Floats are as fragile as pegs

The Dynamics of Exchange Rate Regimes: Fixes, Floats, and Flips;

Abstract: The impermanence of fixed exchange rates has become a stylized fact in international finance. The combination of the “mirage” view that pegs do not really peg with the “fear of floating” view that floats do not really float generates the conclusion that exchange rate regimes are, in practice, unimportant for the behavior of the exchange rate. This is consistent with evidence on the irrelevance of exchange rate regimes for general macroeconomic performance. Recent studies, however, show that the exchange rate regime matters. This can be understood by considering the dynamics of exchange rate regimes. We demonstrate that the “mirage” view is somewhat misleading and incomplete. Pegs frequently break, but many do last. Also, there is a high degree of flipping, that is, the re-formation of pegs that have broken. Thus, a fixed exchange rate today is a good predictor that one will exist in the future. We also investigate the quantitative effect of fixed exchange rates. While the “fear of floating” view suggests little actual difference in fixed and floating rates with respect to exchange rate volatility, we show that fixed exchange rates exhibit considerably greater bilateral exchange rate stability than flexible rates, both today and in the future.

Austerity for Saudi Kings- can it work?

Saudi Arabia’s central bank governor on Tuesday called on the government to fight inflation by curbing public expenditure, warning that economic policies in the kingdom faced “a critical situation”.

The call by Hamad al-Sayari followed a government announcement that it would invest in agricultural and livestock projects in foreign countries to ensure food security and control commodity prices....

Saudi Arabia’s oil-fuelled boom is producing massive investment in infrastructure projects but is also leading to growing social pressure as inflation spirals, reaching 9.6 per cent in March year on year. Although lower than in Qatar and the United Arab Emirates, the inflation rate is tormenting a country accustomed to near zero inflation.

Insisting that inflation is driven by domestic factors – mainly housing and foodstuffs – the central bank has resisted calls to drop the riyal’s peg to the dollar, thus limiting its ability to use monetary policy.

“Powerful and contradictory factors put economic policymakers before difficult choices,” said Mr Sayari at a Euromoney conference, pointing to the need to promote economic growth but also the burden inflation was putting on low-income families.

“The Saudi Arabian Monetary Agency [the central bank] has taken steps to reduce domestic liquidity by raising the statutory reserve requirement several times. Given the dominance of fiscal policies on the economy, it is necessary to reprioritise spending and programme it to fit the absorptive capacity of the national economy,” Mr Sayari added.

-Call to Saudis to curb spending

Related;

A Royal Order was issued on 28/11/1428H (8/12/2007) granting a subsidy of SR1,000 per ton on imported rice, and increasing the flat subsidy on baby milk from SR2 to SR12 per kilo.

Dollarization and Inflation gone extreme

2 killed in Somalia as tens of thousands riot over food prices

In Mogadishu, the price of a kilogram (2.2 pounds) of corn meal has gone from 12 cents in January to 25 cents. Another staple, rice, has risen in that time from $26 to $47.50 for a sack of 50 kilograms (110 pounds).

Food prices also have been affected by the plummeting Somali shilling, which lost nearly half its value this year, tumbling from 17,000 shillings to about 30,000 to the U.S. dollar amid growing insecurity and a market clogged with millions of counterfeit notes printed in bulk locally.

India Development Fact of the Day

India is foregoing as much as 2% of its GDP by accumulating reserves instead of employing resources in alternative uses

-Cost of Holding Excess Reserves: The Indian Experience

Related;
An Account of India’s Growth

Random Course of the Day

Central Bank Watching

Indonesian central bank governor arrested

The credibility of Indonesia's Central Bank is once again under question as it faces allegations of endemic corruption.

The allegations centre on the misuse of Bank Indonesia funds to bribe parliamentarians to ensure the bank's regulator control.

Related;
Statement from the Board of Governors of Bank Indonesia;

In light of the detainment of the Governor of Bank Indonesia related to “the YPPI fund case”, the Board of Governors of Bank Indonesia states that:

1. The Board of Governors of Bank Indonesia regrets and is deeply concerned with the detainment of Governor Burhanuddin Abdullah, and previously two Bank Indonesia officials, Mr. Rusli Simanjuntak and Mr. Oey Hoey Tiong by KPK (Corruption Eradication Commission).
2. The Governor and all officials of Bank Indonesia who have been required by KPK to provide information relating to the case have always fully respected the legal process and have always shown their good intentions as law abiding citizens during the investigation.
3. The Board of Governors of Bank Indonesia has in place a standard procedure and mechanism to ensure that macro-economic and financial system stability are maintained as mandated by the Central Bank Act.

May God almighty bestow his protection upon us.

Lecture for the Day

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Why do Foreigners Invest in the United States?

Why do Foreigners Invest in the United States?
Kristin J. Forbes

Abstract: Why are foreigners willing to invest almost $2 trillion per year in the United States? The answer affects if the existing pattern of global imbalances can persist and if the United States can continue to finance its current account deficit without a major change in asset prices and returns. This paper tests various hypotheses and finds that standard portfolio allocation models and diversification motives are poor predictors of foreign holdings of U.S. liabilities. Instead, foreigners hold greater shares of their investment portfolios in the United States if they have less developed financial markets. The magnitude of this effect decreases with income per capita. Countries with fewer capital controls and greater trade with the United States also invest more in U.S. equity and bond markets, and foreign investors “chase returns” in their purchases of U.S. equities (although not bonds). The empirical results showing a primary role of financial market development in driving foreign purchases of U.S. portfolio liabilities supports recent theoretical work on global imbalances.

Econ Talks

Davies Says U.S. Treasury Lacks Tools to Help Markets

See also his Oxonia Lecture - The Future of Financial Regulation

Zimbalist Says MLB Seeks to Develop International Market

Levitt Questions Plan to Expand Federal Reserve's Power

Why BIS research head, Cecchetti is worried

Econ Talk for the Day

Stephen Cecchetti talks about Treasury Secretary Henry Paulson's proposed overhaul of U.S. financial regulations, Federal Reserve monetary policy and Cecchetti's appointment as head of the Bank for International Settlements' monetary and economic unit

Ricardo Hausmann, Martin Wolf, Guillermo Calvo, debate on rescue of Bear Stearns

From FT, the top macro-economists debate;

In his column last week Martin Wolf argued that it was intellectually untenable for Wall Street to resist more onerous regulation of capital requirements or liquidity. Moral hazard is already visible, he wrote, in the jump of investment banks’ share prices since the Bear Stearns rescue.

Ricardo Hausmann argues that tighter regulation during the past few years would not necessarily have led to better pricing of risk. He would put the blame on “a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment”.

Robert Wade points out that a “new financial architecture” was discussed after the financial crises in in Mexico (1994–5) and East Asia/Brazil/Russia (1997–8) — but by 2000, when these crises appeared limited to the emerging markets, “discussion petered out”.

Just when you thought things could not get much worse, Guillermo Calvo warns that the current financial crisis could be distracting us from another problem: a reduction in central banks’ ability to anchor nominal prices. “In the short run this may be less noticeable in broad price indexes like the CPI but, in my view, it is already being reflected in, for instance, the dollar/euro exchange rate,” Calvo argues. This could have a deleterious effect on trade, he says, because while public policy can respond to trading partners’ technical superiority, for example — it is difficult to effectively reform against arbitrary swings in exchange rates.

Adam Posen echoes Martin’s fears that the current crisis will be interpreted by countries such as China and India as a strike against free market liberalisation. But he fears the misinterpretation will go further. “Life is complicated, so events get overdetermined.” The outcome could be an even deeper rejection of liberalisation, as the entire “anglo-saxon model” is blamed for what Posen calls a “regulatory ankle-sprain”.

Ricardo Hausmann: Martin makes an interesting point. If the Fed’s safety net is extended beyond commercial banks to other market participants, prudential regulation should also be extended to avoid moral hazard. Martin may have a point, but I believe he may be focusing the policy discussion in the wrong place. It is macro policy, not financial policy that needs to be at center stage.

I propose we engage in the following counter-factual scenario. Let us suppose that more stringent financial regulations had been adopted in 2003 or some such date. Let us discuss two macroeconomic scenarios.

Consider first the case where the Fed would have set the same interest rates as we observe in the historical record. In this case, the new regulations would have lead to a smaller rate of credit expansion because the regulations would have meant that, for any interest rate set by the Fed, the market for credit would have been smaller. Presumably, there would have been less mortgage lending, fewer home equity loans and less junk mail offering zero percent loans on credit cards. Aggregate demand would have been lower and presumably so would have been the rate of growth, the level of employment, the inflation
rate and the current account deficit.

Now, consider the alternative scenario in which the FOMC would have set interest rates following the way monetary policy is conducted, with the same inflation and employment targets. What would have been the consequences of this alternative and more plausible financial scenario?

Obviously, the Fed would have lowered interest rates until the amount of lending required by the inflation and employment targets had been achieved. The financial system would have been asked to find other ways to expand credit.

Maybe, that additional lending might have been safer than the form that lending actually took because risk would have been better priced. But I am not so sure that this would have been the case. With the even lower level of real interest rates, the incentives for financial engineers to invent new instruments that could be placed in large numbers would have been enormous and many more bright minds would have been hard at work at circumventing the new regulations than those that had crafted them.

My bottom line is that it is impossible to discuss the lessons of this crisis without talking about macro policy. I would put more of the blame on the way monetary policy is conducted. It is based on a so-called Taylor rule - that sets the interest rate as low as possible, so long as the discomfort with inflation is not larger than the discomfort with unemployment, with blatant disregard to the current account, the exchange rate, asset prices, international finance, the rate of growth of credit or the balance sheets of households.

In the end, a macro policy that overshoots the sustainable growth rate by encouraging millions of citizens to over-borrow is not going to be made safe through financial regulation.

Guillermo Calvo: Martin Wolf is right that the current arrangement in financial markets needs to be revised. How to do that is a much larger issue, and I agree with Ricardo Hausmann that one cannot tackle the financial system in isolation of other macro policies and, in particular, monetary policy. The financial system is much like the nervous system: it is in contact with the whole body. Important as those issues are, however, there is the risk that financial distress may be distracting us from the recent surge of another type of vulnerability, namely, much poorer price and exchange rate anchoring—a weakness that, if left unattended, may result in a new type of crisis.

The period of so-called Great Moderation spanning from the 1980s until now has given central banks the illusion that they can implement an incredibly clever nominal anchoring system by appropriately manipulating a reference interest rate (Taylor’s rule is an example), to such an extent that it is safe to let the exchange rate and the stock of money (whatever its definition) be fully determined by market forces. This arrangement could work under highly demanding rationality conditions, but even if the latter are satisfied one can find examples in which nominal anchoring requires some kind of fiscal anchoring along the way (see, for example, John Cochrane, “Inflation Determination with Taylor Rules: A Critical Review” NBER Working Paper 13409, September 2007). Thus, even under this narrow perspective, the present situation suggests that central banks may be about to lose the awesome power that they enjoyed during the Great Moderation. The reason is that central banks are beginning to venture into areas that go beyond standard liquidity management by acquiring assets, some of which could be insolvent or require major rescheduling. These are fiscal operations that might tend to deteriorate the already weak US fiscal stance, for instance. In other words, the fiscal anchor may become much weaker than it used to be, bringing about the specter of “fiscal dominance,” a phenomenon that has wreaked havoc in several developing economies. (There are even more relevant considerations that may contribute to making nominal anchoring tricky, like dumping of international reserves by Sovereign Wealth Funds while central banks peg their nominal interest rates; but this is not the place to expand on that.)

Consequently, one of the casualties of poor financial regulation may be a weakening of the central banks’ ability to anchor nominal prices. In the short run this may be less noticeable in broad price indexes like the CPI but, in my view, it is already being reflected in, for instance, the dollar/euro exchange rate. Under weak nominal anchoring, market-determined exchange rates could become highly volatile because slight changes in moods or expectations may cause them to veer into wildly different directions. And the solution cannot be found in more sophisticated or better regulated derivatives. Derivatives, if anything, make nominal anchoring even more difficult to achieve.

Weak nominal anchoring could have deleterious effects on international trade. Losing international competitiveness due to your trading partners’ technical superiority is something politicians can deal with in a sound way by, for instance, speeding up the pace of reform. But if the cause is an arbitrary swing in exchange rates, reform could actually be counterproductive, appreciating their currencies even further. Paradoxically, the “solution” could be found in crazy policies, a very dangerous path for the world economy to follow!

This is not the place to offer alternatives (although I believe that some kind of exchange rate coordination merits serious attention). My main point is that the world may be on the brink of a new regime in which exchange rates’ volatility increase the complexity of current problems by involving vital areas like world trade. I think it is time for the international community to urgently address those issues head on. Complacency got us into the subprime mess; let’s not do the same with monetary policy. Maybe my concerns are overblown, but it is always better to prevent than to cure.

Teaching Economics -'Aim high in steering'

The latest EconTalk with McCloskey is highly recommended- the last part of the discussion talks about the art of teaching economics.

Discipline of economics, McCloskey was Russ's teacher of micro, style of economic teaching that is puzzle-solving, intuition based. Profession has become more Samuelsonian, more mathematical. Where would you like economics to go if you had your druthers? Teaching 18-year olds. Adam Smith, more Smithian economics, economics where maximizing is in a context of ethics where the economic actor is thought of as being a human instead of a maximizing machine. The Economic Conversation, elementary book, students and faculty are urged to talk about economics. It's not the math itself that's the problem; it's the thinking that mathematical thought is the same thing as economic thought. Math is a tool. If all we do is run models over and over again, what is point of scholarships? Chess problems, econometrics. Hayekian direction as Russ's personal revolt against Max U. Either the use of emergent market based thinking or the conversational exploration of concepts are hard to write exams for. Compulsion to grade. Time-consuming to give a grade. When we have to give a grade we fall back on the Max U kind of problem. Language is how an economy operates and it's how a science operates. An emergent market is a talk shop. Austrian approach: These conversations are creative and that's why they can't be formulated as exam problems. Information. Talk about the role of language in the economy. Best economic education tragically takes place outside the classroom. "Aim high in steering.

Though teaching style have not made much progress, textbooks are improving for the better.

Related;
Intermediate Macroeconomics- from draft of textbook by Kevin Hoover

Current intermediate macroeconomics texts suffer from three common problems:

♦ Theory is detached from the facts of the U.S. economy. Textbooks often include boxed case studies to illustrate theoretical principles and illustrative graphs and tables of current data. The numbers in the chapters on national income accounting are updated with each edition. Yet, the facts of the economy are usually peripheral – not woven tightly into the main exposition. And it is common for students to emerge nearly as ignorant at the end of the course of the basic features of the U.S. economy as at the beginning.

♦ Exposition of theory is not well adapted to the real world. Macroeconomic news generally reports rates of change (e.g., growth rates, inflation rates), while typical textbooks focus on levels (e.g., the aggregate supply and demand curves determine the level of prices and GDP). The teacher knows how to translate from one context to the other, but the average student finds it difficult. Much of real world macroeconomics is closely tied to the complexities of financial markets. Textbooks typically focus on “the” rate of interest as determined by the supply of and demand for money, leaving a richer analysis of financial markets to later money and banking courses.

♦ Too much stress on theoretical closure and advanced topics at the expense of first principles. Many intermediate macroeconomics textbooks read like graduate textbooks without the mathematics.

From another forthcoming Intermediate Macroeconomics book by Chad Jones;

Economic growth is the first major topic explored in the book. After an overview chapter describes the facts and some tools, Chapter 4 presents a (static) model based on a Cobb-Douglas production function. Students learn what a model is with this simple structure, and they see it applied to understanding the 50-fold differences in per capita GDP that we see across countries. Chapter 5 presents the Solow model—but with no technological change or population growth, which simplifies the presentation. Instead, students learn Robert Solow’s insight that capital accumulation cannot serve as the engine for long-run economic growth. Chapter 6 then offers something absent in most (all?) other intermediate macro books: a thorough exposition of the economics of ideas and of Paul Romer’s insight that the discovery of new ideas can drive long-run growth.

Chapter 12 is where the payoff occurs, and we see the simple, familiar AS/AD framework. The innovation is that the graph is drawn with inflation on the vertical axis rather than the price level—perfect for teaching students about the
Volcker disinflation, the Great Inflation of the 1970s, and modern monetary policy. All of the short-run analysis—including explicit dynamics— can be performed in this single graph. Another innovation in getting to the AS/AD framework is a focus on interest rates and the absence of an LM curve. The central bank sets the interest rate directly in Chapter 11; Chapter 12 introduces a simple version of John Taylor’s monetary policy rule to get the AD curve. A final innovation in the short-run model is that it features an open economy from the start. Business cycles in the rest of the world are one source of shocks to the home economy. To keep things simple, however, the initial short-run model does not include exchange rates...

Relative to many intermediate macro books, this text features more emphasis on the world economy. This occurs in three ways. First, the longrun growth chapters are a main emphasis in the book, and these inherently involve international comparisons. Second, the short-run model features an open economy (albeit without exchange rates) from the very beginning. Finally, the book includes two international chapters in Part 4: in addition to the standard international finance chapter that appears as Chapter 15, Chapter 14 is entirely devoted to international trade.

Brad DeLong can improve;

I wrote this book out of a sense that undergrad macro needed to have the barnacles scraped off of its hull. It is more than three-quarters of a century since Keynes wrote his Tract on Monetary Reform; it is two-thirds of a century since Hicks and Hansen drew their IS and LM curves; it is more than one-third of a century since Friedman and Phelps demolished the static Phillips curve, and since Lucas, Sargent, and Barro taught us what rational expectations could mean. All this time undergrad macro has been becoming more complicated, as new material is added while old material remains. It seemed to me that if I could successfully streamline the presentation of material, both traditional and more modern, the result would be a more understandable and comprehensible book. I hope that I have succeeded—that this book does move more smoothly through the water than its competitors, and will prove to be a better textbook for third-millennium macroeconomics courses.

Could it turn out like those times?

Depression, You Say? Check Those Safety Nets;

“I used to give a lecture explaining that the Great Depression could never happen now because of the regulations that emerged from that crisis,” said Barry Eichengreen, an economist at the University of California at Berkeley. “But we’re learning that there is a shadow banking system, of hedge funds and investment banks, that are outside of those safety nets. What happened to Bear Stearns last week looked a lot like a 19th-century run on the bank. And that’s why the Fed reacted so quickly.”...

“To understand the Great Depression is the Holy Grail of macroeconomics,” Mr. Bernanke wrote in a 1994 paper, when he was a professor at Princeton focused on analyzing the financial cataclysm that began in 1929. While economists have made great progress, he continued, “we do not yet have our hands on the Grail by any means.”

Three Stages of Financial Crisis - Brad DeLong

As John Maynard Keynes wrote more than eighty years ago: "The Individualistic Capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring-rod of value, and cannot be efficient--perhaps cannot survive--without one."

See also Mankiws's 2008 = 1929?

Quote of the Day

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs."

-Thomas Jefferson

Related;
Hamilton vs. Jefferson: Whose economic vision was better?

It is well known that Hamilton and Jefferson disagreed strongly about the national bank. Hamilton was the architect of the First Bank of the United States, believing it essential to the financing of the federal government and to the establishment of a robust domestic banking system. As such, Hamilton is considered a pioneer of central banking and a forebearer of the modern Federal Reserve. Jefferson believed the bank would put too much power over the government in the hands of the bank’s owners.

But the issue went deeper than that. Jefferson, in fact, didn’t like banks at all. Steadfast in his belief that working the land was the only “honest” way to make a living, he saw bankers as essentially swindlers, and he didn’t trust them. Hamilton, by contrast, thought banks were to be a vital part of the American future—if we want a strong economy, we need lending, and lending is the business of banks. Better to have American banks doing the lending, he argued, than British or other foreign banks.

This disagreement is part of a long history of controversy about banking. There are basically two opposing views: One sees debt as essentially bad and looks at bankers as exploiting borrowers’ bad fortunes or poor judgments; the other sees lenders as providing a useful service for which there is enough demand that borrowers are willing to pay interest.

In retrospect, it may seem obvious that Hamilton was right, at least in predicting how America would develop. But this controversy is still alive, and Jefferson’s voice can be heard today, for example, in the reaction to problems in the subprime mortgage market.

Gaps in Securities Market Regulation

A summary of a recent IMF Conference on Securities Statistics

Conference participants agreed on the need for a compilation guide for securities statistics, because no international standard for compiling these statistics exists. The intention is to have a concise reference document that will address the key methodological issues identified at the conference. The guide, which will include some templates and a list of reference metadata, will focus initially on statistics on debt securities issued but will eventually be expanded to cover other securities and securities holdings. The manual will also include an assessment of costs and benefits of security-by-security databases.

Related;
IMF Study Points to Gaps in Securities Market Regulation
IMF Helping Fill Global Securities Data Gap

The Value of Bernanke's house

Bernanke lives in Washington's Capitol Hill area in a four- bedroom, 2,600-square-foot house he bought new in May 2004 for $839,000. Almost four years later, it may not be worth any more, according to real estate records and local agents....

Real estate records show Bernanke's next-door neighbor's house sold in July 2007 for $880,000, 4.9 percent more than Bernanke's purchase three years earlier. A home four doors down and comparable in size and condition to Bernanke's has been on the market for five weeks at $899,000, after a failed attempt to sell for $988,000 in 2006....

The average sales price in the Washington area dropped to $217,780 in December, a decline of 13 percent from a record of $251,070 in May 2006, S&P/Case-Shiller data show. Washington's home prices had gained an average of 15.9 percent a year in the 10-year period ending in 2005, according to Case-Shiller figures.

-Bernanke's Own Home on Capitol Hill Shows Housing Boom and Bust

Related;
Housing Markets: A Vacant Look

Paul Volcker the practical monetarist

FT coverage of the Volcker interview;

He told CBS Charlie Rose show: “We have seen the Federal Reserve take more extreme measures in some respects than any that have been taken in the past to deal with a financial crisis.”

He said the decision to lend cash to Bear Stearns and make emergency fin-ance available to other primary dealers was “understandable” but raised “real questions” as to the appropriate division of labour between US authorities.

The former Fed chief said the US central bank had not been thought of as a place “where you put in bad assets, possibly bad assets” – an apparent reference to the collateral backing the $30bn credit line extended by the Fed as part of the Bear rescue takeover deal.

“At some point the government, in my view, ought to be taking responsibility for that kind of action, not the Federal Reserve,” Mr Volcker said.

He added that the Fed’s latest move “stretches their authority to the limit”. The problem of what to do with bad housing loans was “basically a governmental responsibility”.

He urged the government to channel funds into the market through Fannie Mae and Freddie Mac, the government-sponsored agencies – possibly by activating a longstanding Treasury credit line to these institutions.

Echoing the message from the Fed this week, which cut interest rates by less than the market had expected and highlighted concern about inflation, Mr Volcker said “there are limits to how much you can reduce interest rates”.

He warned that the threat of resurgent inflation was “lurking not very far in the background”. That would be “the ultimate destructive result of this”, he said. “We just must not let that happen.”

The former Fed chief also said the administration’s strong dollar rhetoric had “become meaningless”.

He said a weak dollar allowed the US to increase exports and reduce its reliance on foreign savings but “begins to raise questions” as to its role as a world currency.

In addition to above Volcker raised the issue compensation packages of investment bankers that may be providing incentives to take greater risks.

Related;
Former Fed chair Volcker: financial crisis not over

The realignment of the regulatory powers

Second, the more commitments made by the Fed, the more we lose the (quasi) independence of our central bank; for a large commitment Treasury sign-off is needed. The realignment of the regulatory universe will eventually emerge as a big story from the current crisis, though it is hardly commanding much attention right now.

How to deal with banking crises;

One lesson is that trouble is all too common. Most members of the IMF have undergone at least some distress since the late 1970s. Crises in poorer countries tend to be deeper and more costly, often because they are twinned with collapsing currencies. According to a 1996 survey of insolvencies by economists at the World Bank, the bail-out of Argentina's banking system in the early 1980s cost a stunning 55% of GDP to fix.

The rich world's banking troubles have not been cheap either. The bill for bolstering Finland's banks in the early 1990s came to 8% of GDP; Sweden's bail-out was scarcely less dear. America spent more than 3% of GDP cleaning up the savings-and-loan crisis, its priciest to date. That suggests that the possible cost of today's troubles, though alarming, is not off the charts. The best, though still highly uncertain, estimate of prospective lending losses is around $1.1 billion, less than half of which would be borne in America by banks, investors and in forgone taxes: $460 billion is equivalent to about 3% of last year's GDP.

History shows wide-ranging reasons for recessions

How Paul Volcker became a practical monetarist;

It always seemed to me that there is a kind of commonsense view that inflation is too much money chasing too few goods. You could oversimplify it and say that inflation is just a monetary phenomenon. There are decades, hundreds of years, of economic thinking relating the money supply to inflation, and people to some extent have that in their bones. So I think we could explain what we had to do to stop inflation better that way than simply by saying that we've got to raise interest rates. It was also true that we had no other good benchmark for how much to raise interest rates in the midst of a volatile inflationary situation.

At least as important was the idea to discipline ourselves. People in the Federal Reserve don't like to raise interest rates. So the danger is you're always too little too late. I think that would apply to the current situation [April 2000]. So, when inflation really had the upper hand, it was, I think, very important to put something out there so you could discipline yourself. For that kind of a commitment, you've got to know what's at stake, and it does make some broad sense if you have that much inflation [pp. 178-179].

What really propelled me to make the change was when we raised the discount rate for the second time, when I was first down there. The vote was 4-3. I thought it was a reasonably strong move and we'd get a favorable reaction in the market, but we didn't. The response was, "Well, gee, the Federal Reserve is behind the curve anyway, the vote was 4-3, and that's the last increase of the discount rate we'll see." So the market reacted very badly, which surprised me. I guess I was a little naive. I remember very clearly, I didn't bend over backwards to try to twist the arms of the three people who voted the other way. I knew I had four votes. If we had to increase the discount rate again, we'd have another 4-3 vote. But that's not the way the market read it. Then I realized that we had this credibility problem worse than I thought. That got me off and really thinking operationally about the other approach [basing policy on target growth for the monetary aggregates]. But when it was sprung on them, everybody was very much in favor, even those who were voting against the increases in interest rates [pp. 178-179].

Fannie and Freddie: The End of the Punishment is Nigh

Cost of insuring bank debt falls after Bear bail-out

The cost of protecting the senior debt of the 25 European banks in the iTraxx Financials index has fallen 44bp this week, or about 28 per cent. It now costs an average of €114,000 per year to insure €10m of the banks' debt against default over five years, €44,000 less than it did on Friday.

Defending Market-Value Accounting

The Prisoner of Wall Street

So central banks, including the Fed, should stand ready to act as market maker of last resort, accepting a wide range of private securities as collateral in repos (or purchasing such securities outright) from a wide range of counterparties at a wide range of maturities. Likewise, individual systemically important financial institutions should have recourse to lender of last resort facilities, including the discount window.

The Fed has recently extended access to its discount window to the 20 (or is that now 19?) primary dealers. Other non-deposit-taking institutions will no doubt be granted the same privilige before long. The restriction of the new PDCF to overnight finance only should also be lifted. The same terms as those available to deposit-taking institutions (up to 90 days) should be available. Provided the collateral is priced appropriately (which means the prompt abandonment of the approach outlined on the Fed’s website that “…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” - an invitation to stuff the Fed with fools’ gold priced as bullion), this will stop the unavoidable and fundamentally warranted solvency problems of a number of households and financial institutions from triggering a system-wide liquidity crisis and a system-wide fundamentally unwarranted solvency problem, and will do so with minimal damage in terms of moral hazard.

Seeing Red at the Fed

Home Sweet Investment

Can’t Grasp Credit Crisis? Join the Club

“If anything goes awry, these dominos fall very fast,” said Charles R. Morris, a former banker who tells the story of the crisis in a new book, “The Trillion Dollar Meltdown.”

This toxic combination — the ubiquity of bad investments and their potential to mushroom — has shocked Wall Street into a state of deep conservatism. The soundness of any investment firm depends largely on other firms having confidence that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio, regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Goodbye, Bear Stearns.

Bear Economists Snipe at Bernanke
But in their most recent economics report released Wednesday — titled “Apart From That, Mrs. Lincoln, How Was the Play?” — Bear Stearns economists detail their sometimes sarcastic critiques of Mr. Bernanke, and lay their firm’s inescapable demise squarely on his shoulders.

Post-Bailout Punditry

A Primer on Monetary Policy in Australia

A recent speech by Australian Reserve Bank governor;

I turn now to arguments about monetary policy and inflation. The first one that I want to address is the assertion that monetary policy, in adjusting interest rates, is ineffective in controlling prices, because it is failing to restrain demand. More than once I have seen people state that the rises in interest rates seemed not to make much difference.

But if it were really true that the sequence of adjustments that took place to raise the cash rate from its low of 4.25 per cent in 2001 to 7.25 per cent today made no difference to the economy or inflation, it would follow that we could reduce the cash rate by 300 basis points tomorrow and nothing would change. If we put it like that, surely not many people could seriously believe that the changes to interest rates have made no difference.

More realistically, people might think that it is the changes in rates that matter, more than the level, and that the changes were too small. In this view, interest rate changes should perhaps have been bigger, so as to give more of a ‘shock’ to behaviour on each occasion (though they should presumably also have been less frequent – otherwise the level of rates we would have reached would have been much higher).

I suppose it is possible that a different sequence of changes, including some bigger ones, would have changed behaviour in the economy. We cannot know because that alternative scenario cannot be run, but as everyone knows, the Board has on occasion in the recent past considered larger movements. So the idea of larger changes is not absurd.

Yet it is hardly as though interest rate changes were so small that no‑one noticed. There are few issues reported at more length than interest rates; no‑one could say they were unaware of what was happening. Beginning with the March 2005 rate change, moreover, the extent of coverage in the media has been far more intense than it had been prior to then, and far more intense than is the case in other comparable countries. We could debate the reasons for that, but they do not matter for present purposes. On every one of those occasions, there was no shortage of dramatic media coverage, and no shortage of predictions of serious consequences for indebted households, the economy and so on. If we were looking for announcement effects, surely they should have been at work through this period.

My own view is that monetary policy is most effective when actions are seen to be consistent with the factual evidence available on the economy, a sensible assessment about future risks, and a framework that has a clear medium‑term objective for policy. Apart from that, we have to accept that the likely effect of any one move of 25 or even 50 basis points is, while uncertain, probably only modest. It is the combination of changes, and more particularly the level reached, that will do most of the work.

A second version of the ‘ineffectiveness’ argument holds that (1) the price rises are coming from factors beyond the control of any Australian policy, and particularly from abroad, from which it follows that (2) monetary policy cannot do anything about them. For some people, it follows that it is therefore (3) futile, and unnecessarily disruptive, to try.

I have already addressed the question of whether all the price rises can be put down to a few special factors, obviously not under our control. The fact is that the price rises are broader than that.

But even if all the initial impetus for higher prices comes from events abroad, we still have to decide how we will respond to that shock. In the case of energy prices, while the world price of oil in US dollars certainly is completely outside our control, it is the Australian dollar price of oil that actually matters for the Australian motorist. That price is lower at present than it might have been, because of the rise in the exchange rate. Insofar as interest rates have a bearing on the exchange rate, they can affect petrol prices, indirectly, and have done so.

Looking across the economy more generally, we can all see that the main external event of recent years is the rise in the terms of trade, which is obviously completely exogenous as far as Australia is concerned. But higher resource prices generate additional income, which then affects demand for goods and services at home. That is expansionary, and puts pressure on prices for non‑traded goods and services. Even though monetary policy cannot stop the initial shock – of course we cannot stop the Chinese demand for resources – we can, and should, seek to condition the economy’s subsequent response to that shock, rather than simply letting domestic overheating go unchecked. Tighter policy will dampen domestic demand and contain the pick‑up in non‑traded prices as well as raising the exchange rate, which makes imports cheaper, exports less competitive and fosters a move of productive resources into the parts of the economy where more production is needed. That is an appropriate form of adjustment to such a shock, particularly if the shock is likely to be fairly persistent.

So even when events beyond our control occur to put pressure on prices, we should still respond, and that response can be quite effective.

Another line of argument takes quite a different tack. It argues not that monetary policy is ineffective, but in fact that it makes the problem worse by actually raising prices. The logic here is that interest payments are a cost to business activity, and that raising this cost will simply result in businesses passing it on.

It is obviously true that interest is a cost, and for a business to stay solvent it has to cover that along with its other costs in its selling price. But when interest rates rise, can business just pass this cost on without losing sales? It might be possible initially, but since higher interest rates do eventually slow demand, it will get more difficult to raise prices in due course. So when some people say that higher rates will just push up prices, I think the answer is that it is the strength of demand that allows that, and the rise in interest rates will, in time, dampen demand. All the historical evidence is that monetary policy is quite effective in that regard.

I turn now to other arguments, not that monetary policy is ineffective, but that it is not terribly precise. One common expression is that it is a blunt instrument. People rarely define what they mean by that term, but I think they have in mind two things. First, if inflation is rising because particular prices are moving a lot, monetary policy cannot focus precisely on exactly those particular prices, or those particular features of economic behaviour causing the price rises. It is a general, rather than specific, instrument in that sense. Second, I think that when people say ‘blunt’, they mean ‘unfair’ – particularly that when interest rates rise, this affects households who owe money on a home loan. (Presumably the same argument would mean that it is equally unfair to savers to put interest rates down when the economy is weak.)

As I noted before, it is not actually true that the recent rise in inflation is confined to just a few items. To that extent, the use of a general instrument would seem quite appropriate. But there are also a couple of other quite important points to make in regard to the ‘blunt instrument’ critique.

The first is that the transmission channels for monetary policy are much wider than just the impacts on households with home loans. Most businesses have debts, too.2 Floating rate debt costs more for them to service as interest rates rise, which presumably causes some of them to reconsider some things they might have been doing or planning. So the ‘cash flow’ channel of monetary policy affects business.

Monetary policy also affects what economists would call inter‑temporal decision‑making. Incentives to save, as opposed to consume, alter. It is commonly observed that many Australians save rather little, but the household saving rate has in fact risen noticeably in recent years, largely unnoticed by conventional opinion. I do not claim that the increase is mainly due to rising interest rates, but I do not think we should assume that these incentives do not matter. Despite Australia’s extensive use of foreign saving to build up our economy, the bulk of our productive investment is financed via domestic saving of one form or another.

Changes in interest rates affect asset values over time, through effects on discount rates, expected earnings growth and so on. These feed through into behaviour in several dimensions – via the cost of capital to firms, wealth effects and so on. Through complex channels, monetary policy can sometimes also affect the non‑price terms of credit, particularly if it manages to affect expectations about future growth, creditworthiness and risk appetite.

Then there is the exchange rate, as I have already mentioned. Numerous factors affect exchange rates, and the relationships are hard to pin down. However, interest rate differentials between countries do matter to exchange rates, along with expectations about how those differentials may change (a function of growth expectations), factors affecting trade positions (such as commodity prices in our case), investor risk preferences and so on. I have already discussed the case of petrol, but there is surely little doubt that the prices of tradable goods and services generally are lower today than they would have been if the exchange rate had been at its long‑run average level. This is the case even with much more muted short‑term pass‑through of exchange rate changes than we used to have. In other words, changes in the exchange rate alter the terms at which the rest of the world supplies goods and services to Australia in a way that is stabilising for prices.

All these are channels for monetary policy’s effects. They operate at different speeds, and to differing extents in different episodes – but they are all there, and I would say that they are all working at present. The transmission of monetary policy is not just about home loan rates, as important a channel as that is.

Secondly, to say monetary policy is a blunt instrument begs the question: where are the sharp instruments? It is not obvious that there are all that many. People mention supply‑side reforms of various kinds and unquestionably these have been extremely important over the years. To the extent that more can be done, that is all to the good for Australians’ standard of living. But they are long term. It is hard to deploy them in a hurry. And many of them are very general – ‘blunt’ even – rather than specific.

Many people will appeal, perhaps not unreasonably, to the possibility of using fiscal policy to counter inflation pressure. For some time now, fiscal policy has not been actively deployed to manage the business cycle. The focus has mainly been on achieving and then maintaining a structurally sound, long‑run fiscal position and, subject to that, making tax and spending decisions aimed at various other objectives that governments have. This does not preclude allowing the budget’s ‘automatic stabilisers’ to operate over the cycle (though it might be observed that, with an elongated upswing like the one we have been having, it is getting more difficult to decide what should be thought of as a temporary rise in revenue and what can be assumed to be permanent).

It strikes me that in the popular discussion about fiscal policy, many participants talk past each other because they are looking at different time dimensions. It is not unreasonable to say that if the budget is perpetually in surplus, there is no debt to speak of and no other looming large unfunded liability, taxes should probably, over some long‑run horizon, be lower. This, it seems to me, is the economic case for structural reductions in taxes, which some observers articulate. Others argue that such reductions should be delayed, for cyclical reasons, given that demand needs to slow to contain inflation. So there is a structural case for taxes to fall, and a cyclical case for them not to. It is no doubt difficult for any government to reconcile these two, equally valid, points of view, the more so if the same tension persists for a number of consecutive years.

Leaving that aside, let us give some thought to just how effective an instrument budgetary policy is likely to be. If inflationary pressures were just due to specific, narrow issues (which, as is clear above, I doubt), precise targeting of the sources of inflationary pressure via tax and spending measures could nonetheless be exceedingly difficult at a technical level, let alone politically.

If it is accepted, on the other hand, that inflation is sufficiently general that overall demand has to slow, the amount of slowing has to be the same regardless of whether it comes via monetary policy or fiscal policy. It would be somewhat differently distributed across sectors and regions, as the impact of interest rate and exchange rate effects obviously would not overlap exactly with the tax or spending measures that would occur in their place. I would hazard a guess, though, that a good many people who are today paying higher interest rates would instead pay higher taxes in a world where fiscal policy was used more actively to manage the business cycle. We are unlikely, I submit, to witness a situation where income taxes are raised only for those without home loans, or only for those living in Western Australia and Queensland, or those working in the mining sector.

Then there are the time lags in implementing fiscal measures. The Budget occurs once a year, and has a very long and gruelling process in the lead up. I am not expecting to be stampeded by people in this room wishing to do that more often. The economy could conceivably look rather different in mid May when the Budget occurs than it did when the budget processes began, and different again by the time the measures actually take effect. Monetary policy has its full effects with a long lag, but we at least get to reconsider each month, and if need be we can reverse direction quickly.

Don’t get me wrong. I am not arguing that fiscal policy does not matter to the cyclical outcomes, or that fiscal policy should not be made with an eye to the cycle as well as to the structural position. To the extent it can be, of course that is welcome. I am not here to offer any particular suggestion on what fiscal policy should do at present. I am simply saying that the task of fine‑tuning fiscal policy for stabilisation purposes, if that were thought desirable, is unlikely to be any more straightforward than that of using monetary policy. Fiscal policy, in its own way and for its own reasons, is also likely to prove a fairly blunt instrument. Inevitably, even with fiscal policy ideally calibrated for the conjunctural position, monetary policy would still have a lot of work to do managing inflation.

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