probably not arbitrary in choosing where it will shine.


Photo of Dave Altig By Dave Altig
senior vice president and research director at the Atlanta Fed



April 13, 2011 in Financial System, Money Markets | Permalink

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Banking is one of many oligopolies that are government ignores.

"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise prices." (Adam Smith, The Wealth of Nations, 1776).

What does the American auto industry, the health care industry, wall street firms and the banking industry all have in common; other than they were all on the brink of failure?

These are industries where the production side of the industry is no longer a free market with many producers competing head-to head to earn the business of consumers, or customers, of the industry. Instead each of these industries are controlled by a relatively small number of very large corporations that have transformed these markets into oligopolies.

Adam Smith when he discussed “rational self interest” and competitive markets in his book Wealth of Nations, envisioned many consumers buying goods and services from many producers with everyone looking out for their self-interest. By keeping markets “free”, producers pursue their rational self-interest and this best meets the needs of the consumers and the citizens of our country, who are also looking out for their self-interest. Under this system, what is in the producers self interest is to provide the best product possible to the consumer, while striving to be a low cost producer for their niche.

This consolidation of markets began in the late 1960's early 1970's in the auto industry when it was transformed from a free market to an industry that was controlled by three giant corporations and one union. As this transformation was occurring the auto company's and auto union's self-interest became separated from what the consumer wanted and/or needed. Competition between the companies broke down and this gave an opening for foreign competition to enter our markets and the beginning of the end of the American auto industry as we knew it.

Other industries saw what was happening in the auto industry and saw that government was not objecting so naturally they followed the same path with little concern on any ones part that we were losing our free market system to a more centralized market system of oligopolies. As a result we now have major markets where the producing entities self-interest is not always in line with the self-interest of the consumer. What is in the self-interest of the entities in these industries is to keep the oligopoly alive. Thus the creation of special interests and lobbyists.

These oligopolies have bought the protection of our representatives in Washington and state capitals. I am always baffled by the fact that corporations and unions cannot vote in this country, however they are allowed to buy votes with their contributions.

We lost track of a key ingredient that Adam Smith identified as necessary in order for “rational self interest” to work. There must be many producers. In too many industries, the number of producers has shrunk and the ones remaining have gotten “too big to fail”. This is true in the auto industry, the banking industry, wall street, health care and will soon be true in the computer software industry.

When discussing the health insurance industry proponents for this specific oligopoly site the fact that the bigger the insured pool, the lower insurance premiums can be. However, I submit that this "bigger pool savings" is more than offset by the fact that the rational self-interest of the companies is not totally aligned with the rational self interest of the insured. The insurance industries self-interest is to keep the oligopoly alive. The self-interest of the insured is to have as many insurance companies as possible clawing to get his business and thus ringing out all excessive cost, including unconscionable salaries for top executives, to earn the consumers business.

The liberals are right that regulation is required and conservatives are right that a free market is the best way to meet the needs and wants of our citizens. The common ground is that regulation is essential to make our markets more free. We have too many industries where companies have too much power, their self interest is not aligned with the citizens of this country and they are too big to fail.

It is time that our politicians breakaway from the shackles of oligopolies, special interests groups and lobbyists. Use antitrust legislation to bring back free markets.http://freeourfreemarkets.org

Posted by: sbanicki | April 13, 2011 at 04:31 PM

A very good post, thank you.

Transactions-oriented banking would seem to require a transactions-oriented regulatory tool-kit modeled after what is done in best-of-breed trading houses today: transactions that increase corporate risk get capital charges, and transactions that decrease it get capital credits. Note that this policy is applied to *transactions*. The balance-sheet provides the direction and intensity of the charges, but the charge is applied to the transaction.

While the details are certainly profoundly complicated, it does seem that transactions-oriented capital regulation has the potential to remediate liquidity problems. The expectations of late-entrants into a crowding market will be dampened by the higher capital charges. Momentum-trading will be less profitable. Counter-cyclic trade charges are a correction to the distribution of expectations of return that are proportional to market depth. It will decrease liquidity demand at precisely the time when liquidity is drying up.

If successful this policy allocates the costs of liquidity risk to the late-comers who actually cause the problem, and it protects the capital of the early-adopters who are the innovators in the market.

The downside is that this will tend to slow price competition in financial services. But in an industry that experiences 35% annual decline in profit margins, that might actually be a good thing. Extreme volatility in the profitability of financial services has the potential of rather spectacularly bad outcomes, as we have seen.

Posted by: Alan King | April 17, 2011 at 10:40 AM

Moritz Schularick's comments on "the divergence between credit supply and money supply" are interesting.

But the "divergence" is only the result of an error in measuring money supply, and this in turn is the result of viewing money not as the sum of credit plus currency but as cash balances. The error of viewing money as cash balances is an error common to the Austrians, the monetarists and the Keynesians. So far as I know only one economist has not agreed with this view: Joseph Schumpeter. And unfortunately, Schumpeter did not do any serious work on money.

In an era when currency is only about 50% of M1, a completely new model of money is required, one that views money as credit plus currency, not cash balances.

I have developed a complete model of money as credit but understanding it calls for unlearning a lifetime's thinking of money as cash balances.

In any case the end result, a graph showing what I call Corrected Money Supply from 2001 to 2011 can be viewed at http://www.philipji.com/Mc2001-2011.gif

If the fact that it accurately tracks the rise of money supply until the beginning of 2006 when housing starts ceased to grow, the contraction of money during the recession and its rise to dangerous levels in recent months is interesting, the logic behind the article can be seen at http://www.philipji.com/riddle-of-money/

In the absence of an accurate monetary aggregate any attempt to identify and prevent bubbles is impossible.

Posted by: Philip George | April 17, 2011 at 11:34 AM

I really like this concept. I just want to know as it consists of how many templates. Better-performing economies featured a better-capitalized banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part. Thanks for sharing this great post.

Posted by: home business | April 18, 2011 at 05:09 AM

Great article, short and precise. What bothers me although is the fact that the jury is impressed by a presentation like this. This just proves that the application of law often does not have anything to do with justice, but more so with who's better at presenting. While the details are certainly profoundly complicated, it does seem that transactions-oriented capital regulation has the potential to remediate liquidity problems. The expectations of late-entrants into a crowding market will be dampened by the higher capital charges. Momentum-trading will be less profitable. Counter-cyclic trade charges are a correction to the distribution of expectations of return that are proportional to market depth. It will decrease liquidity demand at precisely the time when liquidity is drying up. What bothers me although is the fact that the jury is impressed by a presentation like this. This just proves that the application of law often does not have anything to do with justice, but more so with "who's better at presenting".

Posted by: Business Plan | April 19, 2011 at 07:45 AM

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April 08, 2011

Monetary policy exit: Is a bad bank the solution?

It is not difficult to find people who espouse the following belief:

"One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its 'quantitative easing' policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?"


I dare say that I hear that criticism, in one form or another, nearly every day. So the claim above might only merit notice here because it comes from a Wall Street Journal op-ed penned by Professor Allan Meltzer, the eminent monetary macroeconomist and chronicler of Federal Reserve history. But what really distinguishes the critique is that it comes with a fairly novel and creative way of resolving the perceived problem:

"One idea is for the Fed to create its own version of a 'bad bank.' The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank’s assets. (The $1 trillion in Fed-created 'excess' bank reserves as a result of quantitative easing would become the liabilities of the bad bank.)


"The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline. The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away. Letting the market know precisely when the mortgage-backed securities would be sold makes the adjustment to the future elimination of excess reserves manageable."


Generally speaking, the Meltzer strategy offers what I perceive to be two critical criteria for a viable exit plan. One is that the winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible. The second is, of course, that the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.

It should not go unmentioned that these criteria are also features of exit plans that have been sketched by Federal Reserve officials—by Chairman Bernanke last year and by Philadelphia Fed President Charles Plosser more recently, for example. What distinguishes the Meltzer plan is less in approach and more in timing.

In fact, the Meltzer approach is similar in spirit to the Fed's Term Deposit Facility that became operational last summer. The simplified description of this facility is that it involves the Federal Reserve temporarily taking onto its own accounts the excess reserves of banks. If you want to call that account a "bad bank," you're getting close to the Meltzer plan.

Expanding just a bit, in a term deposit facility the private banking system deposits its excess reserves—an asset of private banks—with the Fed. In exchange, banks receive an asset in the form of interest-bearing "accounts," the analog of a time deposit that you might purchase from your bank. Just as you cannot spend the funds you put into a time deposit you own, banks cannot use funds deposited in the Term Deposit Facility to support credit expansion (at least not until the term of the deposit expires).

Which brings me to a point that I don't quite follow about the Meltzer plan: If reserve assets are removed from the banking system, what are the corresponding offsets on the balance sheets of private banks? My guess is you end up with something like term deposits or their economic equivalent—nonnegotiable sterilization bonds, for instance. And if you match the maturities of those deposits with the maturities of the MBS and long-term security portfolio, it becomes pretty clear that the debate is really less about tactics and more about some pretty familiar, but difficult, issues: When is it time to stand pat on policy, and when is it time to reverse course?

On this conversation, I will, as I often do, give the last word to Dennis Lockhart, our Bank's president, who spoke earlier today in Knoxville, Tenn.:

"My view of the future permits a degree of patience as regards monetary policy. There is still a halting and fragile quality to the economy. I think the process of restoration of full economic strength with higher employment continues to require support. That said, planning for an eventual change of course is completely appropriate as long as public discussion about planning deliberations and the plan itself don't create premature expectations of tightening."


Photo of Dave Altig By Dave Altig
Senior vice president and research director at the Atlanta Fed

April 8, 2011 in Federal Reserve and Monetary Policy, Inflation, Monetary Policy | Permalink

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If the American people ever allow private banks to control the issue of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers conquered.
- Thomas Jefferson

Posted by: MC | April 09, 2011 at 05:49 AM

The difference between Meltzer's bad bank concept and Bernanke's exit is cosmetic only. If the bank's excess reserves are "off the table", i.e they can not be lent out, then their existence in the first place is arbitrary. The only real issue here is the fact that the excess reserves are the creation of the Fed (via monetary creation) in the first place. It is truly reaching Alice in Wonderland proportions. The Fed buys assets from banks with money created out of thin air, which it credits to the bank's account which is held at the Fed. It then requires such reserves remain at the Fed and can not be lent out. Then why bother? Why not just call this like it is, and allow the banks true reserves to fall below their required level? Why manufacture reserves out of thin air just to say they are there and pretend the bank's are now healthy?

Probably the single greatest error I see among virtually all economists is this notion that if the funds are not lent out, there is no "real" monetary creation" and therefore no multiple effect, and therefore no inflation. If you only define inflation as an increase in prices...that might well be true. But preventing prices from falling to their natural, market driven prices...is an inflation of prices. If supply and demand leads to an item declining to $10, but monetary policy is propping up the price to $12, that is still a 20% inflation of prices.

Looking at a free market alternative shows this plainly. If the Fed did not intervene with the massive purchase of securities, and some banks would be forced to liquidate assets, and therefore liquidate the banks...what would happen to prices then? Of course they would deflate. They were ALREADY inflated...

So why allow prices to deflate? Isn't deflation "bad"? Having inflated asset and consumer prices leads to locking up resources in assets to which capital never should have been allocated in the first place. The approaches outlined above virtually guarantees that the natural flows of capital will be slowed for some time to come. Instead of perpetuating the problem, let the short sales and over-priced homes be liquidated (as they are going to do anyway). Yes it will be painful, but then capital can resume its flow to the places it should be flowing. Having a massive portion of the capital stock in housing is not exactly a good long-term policy anyway...even if one does wish for the Fed to skew the allocation of capital.

Posted by: Chris | May 26, 2011 at 08:13 PM

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