1. Is the European Central Bank, or maybe the whole EU, a good candidate for a Darwin Award? There doesn't seem to be a category for institutions that bring about their own demise through their own self-destructive behaviour, but perhaps there should be. In the very long run we should perhaps be thankful for dysfunctional systems' destroying themselves. But in the short run they tend to take a lot of other people and institutions down with them.
2. Is there really any difference between the fiscal policy of a Eurozone government and the budgetary policy of a household? I know it's heresy for a macroeconomist to entertain such a notion, but is there? Neither can print money, so that difference is out. Both seem to tighten their belts when interest rates rise and it gets harder to borrow, so no difference there either. And there's 17 of them, sharing the same monetary system, and any microeconomist knows that a Cournot oligopoly with 17 firms is much closer to perfect competition that to monopoly, and that 17 is much closer to infinity than to one.
3. Are Eurozone governments, on average, any riskier than Eurozone banks, on average? If any significant fraction of the governments go bust, a much bigger fraction of the banks will go bust too, I think. So does it make sense for the ECB to lend to banks at 1.25%, on loans collateralised by government bonds, even with a haircut, and not lend to the governments at anything like those terms?
4. Maybe, just maybe, a run on the Euro itself, as opposed to a run on Euro bonds, is just what the patient needs. If recessions are caused by an excess demand for the medium of exchange, then an increased risk that the medium of exchange might become an orphan currency might reduce the demand to hold it. If Euros themselves become a risky asset, even notes carefully buried in the back garden, then what are people going to buy if they decide to get rid of them? Unfortunately, it may not be investment in newly-produced real assets. Because if the monetary system collapses altogether, so there is no functioning medium of exchange and credit system to go along with it, a new factory might not be very profitable. Barter doesn't work very well.
5. Stephen Harper (Canadian Prime Minister) and Mark Carney (Governor of the Bank of Canada) have been telling the EU to solve its problems, because they fear the collapse of the Euro will affect Canada and other countries. I doubt their words had any effect, though there's no harm in trying. Other than print up 17 batches of new banknotes for Christmas presents, whether they ask for them or not, I don't think there's much Canada can do to help. And I can't think of anything Canada can really do to protect ourselves from the fallout either. Except keep our own monetary policy looser than we otherwise would, and have Export Development Canada be ready to expand trade credit on a larger scale.
6. At root, the coming Eurozone crash, like the 2008 crash, are not caused by a failure of governments, or of finance, but by a failure of monetary systems. Yes, people and governments borrowed more than they should have, and other people lent them more than they should have. But people make mistakes, and do stupid things, and loans go bad. A good monetary system should have the ability to keep the economy functioning even if loans go bad. Nowhere is it written in stone that if a lot of borrowers can't pay a lot of lenders that there has to be a recession and we all stop working and producing and buying and selling and just sit and watch while those borrowers and lenders sort themselves out.
We need a monetary system that keeps on functioning despite human mistakes, stupidity, or asteroid strikes.
Perhaps the Ignobel awards, not the Darwin Awards. The 2008 Ignobel Award for Economics was awarded to the Icelandic Banking Industry and the Central Bank of Iceland, for demonstrating the symmetry of the economic cycle.
Plus the Ignobels have an Operatta each year at their award presentation. And costumes.
Posted by: Determinant | November 24, 2011 at 11:46 PM
Ah, here we go. http://www.youtube.com/watch?feature=player_detailpage&v=20B_chX9iiU
"The Big Bank Opera"
Delicious.
Posted by: Determinant | November 25, 2011 at 12:01 AM
Are you opening a thread on how to engineer a better monetary system? Well, since you asked, I think this would be pretty good:
1) Give everyone access to an account at the CB
2) Get rid of physical currency
3) Revoke deposit insurance. This will get the banks out of money.
4) Back money with a representative portfolio of liquid capital assets (not repo!) The money is a claim on the portfolio and can be redeemed for a share of the underlying assets. Capital assets are the new gold.
5) As required, split the units of money - a purely nominal solution for a nominal problem.
This system comes with a bunch of benefits:
1) Since money *is* capital assets you can't flee risk by holding money. You can invest or you can spend. But you can't *save*. So if the Market Monetarists (or at least Nick) are right that money is the root of all recessions, then we can't have any more recessions.
2) Should we still have AD problems due eg. to nominal rigidities, we can trivially change the quantity of the unit of account (with no impact on the value of the outstanding medium of exchange) by just splitting or reverse splitting the money (pay interest). And since there is no physical currency we are free to expand or contract the quantity of units of account and so we totally escape the ZLB.
3) since we no longer depend on banks for our money and most people will just keep their deposits safely at the CB, banks will raise capital in the free market like everyone else. And bank investors will be on the hook for their own losses which will result in efficient, responsible behaviour. And since we don't depend on them anymore to keep our money safe, we no longer need to regulate them. Which will hugely reduce the potential for rent-seeking.
4) Since money is a representative portfolio of capital assets most people will no longer need to deal with the investment industry in order to "invest their money". They will just need to *hold* their money. Those who really feel they want something custom could get a brokerage account.
5) Since the whole financial sector would be vastly smaller as would be the opportunities for rent seeking, the next generation of talented young workers would be drawn into productive enterprise elsewhere in the economy.
Posted by: K | November 25, 2011 at 12:19 AM
K: a monetary system that completely stops during a blackout is perhaps not very robust.
Posted by: Lorenzo from Oz | November 25, 2011 at 01:47 AM
"A good monetary system should have the ability to keep the economy functioning even if loans go bad. Nowhere is it written in stone that if a lot of borrowers can't pay a lot of lenders that there has to be a recession and we all stop working and producing and buying and selling and just sit and watch while those borrowers and lenders sort themselves out. We need a monetary system that keeps on functioning despite human mistakes, stupidity, or asteroid strikes."
Excellent. I would say "financial system" rather than "monetary system". But that's just quibbling.
Posted by: Steve Waldman | November 25, 2011 at 03:39 AM
Nick, I think you are biased.
1) First of all, from a macroeconomic perspective, the Eurozone is doing relatively OK:
- like the US, it experiences a moderate growth rate (about 1.5%) and slightly about-target inflation (3%);
- the level of public debt is slightly lower than in the US (gross debt of 90% vs 100%), and the budget deficit is much lower (4% vs 10%);
- monetary policy is almost as accommodative as in the US (with 10y German bonds at 2%)
2) Second, countercyclical policies in the Eurozone don’t need to be as aggressive as in the US because: (i) the impact of the financial and the real estate crises has been much less severe, and (ii) the Eurozone trade with the outside world is pretty much balanced.
3) The Eurozone politicians may not have handled the Greek case in the best possible way (just as the US may have made a mistake when it let Lehman go bankrupt), but we have to recognize that their options were limited. The chances that Greece would fully repay its debt were always very slim, even if Greece could finance it at German rates; and the only question was whether the Eurozone would bail out private creditors. Eventually, it turned out that nobody (in particular Merkel) was willing to pay the political cost, and the bailout did not happen, creating a very dangerous precedent of sovereign debt restructuring and pushing the yields up for most Eurozone countries.
4) Greece lax fiscal policies were also responsible for high domestic inflation, reducing its competitiveness and worsening its trade balance. Unfortunately this problem has no easy solution. The Eurozone probably shouldn’t have admitted Greece in the first place, but now the best option seems to be a long period of disinflation and slow growth. If Greece leaves the Eurozone, it will experience a period of chaos - which may have unpleasant geopolitical consequences, given its tense relations with an increasingly assertive Turkey.
5) For everyone else, problems are much more manageable, and we don’t need to rely on the ECB to solve them. Of course, the ECB has the right to buy government debt in exceptional circumstances, but it is understandably unwilling to do so because:
(i) as I argued before, the net effect on nominal interest rates may be very small or even negative,
(ii)the politicians will feel much less pressure to act and we need a political solution to the sovereign debt crisis,
(iii) a political solution is not very difficult to find – there are many good options and now that Italy and Greece have credible governments, negotiations should be going much faster.
So, while the Eurozone institutions are not perfect, they are not fatally flawed either – and, given the constraints within which they have to operate, European politicians and central bankers have arguably done a better job than their American counterparts.
Posted by: Doctor Why | November 25, 2011 at 03:57 AM
Lorenzo: "K: a monetary system that completely stops during a blackout is perhaps not very robust."
Ha ha! My phone works fine in a blackout.
Posted by: K | November 25, 2011 at 06:43 AM
I echo Mr Waldmann in completely echoing your sentiment about our financial sytem.
But how does the *monetary* system keep the economy functioning? I suggest its by enabling payments to be made, not just at the level of the banking system (settling accounts) but at the level of the persons in the economy retaining some ability to pay their bills even when their job may be deemed less necessary by the economy.
The story I tell about our current dilemma is that we had a lot of people building, maintaining and selling houses. A lot more than a healthy economy should have (possibly) The mistake was not in removing the people from that sector of the economy but in not having any other alternatives that those folks could turn to to continue making the payments they had promised to make. The further mistake was in letting this contagion bleed to other sectors because the people these housing folks owed money to could no longer count on the level of income they needed to maintain their level of output. Then there were the choices made to voluntarily remove public sector workers at the fed and state level (under the ridiculous excuse that we were running out of money to pay these folks)who of course had made promises to pay people they could no longer fulfill..... etc etc.
So, can the private sector be flexible enough to have income sources (aka jobs)waiting for those who are no longer needed in the housing sector, or any other sector fo rthat matter? No! The only sector that can do that is the public sector. Will it be efficient? Probably not by many standards. Can it be effective? Certainly, if you define effective as continuing to provide people with a level of incomne to keep makingthe minimum payments of their financial obligations, thereby preventing a seizure of the banking/payment system.
Simply trying to work with the money side of this has proven ineffective, we have to work with the people side of this. People make payments, not dollars.
Posted by: Greg | November 25, 2011 at 07:39 AM
Nick:
I suppose that having money be a risky asset (even banknotes in the back yard) might reduce investment in real assets, however, it would increase consumption expenditure. Perhaps we would find out what these Austrian "too much demand for consumer goods" recessions would look like. Can't produce consumer goods to meet demand because we don't have enough appropriate capital goods. But in this case, people don't want to buy the capital goods because they are worried about the future collapse of the economy.
In my view, if money is a risky asset, then people just hold less. It doesn't servce as a store of wealth and it only serves as a media of exchange.
Lorenzo:
You can still write checks in the blackout.
K:
Make the currency private.
By the way, what are "liquid capital assets." Do you mean like publicly traded stocks and bonds with terms to maturity of a year or more?
Posted by: Bill Woolsey | November 25, 2011 at 08:00 AM
K: "1) Since money *is* capital assets you can't flee risk by holding money. You can invest or you can spend. But you can't *save*."
Rephrase. You are using a very non-standard definition of "save". The standard definition is: S=Y-T-C. But I understand what you are trying to say. Sometimes, our standard set of accounting definitions don't work to let us say what we want to say. Those accounting definitions rule our thought in ways they shouldn't. Must do a post on this sometime, just finding the words and accounting definitions so you can say what you want to say clearly and consistently. (Which I basically agree with, BTW).
Lorenzo and K: It's all right for you young trendy people with your smart phones and Starbucks coffee and crap. But whenever people talk about abolishing currency it sends Brave New World/1984 shivers up my spine. I think about me, and all the homeless alcoholics. How will we cope? In Margaret Atwood's Handmaids Tale, the first thing they did was abolish currency.
Unbacked currency doesn't crash. There's nothing to crash. You have to have incompetence on Zimbabwean scale to destroy it. It's backed deposits that crash.
Steve: thanks! But I think it's the monetary system that causes recessions, not the financial system. The only reason that financial failures cause recessions is that the monetary and financial system are linked in a disfunctional way, so one spills over into the other.
Greg: I disagree with you there. Stuff will always go wrong on the real side of the economy, whether due to human stupidity, ignorance, good bets that just didn't come off, or asteroid strikes. And there's always going to be structural unemployment, which we can ameliorate or not through various measures. But none of these ought to cause aggregate demand failures, which are a purely monetary phenomenon. It's the medium of exchange what dunnit.
I'm much closer to K's sort of proposal. Set up a monetary system so a demand to hold money *is* a demand to hold goods. So that Say's Law must be true, by design.
Posted by: Nick Rowe | November 25, 2011 at 08:21 AM
does it make sense for the ECB to lend to banks at 1.25%, on loans collateralised by government bonds, even with a haircut, and not lend to the governments at anything like those terms?
As you have phrased the question, the answer is yes. In theory, so long as the value of the collateral asset is strictly positive (i.e. the recovery rate on the bonds greater than zero in all states of the world), then there is some haircut that makes the collateralized loan less risky than the underlying collateral. (From the perspective of the lender, that is.)
I agree with the substance of your argument, though.
Posted by: Phil Koop | November 25, 2011 at 08:23 AM
Bill: "I suppose that having money be a risky asset (even banknotes in the back yard) might reduce investment in real assets, however, it would increase consumption expenditure."
That would be a tolerable result. The worst result, globally, would be a demand for US$.
Posted by: Nick Rowe | November 25, 2011 at 08:26 AM
"Eurozone is doing relatively OK"
People in hospitals are relatively healthy - the medical staff outnumber the patients, after all! Some of the patients are very ill, and may die - but are still curable. If the patients are allowed to die, they will become zombies and infect the medics, who will then in turn become zombies.
The medics know that the patients only got sick because they didn't eat their greens.
In the real world, medics almost always ignore moral hazard and treat patients regardless. So why, we wonder, is Germany acting differently?
Posted by: Gareth | November 25, 2011 at 08:30 AM
Doctor Why: well, I expect we will see soon enough whether the Eurozone is fatally flawed, as I think it is. The government bond yields are much higher (and more volatile) than on other countries with similar debt/GDP ratios. Financial markets are freezing or frozen. The banks seem to be mostly insolvent, and their governments can't bail them out. If the governments were solvent enough to bail out the banks, the banks wouldn't be insolvent anyway.
Posted by: Nick Rowe | November 25, 2011 at 08:40 AM
Phil: what you say makes sense. But, as I was discussing with K on the previous post:
Suppose Italy goes to the ECB, Gives the ECB an IOU (Italian bond) for $100 as collateral , and then borrows (say) $80 against it. DIY repo, if you like, with a 20% haircut. The net effect is to put the ECB at the head of the queue in the event Italy defaults on its bonds. As long as Italy pays 80cents on the dollar (sorry, that's Euros throughout), the ECB is covered.
Posted by: Nick Rowe | November 25, 2011 at 08:50 AM
Nick : ".. well, I expect we will see soon enough whether the Eurozone is fatally flawed, as I think it is"
I think the worst case scenario is that Greece will leave, GIIPS will restructure their debt, but the Eurozone and its banking system will survive. We'll see.
Posted by: Doctor Why | November 25, 2011 at 08:59 AM
ECB...
short for Extra Crazy Bankers??
Posted by: Poul | November 25, 2011 at 09:09 AM
Bill: Make the currency private.
That's fine. But it'll be a real pain if most people have to deal with more than one in order to make normal payments. Also, it's not going to be very profitable to run and ideally it's universally accepted. And it's really not rocket science. There's nothing to it. But however it happens, I don't really care.
"what are "liquid capital assets."":
Stuff that is transparently traded in size. Mostly stocks and government bonds. Some financial bonds are sufficiently liquid. There'd be a lot more bank securities also once banks are not deposit financed. The important thing is that people can redeem their money for liquid, transparently priced assets in order to perfectly anchor the value of the medium of exchange.
As to the unit of account, there are choices to be made as to how and when to split it. But these are purely nominal decisions to address a purely nominal problem. Personally, I'd prefer to not split, or split at a fixed rate. This would result in anchoring money illusion on our share of ownership of capital assets rather than on purchase power of a current basket of goods. I think that's more natural for humans, but it could result in menu costs. Choices.
Nick:
"The standard definition is: S=Y-T-C. But I understand what you are trying to say."
Thanks! That means a lot to me. By saving I really mean "transporting 'real' purchase power forward in time." This is intrinsically impossible and obviously a great deal of our current problems relate to the fallacy of composition of everyone wanting to defer untransportable consumption. I would really prefer if the unit of account was not pegged to "real" consumption because money illusion then feeds the idea that you can transport consumption. But I understand menu costs and all that...
"abolishing currency"
Well, that's not a necessary piece of the proposal. Even if we want to be able to "split" money we can still have currency. We just need to keep an exchange rate (split adjustment) between currency and the unit of account. (Organized crime thanks you, Nick :-)
"Unbacked currency doesn't crash"
No. But it fluctuates wildly in value depending on liquidity preference. Which demands a lot of central planning. And it's inefficient to hold. I, the representative agent, do not *want* to give up capital assets in order to hold your intrinsically worthless junk just because I have a need to make transactions. Why does someone always have to pay seignorage to someone else? I just want to hold capital assets.
"It's backed deposits that crash."
As you once said, debt is like glass. Deposits crash because they are short term debt backed by long term assets. This is impossible BS, but people fall for the illusion of stability long enough for the system to get super leveraged. I'm explicitly not proposing repo (debt) backed money. The money I'm proposing is equity. It is not a senior claim on the pool of capital assets; it's the only claim. You can't have a run on it.
Posted by: K | November 25, 2011 at 09:37 AM
"So does it make sense for the ECB to lend to banks at 1.25%, on loans collateralised by government bonds, even with a haircut, and not lend to the governments at anything like those terms?"
Yes, because the loans to the government would not be secured. Central bank loans to banks are always double secured. They provide a senior claim on the bank, and should the bank go bust and not be able to fulfill its promise, the government security is taken in place. A loan to government provides the central bank with a direct claim on the government, but no extra security is being provided as collateral to make the loan good should the government go bust. Such lending is much riskier and deserves harsher terms.
Posted by: JP Koning | November 25, 2011 at 09:38 AM
People, people! I think we can lay this issues to rest! The solution has been provided! All questions answered!
Posted by: Mandos | November 25, 2011 at 09:51 AM
Nick every economist I respect in blogosphere: Krugman, Sumner, DeLong, Michael Pettis, Tim Duy, and you all think the Euro is fatally flawed and near collapse. But driving the other day a parade of Investment Bank economists on Bloonberg radio pretty much repeated Doctor Why's lines, convenient for their employers, no doubt.
And the markets seem split. The debt markets agree with us, no one wants to hold Italian or Spanish debt. Equities are down, but I don't believe a Euro collapse is really priced in at this point. I still don't see how this plays out.
Also, I think I'd side with you over Waldman. As Michael Pettis fequently writes financial crisis are so hard because they are about realizing and assigning losses, which becomes very political, very ugly and very polarizing very quickly. Having a proper monetary response does not eliminate the losses, but it prevents the losses from being compounded. Unfortunately, there are some distributional effects to even a 'properly functioning' monetary response, and in the polarized atmosphere of a post-financial crisis even Pareto efficient solutions are perceived as negative sum games.
Posted by: OGT | November 25, 2011 at 09:52 AM
K: You have a very interesting proposal. But I disagree with this bit:
You are assuming that the shareholders of a bank exercise effective control over the management. This is well-known to be false. It has been known for decades that in large, publicly traded corporations it is difficult for shareholders to effectively monitor and discipline management. This is the classic principal-agent problem, made much worse by the fact that the "principal" in this case is a vast and disorganized mass of shareholders. This part of the reason, for example, that CEOs of many modern corporations are so obscenely overpaid relative to their actual marginal productivity. The classic statement of this argument is the book The Modern Corporation and Private Property by Berle and Means (1932).
In the case of banks in particular, this problem takes on an especially insidious form: that of "looting". William Black diagnoses this problem in detail in his book, The best way to rob a bank is to own one. Another excellent analysis is Yves Smith's recent book Econned, which describes the cynicism, perverse incentives, and short-termism of traders in banks and investment firms. These guys are in the business of gambling with "other people's money". Furthermore, the turnover in this market is so high that next year's losses are somebody else's problem. When one trader raises the issue of long-term risk, the response from his co-workers is the slogan, "IBG,YBG", which stands for, "I'll be gone, you'll be gone." (Smith's criticism of some aspects of economic theory is sometimes a little simplistic, in my opinion. But her description of the dark side of finance is forensically detailed. She knows where all the bodies are buried.)
Of course, this problem is made much worse by the moral hazard which arises when governments implicitly or explicitly underwrite the risk-taking of the banks. But even without tacit government backstopping, the fact that bank investors are "on the hook" has not, and will not, "result in efficient, responsible behaviour."
Next, you write:
I'm sorry to say this is somewhat naive. We do not just rely on banks to keep our money safe. We rely on them as intermediaries in the credit market, which is crucial for the functioning of the real economy. The crash of 2008 was an excellent illustration. The problem was not that depositor's money was at risk ---it was protected by depositor insurance. The problem, rather, was that banks had built up an astronomically large and precarious house of cards of leverage piled on top of leverage piled on top of leverage, so that even a minor hiccup in the price of the underlying assets was sufficient to trigger a cascade of margin calls causing the entire system to implode. The result was that the worldwide credit market nearly ground to a halt, which would have had terrible repercussions in the real economy.
The other result of the crash was that a lot of naive ordinary people lost a lot of money which they had invested, which caused a contraction of aggregate demand. (Smith describes how some Australian fire brigades naively invested their pension plans in credit default swaps, which they were told were magically low-risk, high-yield instruments. Needless to say, these poor chumps lost almost everything.) A lot of investment bank activity in the run-up to the crash was tantamount to fraud. Some of it was the financial equivalent of building a house which you know is a fire hazard, selling it to someone else, and then using the proceeds from the sale to buy fire insurance on the house. But it was very subtle fraud, which was almost impossible for other market actors to detect until it was too late.
In short, financial markets need to be regulated to ensure a healthy and functional credit market, and to prevent banksters from defrauding naive and unwary investors.
You are right to be wary of rent seeking, but contra 40 years of "public choice" literature, the best way to prrevent rent seeking is not to ban the government from interfering with economic actors. The best way is to stop powerful economic actors from interfering with the government. (See: campaign finance reform.)
Posted by: Marcus Pivato | November 25, 2011 at 09:55 AM
Bill: What I really want to say is I don't think it can happen privately. The benefit of a *single* medium of exchange is so huge that it's a natural monopoly. So we would end up paying equally huge seignorage taxes to the monopolist (the money will be under-backed and then it will also be dangerous). It *has* to be a public system. Hopefully seignorage will be small, but if it isn't, I'd rather pay it to ourselves.
Posted by: K | November 25, 2011 at 09:57 AM
Nick,
On your "nowhere is written comment":
The monetary system you describe amounts to a central bank put on credit and liquidity. Actors given such a put would maximize its value by piling on leverage. The system would, as a result be much more fragile and prone to systemic failure.
To use a nature analogy: "Nowhere is it written that we have to let forest fires threaten timber holdings and property. We should have a fire management system that does allow small shocks (lightening) to cause forest-wide losses."
What happens when we have such a "stability seeking" policy for a long period of time? The amount of easily combustible fuel in the forest increases. Catastrophic forest fires result.
Posted by: David Pearson | November 25, 2011 at 10:10 AM
Marcus: Lots of interesting points. With which I mostly disagree (needless to say!). I will reply in full tonight.
Posted by: K | November 25, 2011 at 10:17 AM
"the best way to prrevent rent seeking is not to ban the government from interfering with economic actors. The best way is to stop powerful economic actors from interfering with the government. (See: campaign finance reform.)"
They're not mutually exclusive, can we do both?
Posted by: Bob Smith | November 25, 2011 at 10:31 AM
"Nowhere is it written in stone that if a lot of borrowers can't pay a lot of lenders that there has to be a recession and we all stop working and producing and buying and selling and just sit and watch while those borrowers and lenders sort themselves out."
Disagree here, bad investments breed recessions. The only way to avoid them is to wipe a slate clean and this is practically impossible. But yes in a theoretical world where water flows steadily under the bridge and nothing is sticky, maybe recessions aren't necessary.
Posted by: jesse | November 25, 2011 at 12:22 PM
K:
Private currency is no more inconventient that having private checkable deposits. You seem to be assuming variable exchange rates. In the past, most private currency systems have had all currency denominated in common units and redeemable in a base money.
The obvious choice is central bank reserves.
There is no reason to make hand-to-hand currency central to the monetary system or the banking system.
We shouldn't run the monetary order so that Nick and the Winos can cope.
You don't have to outlaw it. Just don't make everything de jure redeemable in it.
If one, or even all, issuers of currency go broke, then Nick and the winos take a loss. They are out of luck until new currency is issued. No one thinks that currency is a super secure store of wealth. People hold it for limited periods of time. (You know, spend it at the store and the store deposits it.)
What is the benefit of making hand to hand currency central to the monetary order?
Posted by: Bill Woolsey | November 25, 2011 at 12:23 PM
Bill: "You don't have to outlaw it. Just don't make everything de jure redeemable in it."
Got it! Totally agree. I don't want to ban anything. I just want everyone to have equal right to use the central bank money. If some people want to trade seignorage for privacy, I'm fine with that.
"What is the benefit of making hand to hand currency central to the monetary order?"
You are right. The private sector can create it (as needed by Nick and the Winos :-). We could call it "Mafia Money."
Posted by: K | November 25, 2011 at 12:44 PM
The Guardian recently quoted Mervyn King speaking to reporters after the Bank of England Inflation report came out, recently this month. He said (mostly correct in my opinion)
http://www.guardian.co.uk/business/nils-pratley-on-finance/2011/nov/16/mervyn-king-ecb-intervene
"This phrase ‘lender of last resort’ has been bandied around by people who, it seems to me, have no idea what lender of last resort actually means, to be perfectly honest. It is very clear from its origin that lender of last resort by a central bank is intended to be lending to individual banking institutions and to institutions that are clearly regarded as solvent. And it is done against good collateral, and at a penalty rate. That’s what lender of last resort means.
That is a million miles away from the ECB buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries, which inevitably, if things go wrong, will create liabilities for the surplus countries. In other words, it would be a mechanism of transfers from the surplus to the deficit countries. That’s why the European Central Bank feels, and with total justification, that it is not the job of a central bank to do something which a government could perfectly well do itself but doesn’t particularly want to admit to doing.
I think it’s very important to recognise that there are circumstances where governments will try and put pressure on central banks to do things that they would like central banks to do in order to avoid their having to own up to the actions that they actually would like someone else to carry out. So I have every sympathy with the European Central Bank in this predicament …
The only circumstance in which looking at the data for the euro area as a whole has merit is in realising that actually the euro area does have the resources, if you were to regard it as a single country, to make appropriate transfers within itself. It doesn’t actually need transfers from the rest of the world. But the whole issue is, do they wish to make transfers within the euro area or not? That is not something that a central bank can decide for itself. It is something that only the governments of the euro area can come to a conclusion on. And that is the big challenge that they face."
I think the ECB needs a credible commitment from the Euro Area governments that they will go ahead with a fiscal union and will make necessary reforms. Without that it is a bit uncertain about what to do.
Posted by: Ramanan | November 25, 2011 at 02:37 PM
Ramanan:
1. There may be multiple equilibria. The same government might be insolvent at 12% interest, so 12% interest would be needed to cover the risk. But solvent at 5% interest, so 5% would be an equilibrium too.
2. If interest rates were lowered, and AD increased (including less austerity by the 17 governments themselves), those same governments might become solvent again.
Yes, the Lender of last resort role may not be exactly the same, but it does have similarities.
David: that sounds such a defeatist perspective. We either have lots of small bad things happen or fewer big bad things happen. Maybe we could insulate the monetary system from fires instead.
Posted by: Nick Rowe | November 25, 2011 at 04:24 PM
"The monetary system you describe amounts to a central bank put on credit and liquidity. Actors given such a put would maximize its value by piling on leverage. The system would, as a result be much more fragile and prone to systemic failure."
Avoiding mass unemployment is not the same as guaranteeing a profit. You don't have to allow the system to totally collapse, you just have to allow capitalists to lose money.
Posted by: Max | November 25, 2011 at 04:32 PM
OGT, Just to be clear, I do think the euro is a dysfunctional institution, but I am not at all certain it is headed for collapse. I really don't have any strong opinions on what the endgame will look like. I think a last minute bailout by the ECB is also a possibility.
Nick, Good post, and I don't have much to add. One brief historical example of the "so bad it's good" argument. During the 1930s the US stock market generally fell sharply when there was a run on the dollar. The only exception was the first few days of March, 1933, which ironically saw the worst run on the dollar in all of US (modern) history. The press suggested that stocks held up during this period because things had gotten so bad that markets expected something dramatic out of the Roosevelt administration, which was about to take office.
I don't want to put too much weight on that example, as stock prices showed little change, and Europe is not expecting anything like FDR suddenly taking office in Germany. But I do think that "so bad it's good" news is at least theoretically possible.
Posted by: Scott Sumner | November 25, 2011 at 04:37 PM
Nick,
How do you insulate the banking system from catastrophic fires when you keep handing them free puts on leverage and liquidity risk? This is not a "perspective" (i.e. pessimism vs. optimism), it is a question of how the system is likely to behave given the aggregation of individual responses to incentives. In other words, are you saying:
-the central bank does not write free puts to financial actors in your proposed regime? or;
-that the response of financial intermediaries to free puts on leverage and illiquidity is not to raise systemic risk? or;
-that macroprudential can be effective in managing systemic risk despite the possibility of regulatory capture, cronyism, and innovation?
Or is there something else I'm not thinking of?
Posted by: David Pearson | November 25, 2011 at 05:33 PM
Scott: thanks! I expect we will find out in the next few days whether it's gotten so bad it's good. Whether it's all just a big game of Chicken and the ECB and Mrs Merkel are going to change tack now they have scared the PIIGS enough. But I don't think they will, from what they keep saying. And it might be too late now anyway.
David: Suppose the banking system had no relation to the monetary system? Suppose the medium of exchange wasn't the medium of account? Suppose there were no banks at all, but chequable mutual funds of stocks and bonds?
K: your first comment here is to blame for my latest post. I decided to start thinking about blue sky money too. ;-)
Posted by: Nick Rowe | November 26, 2011 at 12:28 AM
Marcus: A long, messy reply. Sorry (to everyone).
"You are assuming that the shareholders of a bank exercise effective control over the management."
OK. Public corporations have agency problems. I agree. But if we take out implicit and explicit government support the arrangement is at least Pareto efficient in the sense that the stakeholders all initially enter into it willingly.
"In the case of banks in particular, this problem takes on an especially insidious form: that of "looting"."
But the question is why this would be caused by credit intermediation. Are you suggesting that there is significant looting in the commercial lending department? The way I see it, the entire crisis was caused by agency problems caused by various forms of regulation ostensibly (but not actually) designed to protect the public. Total regulatory capture. Deposit insurance was one of those agency problems, but there were a few other major ones. Specifically:
1) Clueless investors delegating their investment decisions to investment managers. I would strongly advise clueless investors to *stay away from managed investments* and just hold broad capital market exposures (money under my proposal). The incentives of the investment managers are generally poorly aligned. The current system of 401k's (RRSPs in Canada) uses regulation to force retail investors into the arms of the investment industry.
2) Investment managers (including mutual funds, SIVs, dynamic CDOs, etc) delegating their fiduciary responsibilities to rating *agencies*. Again regulation gives the NRSROs privileged access to private information about issuers. This drives the investment managers into the arms of the investment bankers (who are the ones paying the NRSROs). If it weren't for regulation, the bankers wouldn't be able to issue without further public disclosure. As it was, AAA commercial paper was sold with literally *zero* disclosure about the actual identity of the underlying subprime etc. mortgage risk. Furthermore, the regulation gives cover to the investment manager who has all the plausible deniability he needs for neglecting his fiduciary duties. The regulators *made* him do it.
3) Regulators who represent the public interest but whose expected future income derives principally from Wall Street. These people write and enforce the rules. In reality much of the regulation originates from the Street. If you want these people to work for the public you'll have to pay them like the bankers they are supposed to regulate. That's more than POTUS gets paid. A lot more.
Why no blame for investment bankers? After all, they knew they were stuffing toxic 40 year mortgages into AAA short term paper! Yes, but the investment managers delegated the rating agencies to do the "thinking" for them, knowing full well that those agencies were paid by the bankers. The bankers optimized their profits according to the incentives that were set out for them. Unlike the investment managers and the NRSROs they have no fiduciary responsibility to work in the interests of their clients. They did what our systems fundamental principles tell us they are supposed to do. And they won! It's like we asked the sharks what the sign on the beach should say, and they told us it should say that swimming is safe and mandatory. Then we went and planned a beach party.
The common thread in all of this is regulators, regulation and a monetary system that can't function without them. And what is the problem with regulation? Fundamentally it replaces incentive with legal duty, thinking with rules, personal responsibility with anointed "experts," competition with barriers to entry, and fraud laws with stern regulatory talkings-to. And thus the centrally planned epic fail.
Why would my system (I'm sure it's not actually *my* system - people have been thinking about this stuff for ages) be any different? First of all, the beach party depended on all of the regulatory mechanisms outlined above. Investors don't *want* to have information hidden from them. If they are not fooled into thinking that there is a vast benevolent government regulatory infrastructure looking out for them ("It's all AAA, don't worry about it"), they are more likely to demand to be informed of the nature of their investments and they will have no cover to blame anybody but themselves. Secondly, there will be no need for unsophisticated investors to deal with the investment industry at all as they can just hold money. Thirdly, the shadow banking system created money via repo of mortgage backed securities onto publicly guaranteed, but privately managed bank balance sheets. Not a failure mode in my system. Again this became especially possible because the NRSROs rated the securities AAA and they therefore required minimal regulatory capital.
But lets say that despite all this, the bubble and crash still happen, incurring $3Tn or so in mortgage writedowns. So what? The market (including money) loses $3Tn or so of value (in real terms only - the market never loses value in nominal terms because money is backed by the a market portfolio) including maybe a few banks that go down. A lot like the Enron, Worldcom, Global Crossing defaults and market crash. Except *a lot* smaller. Without deposits and bank runs there just isn't any potential for banks to take us down any more than any other corporation.
"The other result of the crash was that a lot of naive ordinary people lost a lot of money which they had invested, which caused a contraction of aggregate demand."
The loss of AD occurred because people were able to flock to a vehicle that provided them with the illusion of the ability to defer consumption. (Whether, like Nick, you think of that vehicle as dollars, or like most Keynesians claims on future dollars, it is fraudulent as a promise of deferred consumption). I am proposing to eliminate that vehicle. Also, it occurred because of bank deleveraging causing uncontrollable monetary contraction. Again, can't happen in my system. Finally, the CB has total control over the quantity of the unit of account for those who feel that AD problems are principally about nominal rigidities. Given those mechanisms, I see no reason why losses would lead to an *aggregate* demand shortfall.
"In short, financial markets need to be regulated to ... prevent banksters from defrauding naive and unwary investors."
We already *have* fraud laws. Securities regulations are there to *prevent* the "banksters" from coming into contact with criminal law. Trillions of dollars disappeared. Anybody gone to jail yet? Regulations are *useless*. We just need clear fraud laws and prosecutors who understand the meaning of fraud.
"You are right to be wary of rent seeking, but contra 40 years of "public choice" literature, the best way to prrevent rent seeking is not to ban the government from interfering with economic actors."
I think Mancur Olson (public choice theorist, no?) would have agreed with you. But some of the more right wing public choice guys are funny. They are basically bang on about incentives, but their ideology prevents them from following their own advice when it comes to eliminating actual corporate subsidies like deposit insurance. "We need that!" I am fully in favour of government meddling where there is an actual market failure. But this is a faux market failure, due to a badly designed monetary system. So what we need to do is to reengineer it by putting the actual failing part (secure medium of exchange) into government hands, and leave the rest (credit intermediation, Mafia Money) in the private sector.
"The best way is to stop powerful economic actors from interfering with the government."
You want to make the sharks eat veggies. OK. I know a beach that doesn't have sharks. Lets go there instead.
Posted by: K | November 26, 2011 at 12:50 AM
Nick: Looking forward to reading it!
Just submitted a monster comment here. Got deleted by spam filter?? Help!
Posted by: K | November 26, 2011 at 12:55 AM
K: Retrieved from the spam filter!
Posted by: Nick Rowe | November 26, 2011 at 01:20 AM
Thanks, Nick!
Posted by: K | November 26, 2011 at 07:46 AM
K: Thank you for your response. You are entirely correct that the financial regulatory regime leading up to the crisis was entirely captured by financial industries. Thus, it is no surprise that a lot of cynical, irresponsible, and in some cases fraudulent behaviour was technically `legal'. And it is no surprise that banksters in some cases effectively had extra incentives to behave irresponsibly, because the regulations were designed to make that the path of least resistance.
However, you are much more pessimistic than I am that an effective regulatory regime can ever be put in place. You seem to take it as axiomatic that regulators will always and everywhere be captured by industry. For example, you write:
I agree that the `revolving door' between government and industry is an absolutely huge problem, not just in finance, but in all sectors. My solution: senior bureaucrats and legislators should be required to sign the equivalent of a `no-compete' contract, barring them from any form of employment (including `arm's length consulting') in any industry which they have regulated for a period of at least five years after leaving public life. This should be enforced with very stiff penalties (jail time).
[continued...]
Posted by: Marcus Pivato | November 26, 2011 at 07:57 AM
[...continued]
Yes, I know, you will say that this will make it impossible to attract talented people to the government unless we pay them double the salary they could make in industry. I disagree. Money is important, and you certainly must pay public servants generously to attract talent and to reduce incentives for corruption. But money is not the only thing which motivates people. Many people (especially talented, highly educated people with many well-paying options available to them) choose a job partly because of the `satisfaction' it offers ---either because the work is creative, or socially valuable, or socially prestigious, or will leave some sort of `legacy', or because they enjoy exercising power or being in a position of authority. University professors are an excellent example; they are quite well-paid, but many of them could be making far more money in the private sector. But they choose an academic career because it offers other rewards besides money.
Unlike you, I think it is possible to align incentives within government to produce much better regulations. Not perfect regulations, but much better than what we have now.
On the other hand, I am much more pessimistic than you are about the functioning of a deregulated market. There are at least three reasons why we should not expect a deregulated financial market to always produce efficient outcomes:
There is a large literature on how information asymmetries lead to market failures. Your last message seemed to suggest that many of these information asymmetries are actually the perverse consequence of regulations. For example, you wrote:
I don't see how this is a consequence of regulation. Actually, it is SEC regulations which require full and accurate information disclosure (e.g. financial statements) in equities markets. These regulations did not apply to the CDO market. If I am in the business of designing and selling CDOs, then the actual asset mix of these products is effectively my intellectual property, my competitive advantage, my `secret recipe'. Why should I disclose that information unless I am forced to by regulations?
Presumably you think that, in a free market, asset buyers will demand full disclosure, and this will force asset vendors to provide it. History shows this is naive. Even in equities markets (where disclosure is legally reguired), vendors release misleading information (see: Enron), by exploiting the accounting ambiguities inherent in trying to put a price on financial instruments.
But this is false. The fact that a solution to some mathematical problem exists in principle does not mean that you can compute this solution on a reasonable time-scale. Indeed, this is the central principle of mathematical cryptography. All encryption schemes are breakable `in principle'. But in practice, this decryption may take a million years on the fastest supercomputer. So for practical purposes, the encrypted information remains hidden.
In the same way, you cannot assume that an agent in a financial market will be able to accurately price the instruments in the market and compute her best-response, even if she has access to all the necessary information. (The analogy to cryptography may seem inappropriate. But the fact is that many CDOs were deliberately structured to be obscure and hard to analyze; `encryption' seems like a suitable metaphor).
Economists are used to thinking of market dynamics in terms of `negative feedback' cycles, which drive the market back to equilibrium and stability. This is probably a good heuristic when thinking about markets for physical goods and services (although I think these feedbacks operate on much longer timescales than many economists do). But these heuristics do not apply in financial markets. Positive feedback leads to instability and disequilibrium.
For all these reasons, markets must be regulated.
[continued...]
Posted by: Marcus Pivato | November 26, 2011 at 07:57 AM
[...continued]
In your last message, you wrote:
This passage seems to involve several false dichotomies. Incentives always exist in the context of a regulatory framework. There is no such thing as a market without rules. The purpose of regulation is not to `replace incentive with legal duty' or `relace thinking with rules'. It is to make sure that private incentives are correctly aligned with social efficiency.
Likewise, markets involve plenty of anticompetitive forces even without regulation (see: mergers and acquisitions). Regulations can act as barriers to entry (especially in situations of regulatory capture). But they can also act as checks against oligopolistic behaviour.
As I have argued above, `personal responsibility' (by which I assume you mean the structure of incentives in a free market) is not always sufficient to produce socially efficient outcomes. As for `anointed experts', markets are full of experts ---especially markets like finance which involve highly specialized knowledge and skills. As a private agent, I have absolutely no choice but to place my trust in `experts' ---doctors, lawyers, car mechanics, and fund managers ---to perform certain tasks I don't know how to do myself. Indeed, not only am I unqualified to perform these tasks myself, I am not even qualified to judge the competency of the experts I hire. What I need is a regulatory framework to protect me from being defrauded by so-called experts. Medicine, law, and auto-repair are all highly regulated markets for exactly this reason.
Finally, you contrast `fraud laws' with `stern regulatory talkings-to'. Obviously, to the extent that the enforcement of regulations boils down to a `stern talking-to', it is totally useless (again, probably due to capture). Effective regulation has effective enforcement, with serious penalties. In other words, it is fraud law.
As for the rest of your message: you seem to be arguing that, even if a financial melt-down occurs, in your monetary system this will have very limited macroeconomic effects (e.g. on aggregate demand). This may well be the case ---I can't really say for sure, because I haven't really thought through the implications of your money system (although it sounds very interesting). But even without macro effects, there are a lot of negative micro effects in a dysfunctional financial market, such as individuals being defrauded and inefficiencies in the real economy due to massive misallocation of resources.
Anyways, I fear that, between your very long message, and my even longer response, we are at risk of derailing this thread from into a debate about market failures, when Nick presumably wanted it to be about monetary systems. So perhaps we should let this go.
Posted by: Marcus Pivato | November 26, 2011 at 07:59 AM
Hmmm.. part three of my message seems to be trapped in the spam filter. (?) (Sorry for splitting the message into three parts; the system rejected it when I tried to post it all at once.)
Posted by: Marcus Pivato | November 26, 2011 at 08:10 AM
Ah... there it is.
Posted by: Marcus Pivato | November 26, 2011 at 08:40 AM
Marcus,
Thanks for your clear comments. It is a pleasure to disagree with you!
"Finance is full of information asymmetries"
Yes. But we don't need to participate in it. We just need to hold a market portfolio and I'm giving everyone that in the simplest possible form. If you can't compute the value of a CDO, don't buy one. Then we need to provide everyone with education (through schools, public awareness campaigns etc) in roughly the following terms:
"
Boys and girls!
Your government provides you with a 'medium of exchange.' It's useful for buying and selling stuff including your own labour. Other organizations also provide money. You can use that money if you are doing things you really don't want the government to know about. But that money is *not* necessarily safe, and should it lose its value completely, nobody is going to help you. So try hard to avoid it.
The money the government provides you with is also useful as a store of wealth. It is backed by a large diversified pool of liquid capital assets. As proof of the solidity of the money, you can exchange your money for a share of those assets any time you want.
Over there are some big boys and girls who trade in a casino we call the 'financial markets.' Some of those boys and girls are extremely clever and are able to make extra money by winning it from some of the others. If you look carefully, you will see that only a few of them have lots of money. Mostly they got that way by winning money from boys and girls who aren't playing over there any more. Those boys and girls often lost *all* *their* *money*. There are no playground monitors over there. If you go there and they take your lunch money there will be nobody to help you. If they beat you up we will try to punish them, but you will still have been beaten up. You have no need to be there. Do you understand? I said DO YOU UNDERSTAND?
"
The problem is that current regulation forces you to play with the big boys and girls. Which is *bad*.
"Finance is very computationally complex."
Yup. But the problem is not so much what you describe, rather than the fact that we have no idea what the underlying future asset dynamic might be. There are insufficient assets in the market from which to imply the correct dynamic and historical dynamics are no guide to the future. So we don't know what model we should be computing. But either way, regulation doesn't do anything for us here. This is all about intelligent humans making optimal decisions for which they bear the full consequences. It's not a market failure.
"Financial markets are full of positive feedback cycles."
Sure, and I think my proposal eliminates some of the worst ones (e.g. the systemic bank run). As far as the other ones go, regulators have no special ability to counteract them. They don't see bubbles coming and are no more likely to than investors with their own money at risk. There is simply no gain from regulation here.
The Italian "self-fulfilling prophecy," to the extent that it's real, is a result of badly engineered money. If the response of the monetary authority is predictable, the system is far more likely to have a unique equilibrium. But I haven't (necessarily) argued against central bank discretion.
"As a private agent, I have absolutely no choice but to place my trust in `experts' ---doctors, lawyers, car mechanics, and fund managers"
I am giving you the opportunity not to have to deal with fund managers. You should jump at it.
"we are at risk of derailing this thread from into a debate about market failures"
To me, monetary system design, and which parts are rightly public and which parts are rightly private, is *entirely* about market failures.
Posted by: K | November 26, 2011 at 09:54 AM
Marcus and K: Don't worry about being off topic. You are having a very good argument, and I think everyone's already said what they want to about the original post anyway. So carry on if you want to.
Posted by: Nick Rowe | November 26, 2011 at 10:05 AM
OGT: "Nick every economist I respect in blogosphere: Krugman, Sumner, DeLong, Michael Pettis, Tim Duy, and you all think the Euro is fatally flawed and near collapse. But driving the other day a parade of Investment Bank economists on Bloonberg radio pretty much repeated Doctor Why's lines, convenient for their employers, no doubt."
Just a couple of thoughts:
1) Academic economists are right in the sense that the Eurozone imposes too many constraints on fiscal and monetary policy and, as a result, may not be able to withstand a sufficiently large shock. However, the real question now is whether this particular shock is strong enough to destroy the euro, and to answer this question one needs detailed quantitative models of the real economy and the financial sector - something that bank economists have, and academic economists don’t.
2) People tend to overreact to purely financial developments. Yes, the yields are high, but it will be many months before those yields have a measurable impact on budget deficits and the real economy, which leaves plenty of time for negotiations. (For example, Italy’s financing needs for 2012 are around 350 billion euros, so by the end of 2012 a 500bp increase in the average yield will increase the budget deficit by only 1% of GDP). Of course, if high yields cause a wide-spread liquidity crisis, then the situation could deteriorate very quickly – but in this case the ECB will definitely intervene to stabilize the markets.
Posted by: Doctor Why | November 26, 2011 at 12:51 PM
Doctor Why:
"Of course, if high yields cause a wide-spread liquidity crisis, then the situation could deteriorate very quickly – but in this case the ECB will definitely intervene to stabilize the markets."
The markets are increasingly worried they won't do it.
Look at the las Merkel comments
"The countries who don’t keep to the stability pact have to be punished – those who contravene it need to be penalised. We need to make sure this doesn’t happen again."
She is a Lutheran pastor daughter. She can't compromise with sin. Purgatory will cleanse your soul.And Hell is the punishment.
As a refugee from the East, she worship the idealized capitalism they dreamed about from the other side of the wall. Moses had to lead his tribe 40 years through the desert to purify them of their old thinking. She should not have been permitted to hold office before being purged of her phantasms.
Posted by: Jacques René Giguère | November 26, 2011 at 01:28 PM
Dr Why: I think it's worth noting that even if the secondary market is liquid at a spread of 700 bps that doesn't mean you can issue there. The primary market basically always goes into a total liquidity crisis somewhere north of 500. It's sort of weird, but a 1000 bp new issue doesn't fit into the category of things an investment banker can spin a pitch around. So the market is shut. I guess it's also worth considering that since new issues must be at par, the resulting coupon places an immediate massive liquidity burden on the issuer which might be viewed as only aggravating the problem. Alas, you can't issue at discount.
Posted by: K | November 26, 2011 at 01:52 PM
(Issuing at discount = insolvent trading).
Posted by: K | November 26, 2011 at 01:55 PM
Jacques René Giguère: "The markets are increasingly worried they won't do it."
I'm sure they will - Jürgen Stark and Axel Weber are gone, and Mercozy have just agreed to leave the ECB alone.
Posted by: Doctor Why | November 26, 2011 at 01:58 PM
@K My point is that the ECB understands the difference between high yields and illiquid markets and will act when an intervention becomes truly necessary - as it has done before on multiple occasions.
Posted by: Doctor Why | November 26, 2011 at 02:07 PM
.. and I think the ECB will rely on a broad definition of liquidity, which includes primary markets.
Posted by: Doctor Why | November 26, 2011 at 02:11 PM
For whom? Portugal, Ireland, Greece etc are already out of the market. Italy is on the break. If you are talking about Italy then they are setting the Italy spread cap at 500. And then buying Italy here is a risk free trade. You think they are going to draw the line at Italy?
Posted by: K | November 26, 2011 at 02:30 PM
Yes, Italy and maybe Spain. Those two are too big for a Greece-style rescue package.
Posted by: Doctor Why | November 26, 2011 at 02:42 PM
In any case, I wouldn't say buying Italy is a totally risk free-trade:
- governments usually have cash reserves, so the ECB may take its time,
- and the intervention may be limited to certain maturities.
Posted by: Doctor Why | November 26, 2011 at 02:56 PM
"- governments usually have cash reserves, so the ECB may take its time"
It's still arbitrage if you are going to win eventually.
"and the intervention may be limited to certain maturities."
So buy short end. The curve is inverted.
"I wouldn't say buying Italy is a totally risk free"
Yes. I didn't rush out to buy. :-)
Posted by: K | November 26, 2011 at 03:10 PM
Sumner, I perhaps over-interpretted your agreement with Krugman and some of the other MM'ers. Thanks for clarification.
Doctor Why, perhaps you're right. My sense, however, is that both the ECB and Merkel overestimate their ability to control the situation. There any number of political events that could spin this out of control rather quickly. I also suspect a Greece or Portugal leaving the Euro could have more effect than you seem to believe. The banking system is nearly frozen as it is, and there would certainly be no way to prevent the derivatives trades from taking effect if that happens.
Interestingly, Pettis, who cut his teeth in investment banking on the 80's Latin debt crisis, based his call entirely on history of cross country currency unions. If the Euro makes it they'll be the first, and given that it's not a particularly well designed one as it currently stands that would be surprising.
Posted by: OGT | November 26, 2011 at 10:19 PM
I agree with Dr Why. The eurozone crisis is being overhyped - by the financial industry which has exposure to eurozone debt and would like to be bailed out, by academics who are enjoying the unwonted attention, and by a media that is increasingly sensational for a public with an increasingly short attention span. I suspect that the euro will muddle through, with some restructuring, some austerity, and a little buying by the ECB. In reality, the sustainability of euro debt and currency are different issues, and few of the eurozone public want to give up the euro, so I think that the euro will survive (and, I suspect, so does the market, which is why the euro continues to remain quite strong). I would prefer more restructuring and less ECB buying, so I think that the ECB is doing the best job of the major central banks at the moment.
Posted by: RebelEconomist | November 27, 2011 at 06:39 AM
K: Thank you again for your response. In your original message, it sounded like you were making the (often-heard) claim that financial markets do not need any regulation, because they are inherently efficient, equilibrium-seeking, and self-correcting, and regulations just create distortions and rent-seeking opportunities.
But in your most recent message, it sounds like you are acknowledging that financial markets are prone to market failures. But you argue that this is okay, because your new monetary system limits the damage. First, aggregate demand will no longer be affected. (There can be no such thing as `flight to security'). Second, ordinary people will no longer have any legitimate reason to trade in financial assets, since their money itself is a high-quality bundle of such assets. If they insist on playing with fire, then they can't complain about getting burned.
This may be so. I will have to think a bit more about whether your proposal really contains the fallout from financial meltdowns. But it certainly sounds promising.
One issue which I think your model does not address: since the supposed purpose of financial markets is to allocate resources in the real economy, inefficiencies in financial markets can translate into inefficient allocation of resources, resulting in real economic inefficiencies. Two examples: during the `dot com' bubble, there was massive overinvestment in communications infrastructure (i.e. thousands of km of `dark fibre'), while during the housing bubble, there was massive overinvestment in housing construction.
Now, I grant that it is hard to imagine regulations which could prevent such overinvestment in general. After all, regulators can't see the future either. But a lot of overinvestment can be traced partly to fraud, which can be controlled through disclosure requirements (i.e. regulations). Also, a lot of overinvestment is due to the aforementioned positive feedback cycles. In your last message, you write
In other words, according to the `Efficient Markets Hypothesis', bubbles are impossible to identify in advance, hence, impossible to prevent through regulation.
There are two problems with this argument. First, it is not always true that bubbles are impossible to identify. One can construct models of financial markets where everyone `knows' there is a bubble in progress, but it is still rational to buy, because every trader bets that they personally can cash out before the market crashes, and leave some other chump holding the bag. Of course, there are other models where this doesn't happen, so this debate comes down to `my model is better than your model'. From what I have seen, however, the dynamics of financial markets is still very poorly understood, because an accurate model must have an accurate representation of the psychology of the traders, and our models of trader psychology are still 1-dimensional caricatures. So I think it is best to be suspicious of all models. But in particular, it is best not to put too much faith in models which assume a priori (or claim to `mathematically prove') that markets are always and everywhere efficient, and speculative bubbles are logically impossible.
[continued...]
Posted by: Marcus Pivato | November 27, 2011 at 10:34 AM
[...continued]
But let's even suppose you are correct, and bubbles are inherently impossible to identify in advance. It is still possible for regulators to put a lid on the gyrations of the financial market, by restricting leverage. Bubbles (and the inevitable crashes which follow) are hugely exacerbated by leverage. During a bubble, investors borrow against the inflated value of their assets. The more prices go up, the more they can borrow, the more they can buy, and this drives prices up further. When the market heads south, the feedback cycle reverses. Highly leveraged investors immediately start to look like credit risks. They are forced to liquidate to pay back their creditors, driving prices down further.
Even a totally blind regulator can moderate leverage cycles by imposing larger reserve/collateral requirements on investors. These centrally imposed collateral requirements must be `soft', in the sense that the investor is not required to meet them immediately, but is given some time window inversely proportional to the size of the collateral short-fall. For example, an investor might have one month to correct a 2% shortfall in collateral, two weeks for a 4% shortfall, one week for a 6% shortfall, 84 hours for an 8% shortfall, etc. (Why this schedule? If the centrally imposed collateral requirements were `hard', meaning they had to be met immediately, then they would trigger exactly the same cascade of margin calls that we see right now. That's why they should be soft. The optimal schedule for collateral corrections would have to be determined empirically ---the schedule I give here is just a crude example.)
Credit default swaps are another financial instrument which could benefit even from `blind' regulation. CDSs are effectively default insurance on credit instruments like bonds or CDOs. However, unlike traditional insurance, the buyer of a CDS does not actually have to own the bond/CDO in question (i.e. they are not required to have what is called an `insurable interest'). This means you can buy a CDS as a way of `betting against' a bond/CDO you don't own. Sounds like exactly the sort of instrument we need to `complete' the market, right? There are two problems:
Both these problems could be easily corrected by requiring CDS buyers to have an `insurable interest' (i.e. their portfolio of CDS must match their portfolio of credit instruments).
There is third way that regulators can mitigate financial market gyrations. A lot of speculative activities is correlated with traders moving in and out of markets at high frequency. (This is to be contrasted with `value investing', which involves very long-term investments.) This sort of high-frequency trading can be discouraged with a small (e.g. less than 1%) transaction tax, a.k.a. `Tobin tax'.
Of course, this depends on whether you think high-frequency trading is a net social positive or a net social negative. There is an argument that `most' high-frequency trading is socially positive, because it simply mops up arbitrage opportunities, thereby making price signals more accurate. I don't understand finance well enough to take a position on either side of this argument. I am simply pointing out that the `Tobin tax' has some fairly strong arguments in its favour.
There are also other ways in which regulation can improve financial markets. The last chapter of Smith's book Econned contains some interesting suggestions, but it would be redundant to reproduce them all here.
Anyways, none of this represents a criticism of your central proposal, which I basically like. I am simply quibbling with some of your remarks about regulation.
Posted by: Marcus Pivato | November 27, 2011 at 10:34 AM
Marcus,
Just saw your excellent comment. Will try to get back tonight.
Posted by: K | November 28, 2011 at 12:41 PM
"it sounds like you are acknowledging that financial markets are prone to market failures."
Absolutely. I probably came across way too strong. It's easy to err on the side of structuring your argument to appeal too much to either the left or the right, especially when there are elements that are intuitively distasteful to both. But fundamentally, conservatives are going to be more difficult to convince which is probably why I try to use their pro-deregulation bias as a lever.
First, before I address each of your points, I wanted to elaborate a little bit on a feature of my proposed system that I only passed over quickly above: that of money illusion. It seems like a minor detail but to make the importance of it really clear, imagine that we never "split" our capital asset backed money. I.e. the unit of account (to first approximation) is a fixed fraction of the total quantity of all capital assets. With this new numeraire, the total nominal value of the capital asset market *never changes* by construction. All we ever observe are relative price moves of different instruments. When borrowing in this money to invest, one would be short the general market and long the specific investment which really underscores the zero-sum hedge fund nature of participating in financial markets. Positive returns are alpha, not beta. I think that ought to significantly reduce the appeal of leverage which could be an important factor in protecting us from general asset bubbles.
Borrowing, as we currently see it, which involves shorting the future value of real goods, would hopefully be seen as the fairly odd inflation index derivative contract that it is. Keep in mind that there exists no asset that transports a fixed quantity of consumption into the future. Any contract that guarantees future consumption, necessarily requires someone else to short it. So if we don't define money relative to the value of real goods then I'm hoping that we will no longer have a significant demand for fixed future consumption (currently government bonds) which can only be met by someone else shorting future consumption (e.g. a leveraged investor borrowing to buy capital assets.) So I am hoping that by breaking the anchor of money illusion to a consumption basket, that a conservative investor would simply be content to be guaranteed a fixed portion of the value of all capital assets (i.e all future consumption assuming fixed share of taxes and wages) and that the consumption basket would disappear as a relevant reference point.
As far as more specific bubbles go, I think 401k's played a major role in fueling the dot com bubble. From 1990 to 1998 the size of 401k's grew from $380bn to $1.5Tn which fed a steady stream of hapless online traders to the investment industry. The bubble probably wouldn't have been prevented, but I feel like it was aggravated by this vehicle which was to a large extent the result of investment industry lobbying.
As for the mortgage crisis I think regulation did a lot of harm as discussed above. And since land value is essentially a positive externality of other peoples activities, the real solution is a Georgist style land value tax, which wouldn't require regulators to diagnose a bubble. The tax would just kill it.
Uncovered short market CDS's are, as far as your discussion is concerned, equivalent to a short corp, long treasury position. Again they can be manufactured in quantity so long as you have a willing seller and a willing buyer. Yes, the mechanics of borrowing bonds etc are more complex and introduce annoying funding cost uncertainty. But there is nothing radically new here. It is my opinion that short selling, whether stock, credit or whatever else is a critical part of market efficiency. The short sellers sell hard into the bubble and are the first and often the only ones brave enough to buy into the crash. If those who think an asset is over-valued cannot express their opinion, the market trades at the price at which the person who has the highest possible opinion of the future outlook will buy. That is a recipe for disaster. So I am not in favour of any kind of short selling ban.
You may know the work of Alp Simsek (and others) who demonstrates pretty convincingly that financial innovation (new derivatives) can be variance increasing for the average agent if agents use significantly different market measures. But this is a temporary effect as the long term observation of the instrument dynamics will tend to lead to a convergence in our understanding of the dynamic. So there were lots of things we didn't know about CDS/corp/basis risk and CDO or index tranche correlation risk before the crisis which meant that people entered into bilateral trades based on very different expectations of the forward dynamic. Both parties were quite significantly surprised, but market players have much more consistent understanding of the instruments now, which improves the likelihood that they can be used to complete our real exposures and reduce rather than increase our risk.
As far as toxic CDO's go, that was *entirely* the fault of the rating agencies. The CDO primary market *was* a giant ratings arb. The dealers would simply take the latest S&P model (which was fully available to them as a convenient spread sheet) and set out to engineer a structure that would result in the highest possible tranche ratings using the widest spread possible underlying names. This wasn't very hard since, for starters, there was huge variation in market spread between different names of the same rating, and the agency models didn't distinguish between an A-rated mortgage insurer and an A-rated railroad. And so on (see my previous comment).
AIG blew up because of too much credit risk. The fact that *the regulators* set up rules that permitted AIG to take vastly more credit risk in derivative form that they could have in cash form is yet more proof that regulators are not particularly adept. And as yet more proof that derivatives weren't the problem, if they had taken the same exposures in cash bonds they would have blown up twice as much because of the blowout in the bond basis. I will admit however, that I don't have a regulator free insurance industry solution. Unlike private money, people *do* need a private insurance market. And they certainly aren't able to evaluate the solidity of insurance company balance sheets themselves. Alas...
"Anyways, none of this represents a criticism of your central proposal, which I basically like."
Thank you! You and Nick, are about the only constructive feedback I have had, and I'm hugely appreciative. This debate is helping me think through a lot of issues.
Posted by: K | November 29, 2011 at 01:09 AM
Nick!
Spam filter!!!
Thanks,
K
Posted by: K | November 29, 2011 at 01:18 AM
Thanks Nick!
One more thought: If people want to use derivatives to fix future consumption (and I guess we still would as we get older) a more natural hedge would be to buy NGDP futures since that would give a claim on a fixed fraction of output rather than a fixed consumption basket.
Posted by: K | November 29, 2011 at 07:30 AM