News about financial stability, central banking and theory of money
The highlight of this week has been the high-profile critique by Pollin & Co from UMassAmherst of professors Reinhart and Roghoff and their “austerity” paper, where they showed that the danger zone of public debt is 90 % of GDP. Their results has been used by the UK finance minister Osborn to justify their current harsh budget policy, and by many otheres to justify the current fashion of “austerity growth driven policies”.
Financial Times has given the debate wide coverage, see here and this very good summary blog post by G. Davis here. But you may also be interested in these posts by Prof. Mitchell here and prof. Wray here that is much more direct in their critique of R&R and also show the absurdity in their initial paper. As Wray and co-author Nersisyan noted in a Levy WP from 2010:
R&R … have no idea what sovereign debt is. They add together government debts issued by states on gold standards, fixed exchange rates and floating rates. They aggregated across governments that issue debt in their own currency and states that issue debt denominated in foreign currency. It is not even possible to determine from their book exactly what is government debt versus private debt.
So, it does not make sense to compare apples and oranges; the debt ratio of Spain (w/o its own currency) is obviously not the same as the debt ratio for the UK. And the debt ratio for Japan (borrowing mainly domestically) has a different meaning than the US debt ratio (most US debt is to foreigners; and the US dollar enjoy resever currency status).
This has huge implications for macroeconomic policy going forward. The IMF is gradually coming around to a “less austerity” position, and the FT notes that they will get into a fight with the UK government in the forthcoming Article IV discussion. So watch out for the continuation of the contiuation of the R&R story.
There is a frentic activity out there on how to revise the modelling paradigm to the new norm of financial instability. Andrew Haldane from the Bank of England has recently been very critical of the current generation of macro models, including the DSGE tradition, and he recently challenged economist to come up with something better.
This calls for an intellectual reinvestment in models of heterogeneous, interacting agents, an investment likely to be every bit as great as the one that economists have made in DGSE models over the past 20 years.
But even his boss, Mervin King has recently been skeptical of the mainstream modelling paradigm, and in reviewing the last 20 years of inflaiton targeting, he noted (in footnote 14!) that
Several interesting papers presented at a Federal Reserve conference in Washington in March 2012 analysed a wide variety of potential “financial frictions” that might create externalities that would justify a policy intervention. My concern is that there seems no limit to the ingenuity of economists to identify such market failures, but no one of these frictions seems large enough to play a part in a macroeconomic model of financial stability. So it is not surprising that it has proved hard to find examples of frictions that generate quantitatively interesting trade-offs between price and financial stabilit …
Where this will end is not clear yet. The DSGE camp held a conference recently showing strenght among the Northwestern crowd, which is particulary strong among central banks (including Norges Bank and Riksbanken).
ECB will host a conference this week with a more varied program, so it will be interesting to see if they arrive at some sort of consensus on the way forward.
One person to watch out for is Michael Kumhof from the IMF. He is a devoted DSGE person, but conduct interesting research within this framwork on income inequality, narrow banking and the future of oil. He will be at the ECB conference as a discussant of a paper by goodhart and tsomocos, that represent an alternative modelling strand.
Quite something to watch, although impossible to follow it all.
Also investors may think so. As FT banking commentator Patrcik Jenkins notes in this post, banks are trading at very low book/values and investors may actually benefit from breaking up large conglomorate banks:
Shareholders appear to be coming to the view that banking conglomerates do not make economic sense. There are many factors subduing banks’ stock market values, including the eurozone crisis and global regulatory uncertainty. But another brake is investors’ fading faith in size for its own sake. Most western banks – especially the universal ones comprising retail and investment banking under one roof – are trading at a discount to the book value of their net assets.
This is a view that Andrew Haldane of the Bank of England also has voiced earlier, indicating that proposals for splitting trading and commerical banking actually may be in the banks best interest. A clean split – ala the Volcker rule – would then be preferable to a holding company solution as proposed by the UK Vickers commission. Time will tell which will be the choosen one.
This VOX post by one of the leading authors of this years Global Financial Stability Report Not making the grade: Report card on global financial reform | vox. argues that the pace of reform and restructuring of the financial sector is too slow. Important issues remain unresolved, including
There is still little progress (or politicla will?) to tackle the TBTF problem, and the financial system remain too complex. Shadow banking continue to be a problem, as well.
Key question is whether “traditional” program of reform, inkl. Basel 3, will deliver the required reforms in time? The lobbying pressure is intense, ref. the latest defeat of the SEC on money market reform. May be we need other approaches, ref. Haldane’s critique of Basel 3?
I did not stay up to watch the debate tonight, but according to Zero Hedge Romney managed a freakish 217 words per minute compared to Obama’s 172. That’s quite a performance; try it yourself. Will obviously have to watch on YouTube learn his tricks.
This post by Zero Hedge gives a subjctive interpretation of the current rush of covered bonds by Europeans banks, some of them soon approaching the limits for such issuance. Many banks retain large portion of the new bonds themeselves; which raises the interesting question if you can own your own debt!
The post goes on to argue that central banks are painting themeselve into a corner, where lack of collateral and requirement of collateralized lending (from CBs to banks) will finally meet.
If, however, the covered bond bridge is pushing up against its very real statutory and quality limitations, that might mean the ECB is now fighting a two-front funding war – retail deposit flight and collateral diminishment at the same time.
At that point the system will collapse or central bank will be force to relax collateral requirements, ref. Tuckers discussion of this problem under the heading of “central banks’ time inceonsistency problem”, for a discussin of this dillemma see my Levy WP here on The Collateral Squeeze, p. 17
Alternatively (and better), central banks should let failing banks go into resolution and stop the collateral chasing. Better to start on this process before it becomes too late.
Somewhat old interview (August 1), but still interesting points about central bank lending to CCPs, how to solve the TBTF problem, and the need for more liquidity for trading activities:
Since then, I have wanted trading book positions to incorporate an element of capital against illiquidity risk, because these books get marked to market so even if there is no change in fundamentals but the market suddenly dries up, values will fall as a result and the net worth of the dealer or bank falls sharply.
And also about how to prevent a new “blow-out” of the financial system:
Risk: Do you see any danger in a more prescriptive approach to capital modelling?
PT: This is a genuine consultation by the Basel Committee, but I would point out that there are something like 15 million people unemployed in the western world because finance imploded, and finance imploded because the rules of the game in finance were inadequate. That’s a terrible price to pay. So this business of debating exactly how to calibrate things, this is for grown ups. It’s not about whether we – if the following rich assumptions hold – can optimise capital levels. It’s about whether we can avoid having a financial system that is fragile in ways that have very high social costs.
Agree fully with Tucker!
Many commentaries today on whether Bernanke’s QE will work. This transcript from the press conference depicts his thinking well, I think. The question is will it work? May the idea of Anatole Kaletsky could give more traction, i.e. QE for the people?
This post gives a good review of the issues and consequences of pesistent Negative Interest Rate Policy (NIRP)
The NIRP acronym is misleading, however, because unlike ZIRP, NIRP isn’t actually an official “policy” per se, but rather a symptom of a broken financial system increasingly starved for good ‘collateral’.
This phenomena, thought by many to be of short duration, is now having its impact on investors, especially insurance companies and pension funds.
The impact is felt only gradually, but will get worse if NIRP continues. Together with the crisis in the real economy, this dosn’t look good.
Financial Stability News 