tag:blogger.com,1999:blog-82817256198233195472024-02-19T06:08:55.556-05:00John Wood's Policy WatchTaking economics seriously.
Analyzing public policies in light of incentives and experience.John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.comBlogger17125tag:blogger.com,1999:blog-8281725619823319547.post-53394603531785453892010-07-14T14:20:00.004-04:002010-07-14T14:33:41.674-04:00Another Excuse: Shadow Banks<a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjGBbgUzWPmGLaAoVOpU-pjmPFk0-jlfpLviUQACyyhCIulAj_lTqICKK97KYDG-rijxko_iSYSzm2YjoEylzNlSrIYShbMvulAaudvGUIs7OIJAaJyNx5_th7aJMX6aIJrI7SRLtg-khXo/s1600/Bks&FIs.jpg"><img style="display: block; margin: 0px auto 10px; text-align: center; cursor: pointer; width: 400px; height: 292px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjGBbgUzWPmGLaAoVOpU-pjmPFk0-jlfpLviUQACyyhCIulAj_lTqICKK97KYDG-rijxko_iSYSzm2YjoEylzNlSrIYShbMvulAaudvGUIs7OIJAaJyNx5_th7aJMX6aIJrI7SRLtg-khXo/s400/Bks&FIs.jpg" alt="" id="BLOGGER_PHOTO_ID_5493829464754699506" 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mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">“One important reason” for the magnitude of the recent crisis, Federal Reserve Chairman Ben Bernanke told a Dallas audience on April 7, was “that the subprime mortgage market was closely linked to a broader framework for credit provision that came to be known as the <i>shadow banking system</i>…. The innovation underlying the shadow banking system was that it helped provide a wide range of borrowers indirect <i>access to global credit markets</i>” (my italics).<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>On May 6, Treasury Secretary Timothy Geithner told a commission investigating causes of the crisis that “Failure to give regulators enough legal power and the growth of a shadow banking system were behind the eruption of the financial crisis…. [L]oosely-regulated non-bank financial firms had grown to a size nearly equal to the traditional banking system.”<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>Who are these shadowy lenders outside the control of regulators and therefore able to bring the system down?<font style=""> </font>So far as I can tell from the discussions of Bernanke, Geithner, and others, they are simply the nonbank financial intermediaries that have always been with us, and, as in other developing economies, have tended to grow faster than commercial banks.<font style=""> </font>The figure shows the percentage of commercial bank assets relative to those of all financial intermediaries (including banks, savings and loans, credit unions, and insurance) in the U.S. since 1900, based on data in the references below (Goldsmith, Boyd and Gertler, and Mishkin).<font style=""> </font>Geithner’s belated recognition of the “problem” is an understatement.<font style=""> </font>Textbooks on “money and banking” have long considered, and often been titled, “money, banking, and financial markets,” with extensive treatments of nonbank financial intermediaries (NFIs).<font style=""> </font>An example, is, Ritter and Silber, dating from the 1970s and now in its 12<sup>th</sup> edition.<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">So if the shadow banking system (NFIs) is not new, what’s their point?<font style=""> </font>It’s apparent that they are using shadow banks as an excuse for policy failure – not for the first time.<font style=""> </font>In the 1960s and 1970s, NFIs were cited as a reason for the impotence of monetary policy, inspired by Goldsmith’s data (see the figure) that showed the considerable relative decline of commercial banks since 1900.<font style=""> </font>If most of the credit system is outside the Fed’s control, monetary policy must be irrelevant, argued proponents of the <i>New View</i> of banking and credit, who also denied the special characteristics of commercial banks.<font style=""> </font>“The distinction between commercial banks and other financial intermediaries has been too sharply drawn,” James Tobin (1963) wrote.<font style=""> </font>“The differences are of degree, not of kind [and] have little intrinsically to do with the monetary nature of bank liabilities.”<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">That leaves fiscal policy the Keynesians said.<font style=""> </font>Keynes’s (1936) definition of money had been loose, applying to short-term assets in general rather than to the medium of exchange, and therefore, his followers alleged, could not be controlled.<font style=""> </font>Anyway, they said, prices were due to the wage- and cost-push of unions and monopolists rather than money.<font style=""> </font>These views coincided with the Great Inflation that lasted from the effective end of the gold standard in the early 1930s to the early 1980s, during which the U.S. price level rose eightfold.<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">The turnaround of monetary policy in the 1980s followed the rejection of Keynesianism, including the New View.<font style=""> </font>Critics of the New View pointed out that the monetary nature of their liabilities gave banks unique leverage over total credit since all transactions, including financial transactions, are carried on through money (Guttentag and Lindsay 1968; Wood 1970).<font style=""> </font>Money <i>is</i> important, Milton Friedman and Anna Schwartz (1963) argued.<font style=""> </font>That inflation is a monetary phenomenon, which the Fed can control, was accepted in the 1980s and successfully applied throughout the developed world.<font style=""> </font>It was again agreed that price and financial stability follow from stable monetary policy.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>NBIs are not unimportant, but the vital roles of money and commercial banks have not changed.<font style=""> </font>And neither has the principal cause of financial crises – bad bank loans.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3"><b><o:p> </o:p></b></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3"><b>References<o:p></o:p></b></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">John Boyd and Mark Gertler. “Are banks dead or are the reports greatly exaggerated?” Federal Reserve Bank of Minneapolis <i>Quarterly Rev.,</i> Summer 1994.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">Milton Friedman and Anna Schwartz. <i>A History of Monetary Policy in the U.S., 1867-1960</i>. Univ. of Princeton Press. 1963.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">Raymond Goldsmith. <i>Financial Intermediaries in the American Economy since 1900.</i> Princeton Univ. Press. 1958.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">Jack Guttentag and Robert Lindsay. “The uniqueness of commercial banks,” <i>J. Political Economy,</i> Oct. 1968.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">J.M. Keynes. <i>The General Theory of Employment, Interest and Money.</i> Macmillan. 1936.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">Frederic Mishkin. <i>The Economics of Money, Banking, and Financial Markets</i>. 7<sup>th</sup> ed. update. Pearson Addison Wesley. 2006.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">Lawrence Ritter, William Silber, and Gregory Udell. <i>Principles of Money, Banking, and Financial Markets</i>, 12<sup>th</sup> ed. Prentice Hall. 2009.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">James Tobin. “Commercial banks as creators of ‘money’,” in D. Carson, ed., <i>Banking and Monetary Studies</i>. Irwin. 1963.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: -0.5in;"><font size="3">John Wood. “Two notes on the uniqueness of commercial banks,” <i>J. Finance</i>, March 1970.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-align: center; text-indent: -0.5in;" align="center"><font size="10pt"><font size="3">………………………….</font><o:p></o:p></font></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-75172370417309816912010-06-26T13:48:00.005-04:002010-06-26T14:04:45.282-04:00It's Nothing to Do With Us<span style="font-size:100%;"><b><span style="line-height: 150%;"><br /></span></b></span><div style="text-align: center;"><span style="font-size:100%;"><b><span style="line-height: 150%;">It’s Nothing to Do with Us<o:p></o:p></span></b></span></div> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">1.</span></b></span><span style="line-height: 150%;font-size:100%;" > “Global saving intentions … chronically exceeded global intentions to invest…. In short, geo-political events ultimately led to a fall in long-term mortgage events.”<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">2.</span></b></span><span style="line-height: 150%;font-size:100%;" > “I define a bubble as a protracted period of falling risk aversion that translates into falling capitalization rates that decline measurably below their long-term trendless averages.”<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">3.</span></b></span><span style="line-height: 150%;font-size:100%;" > “We have chosen capital standards that … cannot protect against all potential adverse outcomes…. Hundred-year floods come only once every hundred years.”<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">4.</span></b></span><span style="line-height: 150%;font-size:100%;" > “The global house price bubble was a consequence of lower interest rates, but it was <i>long term</i> interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom…. The 30-year mortgage rate had clearly delinked from the fed funds rate in the early part of this decade.”<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">5.</span></b></span><span style="line-height: 150%;font-size:100%;" > “Could the breakdown that so devastated global financial markets have been prevented?<span style=""> </span>Given inappropriately low financial intermediary capital and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.”<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-align: right; text-indent: -0.25in; line-height: 150%;" align="right"><span style="line-height: 150%;font-size:100%;" >Alan Greenspan, <i>The Crisis</i>, March 2010.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="line-height: 150%;font-size:100%;" >These are some of the Federal Reserve’s excuses for the recent crisis.<span style=""> </span>Its disclaimers of responsibility have become famous.<span style=""> </span>We are not sure that they are without merit, but they are not well-reasoned.<span style=""> </span>Most of the evasive statements of Federal Reserve officials have been unsupported assertions of innocence, untroubled by the careful explanations that we are entitled to expect from the “experts” that we have raised to “responsible” public positions.<span style=""> </span>Their actions and calls for action are justified by hysterical claims that <i>if we don’t do something,</i> <i>the world’s financial system will melt down.<span style=""> </span>We won’t have an economy tomorrow.<span style=""> </span>We are looking at an abyss</i> (see the 9/14/09 blog).<span style=""> </span>The transparency so often promised is not forthcoming, although we don’t know whether this is because the Federal Reserve is secretive or because it doesn’t know what it’s doing.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="line-height: 150%;font-size:100%;" > Once in a while, however, one of them provides pieces of an account of events – such as former Fed Chairman Alan Greenspan’s explanation of <i>The Crisis</i>, excerpts from which are listed above.<span style=""> </span>It was not well-received (e.g., <i>The Economist</i>, March 20, 2010), but it might provide an inkling of the economics behind the policies that have baffled students of the Fed.<span style=""> </span>I consider the stated elements of what might be his model in the order listed.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">1.</span></b></span><span style="line-height: 150%;font-size:100%;" > <i>They made us do it.</i><span style=""> </span>Greenspan has an unusual view of how interest rates are determined (we will see more of this below), which in standard economic theory depends on the supply (thrift) and demand (investment) for savings, that is, on the competition for funds.<span style=""> </span>Saving is a fairly steady proportion of income, so that the demand for capital goods drives interest rates and growth.<span style=""> </span>That is why investment, interest rates, and income are procyclical.<span style=""> </span>Greenspan, however, sees no effect of investment on interest rates (ignoring a blade of the scissors that Alfred Marshall used to illustrate the determination of price by the intersection of supply and demand) and attributes low real interest rates to the global saving that accompanied rising income.<span style=""> </span>Funds were so abundant that savers could not be careful about the risks of their lending.<span style=""> </span>It was a borrowers’ market.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="line-height: 150%;font-size:100%;" >Not only is Greenspan’s explanation wanting because it ignores demand during the global boom of the early part of the decade, so is his observation.<span style=""> </span>The figure shows that real long-term interest rates (<i>LTR – p</i>) were not low by historical standards.<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">2. </span></b><i><span style="line-height: 150%;">Changed people or changed incentives?</span></i></span><span style="line-height: 150%;font-size:100%;" > The penchant of each generation to be convinced of declines in morals and the work ethic is not new.<span style=""> </span>Greenspan has joined the crowd in blaming the bubble on a rise in greed (a fall in risk aversion), and neglects the possibility that the boom was due to a change in incentives.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="line-height: 150%;font-size:100%;" >The title of his book, “<i>The</i> Age of Turbulence,” like Kenneth Galbraith’s “<i>The</i> Age of Uncertainty,” reveal his lack of historical perspective.<span style=""> </span>The Tulip Craze of 1630, the South Sea Bubble of 1720, the Panic of 1873, and the 1929 Crash might as well never have happened.<span style=""> </span>Instead of considering the opening lines of Dickens’ “Tale of Two Cities,” Greenspan treats each event as unique and without precedent, and therefore not susceptible to analysis.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="line-height: 150%;font-size:100%;" >He fails to account for the implied government guarantees behind the government-sponsored subprime mortgage creators (Fannie Mae and Freddie Mac), the Too Big to Fail frame of mind of regulators, and the Greenspan put (bailout promise) on the risks perceived by lenders.<span style=""> </span>An increased expectation of bailouts is a reduction in perceived risk rather than risk aversion.<span style=""> </span>However much Greenspan likes the easy explanation, recent events suggest more continuity than change in human behavior.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">3.</span></b></span><span style="line-height: 150%;font-size:100%;" > <i>The hundred-year flood metaphor is false.</i><b><span style=""> </span></b>Snake-eyes occur on average once every thirty-six throws of a pair of fair dice.<span style=""> </span>This changes if the dice are loaded.<span style=""> </span>Similarly, although we might reasonably estimate a financial collapse once every hundred years in a given environment, the odds change if we alter the environment by increasing the incentives to take risks.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size:100%;"><i><span style="line-height: 150%;">Capital has been a poor predictor of financial failures</span></i></span><span style="line-height: 150%;font-size:100%;" >, as must be the case if we are not careful about the risks of assets.<span style=""> </span>The capital sufficient to protect depositors against the dangers of high-risk loans exceeds that for low-risk loans.<span style=""> </span>Capital regulation has never been successful (as was noted in my 9/29/09 blog), partly because capital ratios are determined by the same factors (such as the perceived risks discussed above and the seriousness of regulation) as assets.<span style=""> </span>Regulation in general and capital regulation in particular are popular solutions for those unwilling to admit the effects of information or incentives on the behavior of financial (and other) institutions.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">4. </span></b><i><span style="line-height: 150%;">The claim that long rates were “delinked” from short rates denies economics and central banking.</span></i></span><span style="line-height: 150%;font-size:100%;" > Long rates depend on expected short rates, and central banks have operated through short rates from their beginnings.<span style=""> </span>A classic defense of “bills only” (short-term Treasuries) as its primary instrument was issued by the Fed in the 1950s.<span style=""> </span>If short rates have no effects, one can only wonder what Greenspan thinks the Fed is doing.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size:100%;"><b><span style="line-height: 150%;">5.</span></b></span><span style="line-height: 150%;font-size:100%;" > <i>It was inevitable.</i><span style=""> </span>Booms have often been followed by busts, but central bankers have usually “leaned against the wind,” as Fed Chairman (1951-70) William McChesney Martin, Jr., put it.<span style=""> </span>He also said: “It’s my job to take away the punch bowl just as the party gets going.”<span style=""> </span>Martin and other central bankers have made plenty of mistakes, but they have usually accepted responsibility for moderating financial developments.<span style=""> </span>Greenspan rejects this and other responsibilities, although his stated economic ideas suggest that he couldn’t have been effective anyway.<o:p></o:p></span></p> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><span style="line-height: 150%;font-size:100%;" >……………………….<o:p></o:p></span></p><span style="font-size:100%;"><br /></span><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgn8aqhyphenhyphenwPHuN6cL0P4ItjPedrXroPxBJRTD6jutcM_H-RHEms2BEkc6cgJhkB0eHCsZgcTIHN27tIYiWPVI03A-xaQ_mqh_Qo2R6gxipb4HouSnpADu4PmfrZlroyQOUQ70e_zCS8W3GOL/s1600/p<R&STR.jpg"><img style="display: block; margin: 0px auto 10px; text-align: center; cursor: pointer; width: 399px; height: 240px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgn8aqhyphenhyphenwPHuN6cL0P4ItjPedrXroPxBJRTD6jutcM_H-RHEms2BEkc6cgJhkB0eHCsZgcTIHN27tIYiWPVI03A-xaQ_mqh_Qo2R6gxipb4HouSnpADu4PmfrZlroyQOUQ70e_zCS8W3GOL/s400/p<R&STR.jpg" alt="" id="BLOGGER_PHOTO_ID_5487141859591186882" border="0" /></a><br /><span style="font-size:100%;"><br /><br /><br /><br /><br /><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhFGpR2THhzVn2YlHM68UwBMGJf6UNZHZqWrfjlrzWCOv4OJvgde3dqJF7gIhT8hEASfWeeAQAd6HQr7eXXyTeC-XjwVNdZqYexenzLXeKy_zReLzx2GDz6RIUoaxxNdzfERAafgNvse2Kl/s1600/p<R&STR.jpg"><br /></a></span><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhFGpR2THhzVn2YlHM68UwBMGJf6UNZHZqWrfjlrzWCOv4OJvgde3dqJF7gIhT8hEASfWeeAQAd6HQr7eXXyTeC-XjwVNdZqYexenzLXeKy_zReLzx2GDz6RIUoaxxNdzfERAafgNvse2Kl/s1600/p<R&STR.jpg"><br /></a>John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-6133240747677535452010-04-27T17:46:00.000-04:002010-04-27T17:52:33.277-04:00The FDIC's Call for Papers<meta equiv="Content-Type" content="text/html; charset=utf-8"><meta name="ProgId" content="Word.Document"><meta name="Generator" content="Microsoft Word 12"><meta name="Originator" content="Microsoft Word 12"><link 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mso 10]> <style> /* Style Definitions */ table.MsoNormalTable {mso-style-name:"Table Normal"; mso-tstyle-rowband-size:0; mso-tstyle-colband-size:0; mso-style-noshow:yes; mso-style-priority:99; mso-style-qformat:yes; mso-style-parent:""; mso-padding-alt:0in 5.4pt 0in 5.4pt; mso-para-margin:0in; mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:11.0pt; font-family:"Calibri","sans-serif"; mso-ascii-font-family:Calibri; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:SimSun; mso-fareast-theme-font:minor-fareast; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="margin: 6pt 0in 6pt 0.25in;"><font size="3">In the 19<sup>th</sup> century, U.S. Supreme Court Justice Samuel Miller complained about the "united, vigorous, and selfish effort of the capitalists" to protect their interests. Their suits had "shaken my faith in human nature.… <font style=""> </font>They engage in no commerce, no trade, no manufacturing, no agriculture. They produce nothing."<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">The Federal Deposit Insurance Corporation's Center for Financial Research and the <i>Journal of Financial Services Research</i> recently invited papers for their 10th Annual Fall Research Conference with the following theme:<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><font size="3">Financial services are intermediate inputs that provide benefits to society when they contribute to economic growth and raise standards of living. As a share of GDP, financial services have grown from 2.5 percent in the 1940s to almost 8 percent today. During this period of growth, few questioned whether the finance sector created social benefits commensurate with its share of GDP. Following the crisis, many are re-examining the linkages between the financial sector and sustainable growth.<font style=""> </font>Government policies, moreover, are likely to alter the existing balance between finance and the real sector.<font style=""> </font>Many market failures have been identified as a source of skewed incentives that inflated a credit bubble. <font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">Talk about standing history on its head!<font style=""> </font>Middlemen of all types, including financial, have always been objects of a popular hatred that politicians and regulators have sought to exploit.<font style=""> </font>The present is no exception.<font style=""> </font>In his first <i>Inaugural Address</i>, Franklin Roosevelt said the Great Depression occurred <o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><font size="3">Primarily … because the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence…. <font style=""> </font>Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men…. Faced by failure of credit they have proposed only the lending of more money [we wish]…. They know only the rules of a generation of self-seekers.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: 0.25in;"><font size="3">The money changers have fled from their high seats in the temple of our civilization.<font style=""> </font>We now restore that temple to the ancient truths.<font style=""> </font>The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">We know that the Great Depression was one of the greatest <i>government failures</i> of all time: wildly fluctuating monetary policies (inflation during and after World War I followed by severe deflations) of the Federal Reserve (a government agency created in 1913), which finally abandoned its responsibilities. <o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">Overlooked by populists and politicians, as well as in the theme of the FDIC’s conference, is that intermediaries do produce things – particularly the transport of goods and money from suppliers (including lenders) to users (including borrowers), activities that include the production and use of information, which, contrary to the attitudes of regulators, is not free.<font style=""> </font>We must remember that financial intermediaries exist because of transaction costs, including the costs of information, and that they compete for profits by producing and selling information and other transaction services – just as manufacturers pursue profits by buying inputs, transforming them into tangible products, and selling them.<font style=""> </font>Economist Robert Clower wrote in his compelling fashion:</font><font style="line-height: 150%;" size="3"><o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><font size="3">The trades that take place in a market economy ultimately are determined by the quantity and distribution of natural and human resources and by individual tastes.<font style=""> </font>This is true regardless of the manner in which trade is organized.<font style=""> </font>In the absence of market-making firms, however, … vast quantities of resources would be diverted away from directly want-satisfying production and consumption activities into tiresome and inefficient search and bargaining chores….<font style=""> </font>[T]he firms that make and operate our numerous retail, wholesale, manufacturing, and service markets are the visible fingers of the invisible hand -- the fingers that coordinate the countless activities of people in every modern society.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">The conference call’s suggestion that the growth of intermediary services as a share of the economy is recent also flies in the face of history.<font style=""> </font>Industrial and financial revolutions, old and new, have been inseparable (Goldsmith 1954; Carter 2006).<font style=""> </font>The coiner of the term, Arnold Toynbee (1884), wrote:<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><font size="3">The essence of the Industrial Revolution is the substitution of competition for the mediaeval regulations which had previously controlled the production and distribution of wealth.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">The conference call’s reference to <i>market failures</i> is also misguided.<font style=""> </font>Market failures may occur – although the tendency of economists to attribute failure to the latter when theory and practice do not conform is suspect – but the recent crisis was the result of the responses of households and firms to government-promoted adverse incentives – including the promotion of packages of subprime mortgages by Government Sponsored Enterprises, official endorsements of ratings, too-easy and then too-tight monetary policy, and dependence on prospective bailouts under the Greenspan put and Too Big To Fail – reminiscent of the mercantilist/pre-industrial era that Adam Smith (1776) criticized.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>The U.S. financial sector has always been heavily regulated in the belief that financial intermediation is costless (and therefore useless), so that, for example, bank portfolios are as easily understood and even managed by remote, inexperienced, and part-time overseers without meaningful incentives, as by full-time professionals whose livelihoods are at risk.<font style=""> </font>This attitude was responsible for the creation of the FDIC in the 1930s as part of an attempt to resolve bank problems resulting from (1) official restrictions on bank structure (mainly anti-branching laws) and (2) the erratic monetary problems of the Federal Reserve (referred to above) by means of what might be the classic adverse incentive – deposit insurance without independence of risk or risk-based premiums (which are even today inadequate).<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>Instead of seeking more regulations (and engines of government failure), the conference organizers should address the connections between finance and growth, including the development of financial services in an increasingly specialized economy, and the elimination of regulations and their institutions, including the FDIC.<font style=""> </font>But then they would be out of a job.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font size="3"><b><font style="line-height: 150%;"><o:p> </o:p></font></b></font></p> <p class="MsoNormal" style="line-height: 150%;"><font size="3"><b><font style="line-height: 150%;">References:<o:p></o:p></font></b></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font size="3">George J. Benston and Clifford W. Smith, Jr. 1976. “A transactions costs approach to the theory of financial intermediation,” <i>Journal of Finance</i>, May. <o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font lang="ES" size="3">Susan Carter, et.al., eds. 2006. </font><font size="3"><i>Historical Statistics of the U.S. Millennial Edition</i></font><font size="3">. Cambridge Univ. Press.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font size="3">Robert W. Clower, 1994. “The fingers of the invisible hand,” <i>Brock Univ. Review</i>, April. <o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font size="3">Raymond Goldsmith. 1954. <i>The Share of Financial Intermediaries in National Wealth and National Assets, 1900-1949</i>. National Bureau of Economic Research.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font size="3">Carter H. Golembe. 1960. “The deposit insurance legislation of 1933: An examination of its antecedents and its purposes,” <i>Political Science Quarterly</i>, June.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font size="3">Adam Smith. 1776. <i>An Inquiry into the Nature and Causes of the Wealth of Nations.</i> Strahan and Cadell. <o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font size="3">Arnold Toynbee. 1884. <i>The Industrial Revolution</i>. Rivington’s. <o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.3in; text-indent: -0.3in;"><font size="3">John J. Wallis and Douglas C. North. 1986. “Measuring the transactions sector in the American economy, 1870-1970,” in S. Engerman and R. Gallman, eds. <i>Long-Term Factors in American Economic Growth.</i> Univ. of Chicago Press.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 46.1pt; text-indent: -46.1pt;"><font size="3">Robert H. Wiebe. 1967. <i style="">The Search for Order, 1877-1920</i>. Hill and Wang.</font><font style="" face=""" size="3"><o:p></o:p></font></p> <p class="MsoNormal" style="text-align: center;" align="center"><font size="11pt"><font size="3">……………….</font><o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.5in; text-align: right; text-indent: 0.25in;" align="right"><o:p> </o:p></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-25473508575675638162010-03-26T11:14:00.005-04:002010-03-26T11:33:58.488-04:00The Market Doesn't Believe the Fed<a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh4soIKnRgj4a-OunNM9Fplf_1uhl88O9WsSyvY5p7RsxSzEmNbFwUQsy-MhhJY_XsJjGovhgcm6Fh9yOP51gtm-VvhaaCGHWZ7PY3A_jlxvMQ9t-2Amq2XYLIRojtPBb__avHQVABgwLJj/s1600/TreasuryYieldCurves0910.jpg"><img style="display: block; margin: 0px auto 10px; text-align: center; cursor: pointer; width: 400px; height: 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{mso-style-unhide:no; mso-style-qformat:yes; mso-style-parent:""; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:12.0pt; font-family:"Times New Roman","serif"; mso-fareast-font-family:SimSun; mso-fareast-language:JA;} .MsoChpDefault {mso-style-type:export-only; mso-default-props:yes; font-size:10.0pt; mso-ansi-font-size:10.0pt; mso-bidi-font-size:10.0pt; mso-fareast-font-family:SimSun;} @page Section1 {size:8.5in 11.0in; margin:1.0in 1.0in 1.0in 1.0in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} --> </style><!--[if gte mso 10]> <style> /* Style Definitions */ table.MsoNormalTable {mso-style-name:"Table Normal"; mso-tstyle-rowband-size:0; mso-tstyle-colband-size:0; mso-style-noshow:yes; mso-style-priority:99; mso-style-qformat:yes; mso-style-parent:""; mso-padding-alt:0in 5.4pt 0in 5.4pt; mso-para-margin:0in; mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:11.0pt; font-family:"Calibri","sans-serif"; mso-ascii-font-family:Calibri; mso-ascii-theme-font:minor-latin; mso-fareast-font-family:SimSun; mso-fareast-theme-font:minor-fareast; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">The Consumer Price Index for February was unchanged from January, and only 0.4% above August 2009, meaning inflation less than 1% at an annual rate the last six months.<font style=""> </font>This is apparently not expected to continue, however, since the yield curve is steeply sloping and getting steeper.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>A temporarily low inflation should not be the object of monetary policy.<font style=""> </font>Recent price stability is due to weak demand that has nullified the massive increase in Federal Reserve credit, which is held mainly as excess reserves by banks.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>In arguing against specific targets and their “false precision,” Chairman Greenspan said that the goal of “price stability is best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms” (2002).<font style=""> </font>His successor, Ben Bernanke, reinforced this view in his first (2006) <i>Monetary Policy Report </i>to Congress.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 6pt 0in 6pt 0.25in; text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">Experience shows that low and stable inflation and inflation expectations [are] essential for strong and stable growth of output and employment.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">Although he has said he has a plan to prevent the Fed's credit overhang from fueling future inflation, the market is skeptical.<font style=""> </font>We do not see “stable inflation and inflation expectations.”<font style=""> </font>The Fed announced a policy to reduce long rates (without changing its policy of low short rates), which was bound to be ineffective (see my blog of 10/4/09), but we have, not surprisingly, seen the opposite.<font style=""> </font>The continued low short-rate policy (which the figure shows has become even more pronounced), and the Fed’s incredibility in general, has steepened the yield curve.<font style=""> </font>This is abnormal for expansions, when short rates normally rise more than long rates.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>The extent to which the Fed’s policy will retard recovery depends on expectations and realized inflation.<font style=""> </font>If businesses and consumers are confident of future inflation, expected real long-term rates may be low and therefore encourage spending.<font style=""> </font>In this case, expected inflation had better be realized or bankruptcies will result.<font style=""> </font>The Fed will be pressured to produce expectations and possibly another bubble.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>If high long rates are caused by uncertainty, current spending is reduced.<font style=""> </font> We have no clue which way the Fed will jump.<font style=""> </font>Its behavior the past few years has been unprecedented and gives no inkling of what’s in store.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>“During the past two decades,” a monetary economist wrote earlier in the decade, “central bankers [have come to] agree that price stability is an important goal and that ‘credibility’ of policy and ‘transparency’ of its implementation are crucial to accomplishing that goal” (Green’s 2005 <i>Review</i> of Woodford 2005).<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">We wish.<font style=""> </font>My April blog will discuss the Greenspan/Bernanke denial not only of personal responsibility but of the effects of monetary policy at all.<font style=""> </font>Somehow, flying in the face of the history of central banks, which have nearly always operated through a short rate, monetary policy is no longer responsible for long rates, spending, or inflation.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><o:p> </o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3"><b>References<o:p></o:p></b></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Edward Green. 2005. “A Review of <i>Interest and Prices</i> by Michael Woodford,” <i>J. Economic Literature</i>, March.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Alan Greenspan, 2002. “Transparency in monetary policy,” Federal Reserve Bank of St. Louis Review, July/August.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Michael Woodford. 2003. <i>Interest and Prices. Foundations of a Theory of Monetary Policy. </i>Princeton Univ. Press.<i><o:p></o:p></i></font></p> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><font style="line-height: 150%;" size="11pt"><font size="3">………………….</font><o:p></o:p></font></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-34039354281604506362010-02-14T10:01:00.000-05:002010-02-14T10:05:46.425-05:00<meta equiv="Content-Type" content="text/html; charset=utf-8"><meta name="ProgId" content="Word.Document"><meta name="Generator" content="Microsoft Word 12"><meta name="Originator" content="Microsoft Word 12"><link rel="File-List" href="file:///C:%5Ctemp%5Cmsohtmlclip1%5C01%5Cclip_filelist.xml"><link rel="themeData" href="file:///C:%5Ctemp%5Cmsohtmlclip1%5C01%5Cclip_themedata.thmx"><link rel="colorSchemeMapping" href="file:///C:%5Ctemp%5Cmsohtmlclip1%5C01%5Cclip_colorschememapping.xml"><!--[if gte mso 9]><xml> <w:worddocument> <w:view>Normal</w:View> <w:zoom>0</w:Zoom> 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mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:11.0pt; font-family:"Calibri","sans-serif"; mso-ascii-font-family:Calibri; mso-ascii-theme-font:minor-latin; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><font size="3"><b><font style="line-height: 150%;">What Bernanke believes<o:p></o:p></font></b></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><font size="3">Let me end my talk [in honor of Milton Friedman’s 90<sup>th</sup> birthday] by abusing slightly my status as an official representative of the Federal Reserve.<font style=""> </font>I would like to say to Milton and Anna [Schwartz]: Regarding the Great Depression.<font style=""> </font>You’re right, we did it.<font style=""> </font>We’re very sorry.<font style=""> </font>But thanks to you, we won’t do it again.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.5in; text-align: right; text-indent: 0.25in;" align="right"><font size="3">Ben Bernanke, University of Chicago, Nov. 8, 1992.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">In fact the Federal Reserve has learned nothing, and is doing <i>it</i> again, <i>it</i> being the substitution of controls for monetary policy.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>Whatever attention is being paid to Chairman Bernanke’s allusions to an exit strategy from under the massive reserves the Fed has dumped on the banking system – which is not much because observers realize that they merely repeat the musings of a year ago -- are misplaced because the chairman is not really interested in monetary policy.<font style=""> </font>This may seem strange, but it is not the first time the Fed that has been uninterested in what one might have thought was its principal mission.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>For example, the Fed allowed the money stock to collapse (falling 38% between 1929 and 1933) while the Hoover administration focused on bank reforms (deposit insurance and changes in banking structure and regulation, including the Glass-Steagall Act that separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation, which was expanded by the New Deal.<font style=""> </font>Among other interventions, RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management.<font style=""> </font>In their monumental <i>Monetary History of the United States</i>, Friedman and Schwartz contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the recovery of the money supply (as Christina Romer also pointed out in a 1992 paper in the <i>Journal of Economic History</i>).<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">We might have thought, in light of these experiences and the opening quotation, that Chairman Bernanke would eschew direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock.<font style=""> </font>We would be wrong.<font style=""> </font>He and his colleagues have done the opposite.<font style=""> </font>The failed official strategy of the Great Depression has been repeated in the Fed’s lending to specific institutions, its focus on the risk and liquidity of particular markets, the Troubled Asset Relief Program, Asset Backed Commercial Paper, swap agreements, and numerous other market interventions, as well as lobbying for more regulations of financial institutions of which it would be the principal administrator.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>What about monetary policy?<font style=""> </font>The easy money (negative real rates) of 2002-2005, followed by the tightening of 2006-2007, is reminiscent of the run-up to the Great Depression.<font style=""> </font>In 1928-29, the Fed focused on credit controls and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and to lower rates in recession – just as in mid-2008, when it suddenly became hawkish about inflation.<font style=""> </font>The intensification of the recession began before the financial turmoil of September 2008.<font style=""> </font>“In this recession, unlike the other recessions that followed the Depression [but like the Depression], commentators [like the Fed] have assigned causality to dysfunction in credit markets,” as Robert Hetzel pointed out in a recent paper in the Richmond Fed’s <i>Economic Quarterly</i>.<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">Perhaps the key to these similarities is found in Bernanke’s view of the financial markets.<font style=""> </font>His fame as an academic economist rests on his 1983 paper that stressed the banking structure and the nature of capital flows as causes of the Great Depression.<font style=""> </font>He argued that bank failures and falling bank loans – the interruption of credit arrangements – were significant contributors to the severity of the Great Depression that had been overlooked by Friedman and Schwartz.<font style=""> </font>Although the latter’s message that recovery came with the turn-around in money (while bank loans remained weak) has been reinforced, Bernanke has not, despite the protestation quoted above, come around to the Friedman-Schwartz view of the importance of money or, just as significantly, free markets.<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">As fundamental as money to their monetarist philosophy is the freedom of markets, which necessarily includes their component institutions.<font style=""> </font>The government should (1) let them alone while (2) pursuing a stable monetary policy.<font style=""> </font>The Federal Reserve under Bernanke has done neither.<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">There is much talk of the Fed’s independence (of what or whom is not made clear).<font style=""> </font>We should be more concerned about our independence of the Fed.<o:p></o:p></font></p> <p class="MsoNormal" style="text-align: center;" align="center"><font size="10.5pt"><font size="3">…………………..</font><o:p></o:p></font></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-57752790759175427682010-01-25T10:43:00.005-05:002010-01-25T10:52:35.381-05:00<a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi8Y5W4La6mAYn1Rr_y2CIbSKMeeEH94TXkvc7VFFB3ugFU0XdalBWTGHUItfpxjaFmq4zcHcFTzAV5nii53duKY_sGvAUsEuqYmO7ON3DMSBrK6s5U3G5itZwvR3INSYzacHAvMMwc6aNh/s1600-h/StockVolatility.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 400px; height: 397px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi8Y5W4La6mAYn1Rr_y2CIbSKMeeEH94TXkvc7VFFB3ugFU0XdalBWTGHUItfpxjaFmq4zcHcFTzAV5nii53duKY_sGvAUsEuqYmO7ON3DMSBrK6s5U3G5itZwvR3INSYzacHAvMMwc6aNh/s400/StockVolatility.jpg" alt="" 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font-family:"Calibri","sans-serif"; mso-ascii-font-family:Calibri; mso-ascii-theme-font:minor-latin; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="text-align: center;" align="center"><font size="3"><b>Blame the Quants<o:p></o:p></b></font></p> <p class="MsoNormal" style="text-align: center;" align="center"><font size="3"><b><o:p> </o:p></b></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><font size="3">Thanks to their armies of elite scientists, quant funds can model the markets and predict their future behavior, goes the undoubted conventional wisdom.<o:p></o:p></font></p> <p class="MsoNormal" style="text-align: right;" align="right"><font size="3">Pablo Triana, <i>Lecturing Birds on Flying. Can Mathematical Theories<o:p></o:p></i></font></p> <p class="MsoNormal" style="text-align: right;" align="right"><font size="3"><i><font style=""> </font>Destroy the Financial Markets? </i></font><font size="3">(xxi, Wiley 2009)<o:p></o:p></font></p> <p class="MsoNormal" style="text-align: right;" align="right"><font size="3"><o:p> </o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">It is common, perhaps natural, to attribute increases in the volatility of security prices to improvements in technology.<font style=""> </font>After all, technology reduces the cost of trading, and large price movements are often accompanied by large volumes.<font style=""> </font>It does not seem unreasonable that new technology amplifies the impact of ideas, particularly expectations, on trading volumes and prices.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>Certainly, there have been great technological advances.<font style=""> </font>On May 23, 1962, the ticker at the New York Stock Exchange fell 143 minutes behind trades, the longest lag in history to that time except October 24, 1929.<font style=""> </font>It ran late 124 times in 1966, unable to keep pace with daily volumes that sometimes exceeded 10 million shares.<font style=""> </font>The major exchanges closed Wednesdays from June to December 1968 to catch up on paper work.<font style=""> </font>The computer has since made much greater volumes routine: daily trades hit 50 million shares in 1978, 1 billion in 1997, and 14 billion on July 19, 2007; 5 billion is now a slow trading day.<o:p></o:p></font></p> <p style="margin: 0in 0in 0.0001pt; line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>The new technology enables trades of blocks of securities triggered by relative price movements.<font style=""> </font>This <i>program trading</i> accounts for more than a third of the NYSE’s volume, and is especially active during the <i>triple witching hours</i> that occur on the third Fridays of March, June, September, and December, which are the expiration days of stock options, index options, and index futures.<font style=""> </font>Wikipedia tells us that these “simultaneous expirations generally increase the trading volumes of options, futures and the underlying stocks, and occasionally increase the volatility of prices of related securities.”<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>Pablo Triana has responded to the recent financial crisis with a book which argues that the implementation of recent financial theories made possible by the new technology “drastically moves” (xxv) and is destroying the financial markets.<font style=""> </font>Both pillars of the argument are imaginary.<font style=""> </font>I begin with theory, which is an attempt to understand events, for example, price movements. <font style=""> </font>Triana’s observations that the Black-Scholes-Merton (BSM) option-pricing model (the book’s chief culprit), is unrealistic and a poor predictor are redundant.<font style=""> </font>Theories must be simplified to be understood; the “real” world cannot be modeled. <font style=""> </font>Their inability to predict in fact supports efficient-market pricing theories, which assert that prices incorporate information so that future price movements are random.<font style=""> </font>Furthermore, most traders don’t apply the theory.<font style=""> </font>Nevertheless, Triana claims that the crash of October 19, 1987, and later crashes, were caused by “computationally charged stock-trading strategies directly inspired by the mathematical spirit of the Black-Scholes formula” (p. xlviii).<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>It is in principle possible that such “inspired strategies” have been guilty of any number of evils, including increases in volatility. <font style=""> </font>However, the latter has not occurred.<font style=""> </font>The belief in a positive correlation between volatility and technology finds no support in the data.<font style=""> </font>Financial theories are innocent even of a second-hand cause of volatility.<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">It is also reasonable to believe that technology reduces volatility.<font style=""> </font>Kenneth Garbade and William Silber (1978) reported that the overland telegraph greatly reduced spreads between security prices in New York, Philadelphia, and New Orleans in the 1840s; a result repeated by the Atlantic cable for prices in New York and London in the 1860s.<font style=""> </font>This implies reductions in volatility to the extent that the effects of location-specific shocks are spread over the greater areas made possible by improved communications and lower transaction costs.<font style=""> </font>Thick markets are associated with low volatility.<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">However, in December 1857, the <i>Merchants’ Magazine and Commercial Review </i>identified the recent invention of the telegraph, “by means of which bad news, such as the failure or embarrassment of a bank … was immediately communicated to all the cities and large towns of the United States,” as the immediate cause of the panic” (Jalil 2009).<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>The proof is in the pudding.<font style=""> </font>Our view of the correlation between technology and volatility ought to depend on the data, which predominately points to <i>zero</i>.<font style=""> </font>A strong and well-known example is the history of the volatility of stock prices depicted in the figure (with standard-deviations derived from data through Robert Shiller’s homepage).<font style=""> </font>Many believe that stock and other asset prices are “too volatile” for consistency with the rest of financial theory (Shiller 2000), but there has been little headway in explaining changes in volatility.<font style=""> </font>The figure shows the absence of a trend in the volatility of American stock prices since 1875.<font style=""> </font>The outlier of the 1930s has encouraged investigations of the effects of variations in the volatility of monetary policy (Bordo 2001), company news (Goonatilake 2007; Schwert 1989), and derivatives trading, including triple witches (Edwards 1988), with insubstantial results.<font style=""> </font>The almost continuous advance in technology (exacerbated or not by new financial theories) has had no effect.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>Optimistic expectations, excessive leverage, and volatile episodes are as old as the financial markets. <font style=""> </font><i>The Extraordinary Popular Delusions and the Madness of Crowds</i> (Mackay 1841) during the <i>tulipomania </i>of the 1630s, the collapses of the <i>Mississippi scheme</i> and the <i>South Sea bubble</i> in France and Britain in 1720, and many later booms and busts occurred without computers or sophisticated financial theories.<font style=""> </font>We are told that history will teach people to never again say “this time is different.”<i><o:p></o:p></i></font></p> <p class="MsoNormal" style="margin: 6pt 0in 0.0001pt 0.25in; text-indent: 0.25in;"><font size="3">The four most dangerous words in finance are “this time is different.”<font style=""> </font>Thanks to this masterpiece by Carmen Reinhart and Kenneth Rogoff, no one can doubt this again.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-align: right; text-indent: 0.25in;" align="right"><font size="3">Martin Wolf, <i>Financial Times</i>, review (Sept 28, 2009) of <i>This Time is Different: <o:p></o:p></i></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-align: right; text-indent: 0.25in;" align="right"><font size="3"><i>Eight Centuries of Financial Folly </i></font><font size="3">(Princeton U. Press 2009)<o:p></o:p></font></p> <p class="MsoNormal"><font size="3">Don’t bet on it.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-bottom: 6pt;"><font size="3"><b><o:p> </o:p></b></font></p> <p class="MsoNormal" style="margin-bottom: 6pt;"><font size="3"><b>References<o:p></o:p></b></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Bordo, Michael, Michael Dueker, and David Wheelock. 2001. “Aggregate price shocks and financial instability: A historical analysis,” <i>WP</i> 2000-005B. Federal Reserve Bank of St. Louis.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Edwards, Franklin. 1988. “Does futures trading increase stock return volatility?” <i>Financial Analysts J</i>., Feb. <o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Garbade, Kenneth, and William Silber. 1978. “Technology, communication, and the performance of financial markets: 1840-1975,” <i>J. Finance</i>, June.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Goonatilake, Rohitha.and Susantha Herath. 2007. “The volatility of the stock market and news,” <i>International Research J. of Finance and Economics</i>, 11.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Jalil, Andrew. 2009. “A new history of banking panics in the U.S., 1825-1929,” Univ. of California, Berkeley.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Mackey, Charles. 1841. <i>Extraordinary Popular Delusions and the Madness of Crowds</i>. London: Richard Bentley.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Schwert, William. 1989. “Why does stock market volatility change over time?” <i>J. Finance</i>, Dec.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Shiller, Robert. 2000. <i>Irrational Exuberance</i>. Princeton Univ. 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table.MsoNormalTable {mso-style-name:"Table Normal"; mso-tstyle-rowband-size:0; mso-tstyle-colband-size:0; mso-style-noshow:yes; mso-style-priority:99; mso-style-qformat:yes; mso-style-parent:""; mso-padding-alt:0in 5.4pt 0in 5.4pt; mso-para-margin:0in; mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:11.0pt; font-family:"Calibri","sans-serif"; mso-ascii-font-family:Calibri; mso-ascii-theme-font:minor-latin; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><i><span style="font-size: 11pt; line-height: 150%;">The House’s proposed bank regulation fails to address adverse incentives,<o:p></o:p></span></i></p> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><i><span style="font-size: 11pt; line-height: 150%;">and even reinforces some.<o:p></o:p></span></i></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">Government regulations tend to ignore the private incentives that elicit quality products.<span style=""> </span>This is perhaps best seen in the product-specific subsidies of official health care that discourage consumers from acquiring information about costs and qualities, and suppliers from developing reputations.<span style=""> </span>But it is also seen in banking regulation, such as deposit insurance.<span style=""> </span>What do we care about our bank’s safety if our deposits are insured against loss and even inconvenience?<span style=""> </span>The FDIC insures that the availability of our deposits is not interrupted as the new bank takes them over (usually with a subsidy) from our old failed bank.<span style=""> </span>What do we care about the costs of our medical services if someone else is paying?<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>The reduced concern for risk due to deposit insurance has been limited by ceilings on the amounts insured ($5,000 in 1934, $10,000 in 1950, $100,000 in 1980, and $250,000 in 2008, at first “temporarily” until the end of 2009, then extended to January 1, 2014; although coverage is increased by multiple accounts), which means that large depositors (such as firms with payrolls and other large bills) might have had incentives to monitor their banks.<span style=""> </span><span style=""> </span>But even this positive residue is eliminated by the regulators’ philosophy – underwritten by Congress – of <i>too big to fail</i>.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>House Democrats have promised to end this problem in a “sweeping financial regulation bill designed to prevent another financial crisis.” <span style=""> </span>“The bailouts of AIG and Bear Sterns would not be possible – made illegal – under this bill,” Barney Frank , chairman of the House Financial Services Committee, said last week.<span style=""> </span>“If a company fails, it’ll be put to death.”<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">Experience tells us of the vacuousness of this resolution.<span style=""> </span>Frank was a leader in the bailouts arranged by panic-stricken Congresses and administrations in 2008 and 2009.<span style=""> </span>His successful lobbying for TARP funds for a local bank that had received a cease and desist order from the FDIC for unsound lending practices and excessive executive pay and perks is well known.<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>The Federal Deposit Insurance Corporation Improvement Act of 1991 that followed the bank failures of the 1980s was intended to reduce the TBTF doctrine.<span style=""> </span>“A two-thirds majority of both the Board of Governors and the directors of the FDIC, as well as the approval of the Secretary of the Treasury, are required” to agree that a bank’s failure would “have serious adverse effects on economic conditions or financial stability” (Mishkin, p. 279).<span style=""> </span>The Fed was directed to stop lending to insolvent institutions.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>The futility of these resolutions, no matter how often thay are repeated, will continue until the incentives of government officials, elected and appointed, have changed.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">Other components of the current bill according to news reports are “more oversight and higher capital requirements,” and a new Consumer Financial Protection Agency to oversee consumer financial products lie credit cards and mortgages.”<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">We have seen the ineffectiveness – and worse -- of capital requirements.<span style=""> </span>They are easily evaded and used as cover against serious regulatory oversight, and contributed to the recent financial crisis.<span style=""> </span>They induced banks to reduce risk (so the regulators believed) through credit default swaps issued by AIG, which allowed them to make riskier loans.<span style=""> </span>Banks should have known that these bets on the state of the economy violated a basic requirement of insurance, which is independence of risks, but they succumbed to the regulatory incentive to buy them (Carrey March 2, 2009).<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">The new “protection” agency will be seen, like other agencies in the past (such as the Interstate Commerce Commission and the Securities and Exchange Commission) to reduce competition and consumer choice.<span style=""> </span>Those who will enjoy the most protection will be large firms at the expense of consumers.<span style=""> </span>Nothing fundamental has changed<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: 0.25in;"><i><span style="font-size: 11pt;">As a rule, regulation is acquired by the industry [despite its pretended protests for the public’s benefit] and is designed and operated for its benefit.<o:p></o:p></span></i></p> <p class="MsoNormal" style="text-align: right; text-indent: 0.25in;" align="right"><span style="font-size: 11pt;">George Stigler<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in;"><span style="font-size: 11pt;">A few hundred billion dollars extra won’t hurt, either.<o:p></o:p></span></p> <p class="MsoNormal"><span style="font-size: 11pt;"><o:p> </o:p></span></p> <p class="MsoNormal" style="margin-bottom: 6pt;"><b><span style="font-size: 11pt;">References<o:p></o:p></span></b></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 11pt;">John Carney. 2009. “How bank regulation helped destroy AIG,” <i>The Business Insider</i>, March 2.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 11pt;">Fredric Mishkin. 2006. <i>The Economics of Money, Banking, and Financial Markets</i>, 7<sup>th</sup> ed. Pearson Addison Wesley.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 11pt;">George Stigler. 1971. “The theory of economic regulation,” <i>Bell Journal of Economics and Management Science</i>, Spring. <o:p></o:p></span></p> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><span style="font-size: 11pt; line-height: 150%;">………………………………….<o:p></o:p></span></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-60999599859871526142009-11-28T12:14:00.001-05:002009-11-28T12:17:06.220-05:00There are two college economics courses<meta http-equiv="Content-Type" content="text/html; charset=utf-8"><meta name="ProgId" content="Word.Document"><meta name="Generator" content="Microsoft Word 12"><meta name="Originator" content="Microsoft Word 12"><link rel="File-List" 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@page Section1 {size:8.5in 11.0in; margin:1.0in 1.0in 1.0in 1.0in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} --> </style><!--[if gte mso 10]> <style> /* Style Definitions */ table.MsoNormalTable {mso-style-name:"Table Normal"; mso-tstyle-rowband-size:0; mso-tstyle-colband-size:0; mso-style-noshow:yes; mso-style-priority:99; mso-style-qformat:yes; mso-style-parent:""; mso-padding-alt:0in 5.4pt 0in 5.4pt; mso-para-margin:0in; mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:11.0pt; font-family:"Calibri","sans-serif"; mso-ascii-font-family:Calibri; mso-ascii-theme-font:minor-latin; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">College catalogs list many economics courses, but there are really only two: a theory course and an applied (?) course.<span style=""> </span>(I’ll explain the question mark later.)<span style=""> </span>The former, by which the student is introduced to economics, explains the free choices by intelligent and informed individuals (consumers or entrepreneurs) of their preferred consumption and production paths subject to the limitations set by market prices, incomes, and production possibilities.<span style=""> </span>The model abstracts from uncertainty (except within well-defined limits) and the costs of information and transactions.<span style=""> </span>Its simplicity is revealed by the fixed availability of well-defined goods and technology (there is no innovation) and the uniqueness of prices.<span style=""> </span>There is one price per good/market, that is, no spread between what the buyer pays and the seller receives.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>It is taught that these conditions produce efficient outcomes such that trade-offs between the utilities and costs of goods are equal.<span style=""> </span>Selfish interests are led as if by an invisible hand to promote the general welfare.<span style=""> </span>This theoretical construct defines economics, and students of its finer details, such as the existence and stability of equilibria, are the most prestigious of their profession and are rewarded by Nobel prizes.<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">Notwithstanding these simplifications, advocates of free markets point to their practical successes.<span style=""> </span>The societies in which the behavior described above is given freest rein are the world’s richest, healthiest, and most egalitarian. <o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">Having learned economic theory, students look forward to its application to real world problems.<span style=""> </span>They look in vain, for the lessons of the first course are rejected or ignored.<span style=""> </span>They find that transactions costs are large, information is lacking or perverse, uncertainty is insuperable, individual actions have external effects whose costs and benefits are not fully captured by prices, and most of all, preventing solutions to these problems, individuals are dull and passive.<span style=""> </span>Students learn that these disabilities result in market failures which requiring the government’s correction.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">We saw in earlier blogs how these views have resulted in financial regulations, and will come back to financial markets next time.<span style=""> </span>In preparation, it will be useful to learn more about the strategies of those opposed to free markets.<span style=""> </span>A good place to begin is medicine, where arguments for market failures are carried furthest.<span style=""> </span>Regulated utility monopolies are justified by economies of scale (because unregulated cost minimization is presumed to be inconsistent with profits) and the regulation of financial firms is justified by externalities (a firm’s failure has wider effects) and imperfect information (leading to bank runs), but it seems that no part of economic theory is satisfied in medical markets.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><o:p> </o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">The seminal article on the economics of medical care was Kenneth Arrow’s “Uncertainty and the welfare economics of medical care” (1963).<span style=""> </span>He contended that the market for medical services differed from ideal markets in (1) the irregularity and unpredictability of demand, (2) supply restricted by the high cost of training and doctor licensing, (3) patient (demanders) relations with their doctors (suppliers), who have superior information and emphasize patients’ welfare relative to profits, (4) uncertainty as to the quality of the product, and (5) price discrimination (bills depend on ability to pay).<span style=""> </span>Leading textbooks cite these differences as sufficient reasons for the allocation of medical services according to official cost-benefit analysis (Phelps 2003).<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">We have not yet determined the best system of medical care, nor will we.<span style=""> </span>We can say, however, that it does not follow that because the assumptions of the ideal model are incompletely satisfied, government intervention is an improvement.<span style=""> </span>Arrow also made this leap of logic in other places (1971).<span style=""> </span>General equilibrium theorists have developed sufficient conditions (summarized above) for the existence of an unregulated ideal system, and then concluded that because these conditions are incomplete, regulation is necessary.<span style=""> </span>But sufficiency does not imply necessity.<span style=""> </span>The markets seen by Arrow might work as well, or better, if left alone than when regulated.<span style=""> </span>He is a devotee of the <i>nirvana</i> approach that chooses between “an ideal norm and an existing ‘imperfect’ institutional arrangement,” which must therefore be rearranged (Demsetz 1969).<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">It is often not clear that the resulting rearrangement is an improvement, and in the case of medical care it sometimes looks quite the opposite.<span style=""> </span>Many actual and proposed interventions worsen the problems seen by Arrow.<span style=""> </span>Consider his primary theme of uncertainty, where Arrow neglects the most important theoretical and practical approach to its resolution, which is reputation based on experience.<span style=""> </span>We know nothing about anything until we’ve tried it.<span style=""> </span>Arrow’s argument is like those simple textbook introductions that consist of one-period cases with no learning, or indeed any chance of learning.<span style=""> </span>George Akerlof received a Nobel Prize for his “market for lemons” paper that proved the impossibility of a used-car market.<span style=""> </span>This market does exist, of course, because people invest in information.<span style=""> </span>The practical point of that article, and others on insurance and other contracts affected by uncertainty, is that information has value.<span style=""> </span>Arrow’s implied suggestion that people will not invest in information about the performances of doctors and hospitals, as they do in other markets, is not to be believed.<span style=""> </span>Nor are the other problems raised by Arrow beyond remedies by consumers and suppliers.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">In addition to discouraging investment in the reduction of uncertainty, another unfortunate effect of some health-care proposals is the rejection of information through bureaucratic cost-benefit analyses.<span style=""> </span>Only patients can know the value of their medical services (as with other services, however uncertain the outcomes), which is not realized unless their choices are based on the costs they bear.<span style=""> </span>The high cost (to society) of medical care is due to a related problem: subsidies that cause excess demands which are paid for by third parties (taxpayers).<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">Markets are never ideal, but we should ask why the advocates of change prefer further departures from free-markets to the opposite.<span style=""> </span>The case that medical care is less amenable than other markets to deregulations bringing it closer to the conditions of economic theory has not been made.<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">Economic analysis is rejected in the market for medical care, as in other markets, in favor of politically powerful interests who hope to benefit from regulations and subsidies.<span style=""> </span>They should be grateful to Arrow and other economists of the second sort.<o:p></o:p></span></p> <p class="MsoNormal" style=""><b><span style="font-size: 10pt;"><o:p> </o:p></span></b></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><b><span style="font-size: 10.5pt;">References<o:p></o:p></span></b></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">Akerlof, George. 1970. “The market for lemons: q</span><span style="font-size: 10.5pt;">uality uncertainty and the market mechanism,"<span style=""> </span><i style="">Quarterly J. Economics</i><span style="">.</span></span><span style="font-size: 10.5pt;"><o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">Arrow, Kenneth. 1963. “Uncertainty and the welfare economics of medical care,” <i>American Economic Rev</i>.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">_____ and Frank Hahn. 1971. <i>General Competitive Analy</i>sis. Holden-Day.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">Demsetz, Harold. 1969. “Information and efficiency: another viewpoint,” <i>J. Law and Economics.</i><o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">Phelps, Charles. 2003. <i>Health Economics</i>, 3<sup>rd</sup> ed. Addison-Wesley.<o:p></o:p></span></p> <p class="MsoNormal" style="text-align: center;" align="center"><span style="font-size: 10pt;">…………………….<o:p></o:p></span></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-86530301810916729992009-11-12T12:45:00.000-05:002009-11-12T12:50:40.882-05:00<meta http-equiv="Content-Type" content="text/html; charset=utf-8"><meta name="ProgId" content="Word.Document"><meta name="Generator" content="Microsoft Word 12"><meta name="Originator" content="Microsoft Word 12"><link rel="File-List" href="file:///C:%5Ctemp%5Cmsohtmlclip1%5C01%5Cclip_filelist.xml"><link rel="themeData" href="file:///C:%5Ctemp%5Cmsohtmlclip1%5C01%5Cclip_themedata.thmx"><link rel="colorSchemeMapping" href="file:///C:%5Ctemp%5Cmsohtmlclip1%5C01%5Cclip_colorschememapping.xml"><!--[if gte mso 9]><xml> <w:WordDocument> <w:View>Normal</w:View> <w:Zoom>0</w:Zoom> <w:TrackMoves/> <w:TrackFormatting/> 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mso-tstyle-colband-size:0; mso-style-noshow:yes; mso-style-priority:99; mso-style-qformat:yes; mso-style-parent:""; mso-padding-alt:0in 5.4pt 0in 5.4pt; mso-para-margin:0in; mso-para-margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:11.0pt; font-family:"Calibri","sans-serif"; mso-ascii-font-family:Calibri; mso-ascii-theme-font:minor-latin; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><i><span style="font-size: 11pt; line-height: 150%;">How Could So Much Be So Wrong?<span style=""> </span>U.S. Monetary and Fiscal Policies, 2008-2009 (continued)<o:p></o:p></span></i></p> <p class="MsoNormal" style="line-height: 150%;"><b><span style="font-size: 11pt; line-height: 150%;">8. Monetary Policy as Credit Control<o:p></o:p></span></b></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><span style="font-size: 11pt;">Let me end my talk [in honor of Milton Friedman’s 90<sup>th</sup> birthday] by abusing slightly my status as an official representative of the Federal Reserve.<span style=""> </span>I would like to say to Milton and Anna [Schwartz]: Regarding the Great Depression.<span style=""> </span>You’re right, we did it.<span style=""> </span>We’re very sorry.<span style=""> </span>But thanks to you, we won’t do it again.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.5in; text-align: right; text-indent: 0.25in;" align="right"><span style="font-size: 11pt;">Ben Bernanke, University of Chicago, Nov. 8, 1992.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">In fact the Federal Reserve has learned nothing, and is doing <i>it</i> again, <i>it</i> being the substitution of controls for monetary policy.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>Friedman and Schwartz argued that the Federal Reserve caused the Great Depression by allowing the money stock to fall 38% between 1929 and 1933, while the Hoover administration focused on bank reform (deposit insurance and banking structure in the Glass-Steagall Act, which separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation.<span style=""> </span>RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management (Butkiewicz 2002).<span style=""> </span>Friedman and Schwartz (1963, pp. 325-30) contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the growth of the money supply (Romer 1992).<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>The following contemporary account of the RFC, which was expanded by the New Deal, is interesting:<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><span style="font-size: 11pt;"><span style=""> </span>The best banking walls of Wall Street did not fall down last week before the long trumpet-blasts of Jesse Jones [head of the RFC].<span style=""> </span>But most of them opened their postern <span style=""> </span>gates and let Mr. Jones come in with the money he was determined to inject into them.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><span style="font-size: 11pt;"><span style=""> </span>The National City was the only big bank last week to surrender completely.<span style=""> </span>It the stockholders approve, it will let the RFC buy $50,000,000 of its preferred stock.<span style=""> </span>Mr. Jones radiated assurance that the government would not make itself a nuisance at stockholders’ meetings.<span style=""> </span>But the fact remained that the U.S. will become National City’s biggest stockholder – and if ever two preferred stock dividends should be omitted, the Government will have complete control.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><span style="font-size: 11pt;"><span style=""> </span>Eight other New York banks were able to resist the RFC’s passion to become a stockholder because they were state institutions.<span style=""> </span>They compromised by selling the RFC “capital notes.”<span style=""> </span>Thus supersolvent Guaranty Trust, already vexed by having more money than it can profitably use, planned to let the Government lend it $20,000,000.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><span style="font-size: 11pt;"><span style=""> </span>Having removed the curse of taking government aid, Mr. Jones could now proceed to make the Government a large, if not the largest stockholder … in perhaps one-quartet of all the country’s banks ….<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in;"><span style="font-size: 11pt;"><span style=""> </span>National City planned to use its huge piece of government money to write down its common stock [and] surplus.<span style=""> </span>“With the adoption of the plan,” Chairman Perkins informed his stockholders, “the assets of the bank will be carried at conservative values ….”<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-align: right;" align="right"><span style="font-size: 11pt;">“Without disgrace,” <i>Time</i>, Dec. 18, 1933.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">We might think that, given the opening quotation, Bernanke would have eschewed direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock.<span style=""> </span>But we would be wrong.<span style=""> </span>He and his colleagues have done the opposite.<span style=""> </span>The failed official strategy of the Great Depression has been repeated in the Fed’s lending to specific institutions, its focus on the risk and liquidity of particular markets, the Troubled Asset Relief Program, Asset Backed Commercial Paper, swap agreements, and other market interventions, as well as lobbying for more regulations of financial institutions of which it would be the principal administrator.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>What about monetary policy?<span style=""> </span>The easy money (negative real rates) of 2002-2005, followed by the tightening of 2006-2007, is reminiscent of the run-up to the Great Depression.<span style=""> </span>In 1928-29, the Fed focused on credit control and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and lower rates in recession – just as in mid-2008, when the Fed suddenly became hawkish about inflation.<span style=""> </span>The intensification of the recession began before the financial turmoil of September 2008.<span style=""> </span>“In this recession, unlike the other recessions that followed the Depression [but like the Depression], commentators [like the Fed] have assigned causality to dysfunction in credit markets (Hetzel 2009).<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">A key to this similarity may be found in Bernanke’s view of the financial markets (in which he, like the Fed of 1929-33, has found plenty of support in official circles).<span style=""> </span>His fame as an economist rests on his 1983 paper that stressed capital flows and the banking structure as contributors to the severity of the Great Depression.<span style=""> </span>In particular, bank failures and the fall in bank loans joined the money stock as significant causes of the downturn.<span style=""> </span>The recovery came with the turn-around in money (while bank loans remained weak), but Bernanke has never, despite his protestations, been shared the Friedman- Schwartz view of money’s importance, or of the economy in general.<span style=""> </span>A key element of Friedman’s monetarist philosophy, as important as money, is its reliance on free market institutions.<span style=""> </span>The government should (1) let them alone while (2) pursuing a stable monetary policy.<span style=""> </span>Bernanke and the present Fed have done neither.<o:p></o:p></span></p> <p class="MsoNormal" dir="rtl" style="margin: 0in 0.25in 6pt 0in; text-align: left; text-indent: -0.25in; direction: rtl; unicode-bidi: embed;" align="right"><b><span dir="ltr" style="font-size: 10.5pt;">References<o:p></o:p></span></b></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">Ben Bernanke. “Nonmonetary effects of the financial crisis in the propagation of the Great Depression,” <i>American Economic Rev.</i>, June 1983.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">James Butkiewicz. “Reconstruction Finance Corporation,” <i>EH.Net Encyclopedia</i>, ed. Robert Whaples, July 19, 2002<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">Milton Friedman and Anna Schwartz. <i>A Monetary History of the U.S., 1867-1960.</i> Princeton Univ. Press, 1963.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 10.5pt;">Robert Hetzel. “Monetary policy in the 2008-2009 recession,” Federal Reserve Bank of Richmond <i>Economic Quarterly</i>, Spring 2009. <o:p></o:p></span></p> <p class="MsoNormal"><span style="font-size: 10.5pt;">Christina Romer. “What ended the Great Depression?” <i>J. Economic History,</i> Dec. 1992.<o:p></o:p></span></p> <p class="MsoNormal" style="text-align: center;" align="center"><span style="font-size: 10.5pt;">…………………..<o:p></o:p></span></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-26914074219798859472009-11-05T13:59:00.001-05:002009-11-05T14:02:44.195-05:00<a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgAenZGPMcKyKTno76eM9hGNfP7528Tc-22aKE4ddoIa58rCGcMvutE0GPaQkqiKyvxVMaId3qICZ3yOxzRlcr_S75LogD0T_Jq09Sp93ltMF2ydABGI2Aw1V42rOcV9WxMjcKqntiWcbnI/s1600-h/Henny-Penny.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 300px; height: 394px;" 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line-height: 150%;" align="center"><font size="3"><i><font style="line-height: 150%;">Henny-Penny and friends, whose careers were ended abruptly.</font></i></font></p><p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><font size="3"><i><font style="line-height: 150%;"><br /></font></i></font></p><p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><font size="3"><i><font style="line-height: 150%;">How Could So Much Be So Wrong?<font style=""> </font>U.S. Monetary and Fiscal Policies, 2008-2009 (continued)<o:p></o:p></font></i></font></p> <p class="MsoNormal" style="line-height: 150%;"><font size="3"><b style=""><font style="line-height: 150%;">7. We’ve got to do something<o:p></o:p></font></b></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><font style="" color="black" size="3">We need to compare the cost of this package against the cost of doing nothing. The cost of doing nothing would be catastrophic!<o:p></o:p></font></p> <p class="MsoNormal" style="margin-bottom: 12pt; text-align: right; text-indent: 0.25in;" align="right"><font style="" color="black" size="3"><font style=""> </font>Wisconsin Congressman David Obey.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 12pt 0.25in; text-indent: 0.25in;"><font style="" color="black" size="3">We can’t afford to wait. We have to act.<font style=""> </font><font style=""> </font><font style=""> </font>Presidential spokesman Robert Gibbs.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><font size="3">“I do try to put a lot of weight on what people are saying,” Watt said, referring to the overwhelming opposition of his constituents.<font style=""> </font>“But in this case, I think a lot of people don’t know exactly why a bailout is necessary… On this issue, we have heard the top two economic authorities in the world tell us we’re on the verge of a calamitous event.” <o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 12pt 0.25in; text-align: right; text-indent: 0.25in;" align="right"><font size="3">North Carolina Congressman Mel Watt.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" color="black" size="3">Were the massive government responses to the economic downturn in the interests of the public, i.e., for recovery, or simply political, i.e., to assure voters that government was not unresponsive; there would not be a repeat of the do-nothing Hoover administration, as it has erroneously come down in history.<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" color="black" size="3"><font style=""> </font>We know the futility of the former.<font style=""> </font>A small part of the so-called stimulus packages was directed to the short term, and that part (such as temporary tax breaks) was known to be ineffective (see this blob for September 23 and 29).<font style=""> </font>The best we can hope for is that they will do little harm, that they will, as George Selgin suggests, be like Granny’s cure for the common cold: work in a week to ten days (<i>The Beverly Hillbillies</i>).<font style=""> </font>(It now looks like we’re out of the recession after 6 quarters – IV/2007 to II/2009 – with a fall in real GDP of 2.8%; compared with the most similar post-WWII recession of 3.2% in 5 quarters, IV/1973 to I/1975.<font style=""> </font>Government either shortened or lengthened the recession, depending on your point of view.)<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" color="black" size="3"><font style=""> </font>History suggests that the political motive is also futile.<font style=""> </font>Polls, letters to Congress, and the Tea Parties on tax day (April 15) indicated that many, probably most, Americans opposed the government’s actions.<font style=""> </font>More important to those who will run for reelection, votes have depended not on good intentions but on actual economic conditions (Fair 2009).<font style=""> </font>As the lawyer played by James Mason in <i>The Verdict </i>said to his young assistant: “You’re not paid to do your best.<font style=""> </font>You’re paid to win.”<font style=""> </font>Government actions during recessions have varied from highly (e.g., Hoover) to not very (e.g., Carter and G.H.W. Bush) active (see Hoover 1940, 97-119; Wood 2005, 204-11; Carter 1995, 541; Keech 1995, 69-70).<font style=""> </font>Much more constant, at least since Martin Van Buren, has been the failure of reelection attempts during recessions, whatever the efforts to forestall them, notably in the 20th century, Hoover, Carter, and G.H.W. Bush.<font style=""> </font>The 1990-91 recession had officially ended, but unemployment continued. “It’s the economy, stupid,” was Clinton’s successful slogan in 1992.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" color="black" size="3"><font style=""> </font><font style=""> </font>The lesson is that mindless action is politically futile – at best: spending loses votes (Peltzman 1992).<o:p></o:p></font></p> <p class="MsoNormal"><font size="3"><o:p> </o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3"><b>References<o:p></o:p></b></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Ray Fair. “Presidential and congressional vote-share equations,<b> "</b><i>American J. Political Science</i>, Jan 2009.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Jimmy Carter. <i>Keeping Faith</i>. <i>Memoirs of a President</i>. Univ. of Arkansas Press, 1995.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Herbert Hoover. <i>Memoirs: The Great Depression, 1929-41.</i> Macmillan, 1952.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">William Keech. <i>Economic Politics. The Costs of Democracy.</i> Cambridge Univ. Press, 1995.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Sam Peltzman. “Voters as fiscal conservatives,” <i>Quarterly J. Economics</i>, May 1992.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">George Selgin. “Did Bernanke save us from another Great Depression?” <i>Christian Science Monitor</i>, Sept. 17, 2009.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">John Wood. <i>A History of Central Banking in Great Britain and the United States.</i> Cambridge Univ. 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mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><i><span style="font-size: 11pt; line-height: 150%;">How Could So Much Be So Wrong?<span style=""> </span>U.S. Monetary and Fiscal Policies, 2008-2009 (continued)<o:p></o:p></span></i></p> <p class="MsoNormal" style="line-height: 150%;"><b style=""><span style="font-size: 11pt; line-height: 150%;">6. We need more regulation<o:p></o:p></span></b></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: 0.25in;"><span style="font-size: 11pt;">Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets, [including] tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily…. <o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: 0.25in;"><span style="font-size: 11pt;">House Financial Services Committee Chairman Barney Frank … said any changes would [also] have to discourage “excessive risk taking.”<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><span style="font-size: 11pt;">Treasury Secretary Timothy Geithner said there would have to be “more focused accountability” and a “much stronger set of oversight over all financial institutions that could pose risk of damage to the system.<span style=""> </span>He said core parts of the financial markets, such as markets for derivatives and other complex products, must “have a basic framework of oversight around them.”<span style=""> </span>[T]here would be stiffer capital requirements to deter companies from becoming overleveraged “so that a mess like this never happens again.”<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 6pt 0in 0.0001pt 0.25in; text-indent: 0.25in;"><span style="font-size: 11pt;">“Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking …, and be held to high capital and liquidity standards,” Mr. Bernanke said.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 12pt 0.25in; text-align: right; text-indent: 0.25in;" align="right"><span style="font-size: 11pt;">Damian Paletta, <i style="">Wall Street Journal</i>, March 11, 2009. <o:p></o:p></span></p> <p class="MsoNormal" style="margin-bottom: 6pt; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">All this is empty or disingenuous bombast for two reasons.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-bottom: 6pt; line-height: 150%;"><b><i><span style="font-size: 11pt; line-height: 150%;">A.</span></i></b><i><span style="font-size: 11pt; line-height: 150%;"> Financial regulation as pursued in the United States is, if honestly intended to protect the public, is impossible. </span></i><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span>Financial intermediation is a full-time, complicated, skillful, and costly task.<span style=""> </span>Part-time amateurs removed from the scenes of action cannot assess expected returns or risk.<span style=""> </span>They have neither the means nor the incentives to do so.<span style=""> </span>Those who expect otherwise deny the principles of economics.<span style=""> </span>Economic analysis rests on incentives and information, which itself depends on incentives as well as experience.<span style=""> </span>Official and often artificial portfolio rules are accommodated while their intentions are thwarted by substitutions or innovations.<span style=""> </span>Capital requirements, deposit insurance, and leverage restrictions induce riskier investments.<span style=""> </span>Interest ceilings broke down because of evasions.<span style=""> </span>Ed Kane (1981) has described the process as the <i style="">regulatory dialectic</i><span style=""> of interactions between political and economic pressures in regulated markets</span>.<span style=""> </span>Avoidance leads to more regulation which leads to more ….<span style=""> </span>Normally changing conditions further reduce the effectiveness of regulation.<span style=""> </span>Many of the derivatives and other instruments that government agencies hope to regulate did not exist a few years ago, and will be succeeded by new and imperfectly understood instruments, partly to avoid regulation and partly in the normal course of events.<span style=""> </span>The capitalistic system that has made us rich -- as well as secure compared with earlier times – requires the taking of risks in a free environment.<span style=""> </span>Effective regulation would be self-defeating, but we need not fear because it is impossible.<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><b style=""><i><span style="font-size: 11pt; line-height: 150%;">B.<span style=""> </span></span></i></b><i><span style="font-size: 11pt; line-height: 150%;">Nor is it honestly attempted.</span></i><b style=""><i><span style="font-size: 11pt; line-height: 150%;"><o:p></o:p></span></i></b></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><span style="font-size: 11pt;">As a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in; text-align: right;" align="right"><span style="font-size: 11pt;">George Stigler, “The theory of economic regulation,” <i>Bell J. of Economics and Management Science</i>, Spring 1971.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in; text-align: right;" align="right"><b style=""><span style="font-size: 10pt;"><o:p> </o:p></span></b></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">The history of regulation is better described as one of protection.<span style=""> </span>The Federal Reserve was created by and for the big banks, primarily to support bank loan markets, guarantee cheap credit (the Greenspan put dates from 1913), and help fix prices and procedures (Wood 2009, pp. 105-110).<span style=""> </span>The FDIC was created to forestall legislation favoring competition after the bank failures of the Great Depression (Golembe 1960).<span style=""> </span>The Securities and Exchange Commission has discouraged small firms by increasing the cost of capital, it has cut the number of exchanges and retarded price and service competition in the financial services industry, nominally in support of “standards” but actually in opposition to competition.<span style=""> </span>Whatever new regulations and regulators are decided by Congress, they will not threaten the profits of the politically powerful. <o:p></o:p></span></p> <p class="MsoNormal"><span style="font-size: 11pt;"><o:p> </o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;"><span style=""> </span><i>So what to do? </i><span style=""> </span>The most essential change (one we can believe in) required of governments is to behave -- to stop supplying incentives for risky and inefficient behavior.<span style=""> </span>The degeneration of loan qualities caused by the push for home ownership by government-sponsored enterprises, the easy money (negative real interest-rate) policies of the Federal Reserve, and the government’s too-big-to-fail commitment were the three main causes of the crisis.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">If the urge to regulate is irresistible, it should be directed to results rather than rules.<span style=""> </span>If we wish to reduce a bank’s chance of failure, we could (1) require more capital, less leverage, and/or fewer mobile-home loans; or (2) confiscate the assets of and/or imprison management if failure occurs.<span style=""> </span>Can there be any question which would be more effective?<span style=""> </span>Can there be any question which will be adopted?<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">It should be noted that the recent discovery of “systemic risk” is manufactured.<span style=""> </span>The reason for the greater regulation of banks, which is as old as the republic, has always been the tendency of banks to fail in groups together with the perception that bank failures are worse for the economy than those of other firms. <o:p></o:p></span></p> <p class="MsoNormal" style="margin: 6pt 0in;"><i><span style="font-size: 11pt;">References:<o:p></o:p></span></i></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 11pt;">Carter Golembe. “The deposit insurance legislation of 1933: an examination of its antecedents and purposes,” <i>Political Science Quarterly</i>, June 1960.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><span style="font-size: 11pt;">Edward Kane. “Good intentions and unintended evil: the case against selective credit allocation,” <i>J. Money, Credit and Banking</i>, Feb. 1977.<o:p></o:p></span></p> <p class="MsoNormal"><span style="font-size: 11pt;">John Wood.<i> A History of Macroeconomic Policy in the U.S.</i> Routledge, 2009. <o:p></o:p></span></p> <p class="MsoNormal" style="text-align: center;" align="center">…………………………………….</p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-51403457273026161202009-10-20T14:51:00.001-04:002009-10-20T14:54:33.602-04:00<a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhayG_z5GAIWxFlsKI8v8CjLTK3Ptz3gBg5sw2M7vCHjZlES8Zn9Aj5CqU_CBVTCLzC0ACkgdCQE3Cc08y1b_G7hW7Ha2gSxuX_5ItcMFQBlxgPW-iGDcxU8KWxw5YuSp3-KQYzPESJwu5d/s1600-h/Confusion+of+liq+%26+insol.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 400px; height: 242px;" 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mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><font size="3"><i><font style="line-height: 150%;">How Could So Much Be So Wrong?<font style=""> </font>U.S. Monetary and Fiscal Policies, 2008-2009 (continued)<o:p></o:p></font></i></font></p> <p class="MsoNormal" style="margin-bottom: 6pt;"><font size="3"><b style="">5. Confusion of insolvency and illiquidity<o:p></o:p></b></font></p> <p style="margin: 6pt 0in 0.0001pt 0.25in; text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">Although monetary easing likely offset some part of the economic effects of the financial turmoil, that offset has been incomplete, as widening credit spreads and more restrictive lending standards have contributed to tight overall financial conditions. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Consequently, the second component of the Federal Reserve's strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-bottom: 6pt; text-align: right; line-height: 150%;" align="right"><font style="line-height: 150%;" size="3">Ben Bernanke, speech to the Greater Austin Chamber of Commerce, Dec. 1, 2008.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">The Fed has made loans in various ways, Bernanke said, “to ensure that adequate liquidity is available, consistent with the central bank’s role as the liquidity provider of last resort.”<font style=""> </font>This misrepresentation of insolvency for illiquidity has pulled the Fed into a policy that, in fact, violates traditional central banking.<font style=""> </font>The two tasks of central banks have been the protection of the value of currency in the long-run and support of the payments system in the short run.<font style=""> </font>The Fed has failed dismally in the first (after nearly equal price levels in 1789 and 1913, the purchasing power of the dollar has fallen 95% under the Fed) but it has been attentive to the latter.<font style=""> </font>The central bank’s role as supporter of the payments system has been understood to include the responsibility to serve as lender of last resort.<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>A financial panic, or crisis, is a <i>rush for cash</i>, when “the rate of interest rises to a panic figure.”<font style=""> </font>This normally comes at the end of an upward price movement, Irving Fisher (1922, p. 65) wrote, when those who have borrowed heavily are unable to renew their loans.<font style=""> </font>They “<i>must</i> have currency to liquidate their obligations.”<font style=""> </font>Runs on banks, even solvent banks, occur, and the central bank must come to their aid.<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font><i style="">Liquidity</i> is the proportion of an asset’s fundamental value that can be realized in cash quickly following the decision to sell.<font style=""> </font>This is an individual concept, and differentiates assets in normal times.<font style=""> </font><i style="">Market liquidity</i>, on the other hand, refers to the general availability of cash.<font style=""> </font>All assets except cash are illiquid during panics (Palgrave 1896; Wood and Wood 1985, pp. 163-66))<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">A traditional problem of the lender of last resort in maintaining the system’s liquidity has been to assist sound banks without bailing out the insolvent.<font style=""> </font>The solution, Walter Bagehot advised in the classic <i>Lombard Street</i> (1873, pp. 187-88), has been to lend “freely and vigorously … at a very high rate of interest … on [the security of] good banking securities.” <o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>None of this describes the Fed.<font style=""> </font>The problem is clearly not one of liquidity, as the low interest rates on safe investments tell us.<font style=""> </font>Even the safest securities, even Treasuries, are subject to panic interest rates during rushes for cash.<font style=""> </font>This in seen in Frederic Mishkin’s (1991) account of seven financial crises from 1857 to 1907 (but not 1929 or 1987, when the Fed came to the aid of the money markets).<font style=""> </font>Furthermore, despite the talk of the capital markets “freezing up” (simultaneously with a ”meltdown,” apparently) , bank credit was maintained and mortgages were available at traditionally low interest rates for good borrowers.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>“For good borrowers” is key.<font style=""> </font>The loan curtailments, except at high interest rates, of which some firms complained, and which, supported by the Fed, they called illiquidity, was due to the market’s assessment of their risk of insolvency.<font style=""> </font>John Taylor and John Williams (2009) present data (see the figure) which indicate that the abrupt increase in the 3-month Libor rate relative to the overnight federal funds rate beginning August 2007 (after the failure of large banks heavily involved in mortgage-backed securities; it jumped again upon the failure of Lehman Brothers in September 2008) was due to risk rather than<font style=""> </font>illiquidity.<font style=""> </font>“As long as lenders who are not constrained by liquidity concerns exist, banks that seek to hoard liquidity can borrow from these lenders in the CD market…. Competition will lead to the equalization of borrowing rates across instruments for borrowers of the same credit quality.<font style=""> </font>That CD rates have tracked Libor closely during the crisis …suggests that liquidity concerns at banks are not a significant factor separate from counterparty risk driving term lending rates.” <font style=""> </font><font style=""> </font>Credit default swaps tell the same story, and regressions suggest that injections of Term Auction Swaps by the Fed have not affected what are clearly risk premia. <o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>Recent Fed and Treasury actions have not been concerned with liquidity or the integrity of the payments system, which was not threatened, but rather with the salvage of particular managements<font style=""> </font>(not firms, which would have continued with restructuring).<font style=""> </font>Government purchases, and potential purchases, of bad assets have retarded the resolution of the crisis by preventing purchases of those assets by the many solvent firms who were able and might have been willing.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 6pt 0in;"><font size="3"><i>References:<o:p></o:p></i></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Walter Bagehot, <i>Lombard </i>Street. 1873. (new ed. edited by H. Withers. J. Murray, 1920).<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Irving Fisher. <i>The Purchasing Power of Money</i>, 2d ed. Macmillan, 1922.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Frederic Mishkin. “Asymmetric information and financial crises: A historical perspective,” in R. Hubbard, <i>Financial Markets and Financial Crises</i>. University of Chicago Press, 1991.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">Palgrave, R.H.I. <i>Dictionary of Political Economy</i>(1896),new <font style=""> </font>ed., H. Higgs, ed. Macmillan, 1923.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">John Taylor and John Williams. “A black swan in the money market,” <i>American Economic J. of Macroeconomics</i>, Jan. 2009.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: -0.25in;"><font size="3">John Wood and Norma Wood. <i>Financial Markets</i>. Harcourt Brace Jovanovich, 1985.<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-align: center; text-indent: -0.25in;" align="center"><font size="3">………………………..</font></p><p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-align: center; text-indent: -0.25in;" align="center"><br /><font size="11"><o:p></o:p></font></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-22394865793441284562009-10-13T14:10:00.002-04:002009-10-13T14:15:18.063-04:00<a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGfkeSywh5JfilHHeC8vDO-LVTsDyoIKowVp2qtGA9KHr6aBlFce1duxCL6g6jTTU-yh1AhXFw93A8f-FKfK1eNh1nDWdVXE3p_RKbYKt6cVfCOp1AyYZKJJhkp9_FD136rOsGUbp0Dk57/s1600-h/excessreserves.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 400px; height: 274px;" 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<![endif]--><!--[if gte mso 9]><xml> <o:shapedefaults ext="edit" spidmax="1149"> </xml><![endif]--><!--[if gte mso 9]><xml> <o:shapelayout ext="edit"> <o:idmap ext="edit" data="1"> </o:shapelayout></xml><![endif]--> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><font size="3"><i><font style="line-height: 150%;">How Could So Much Be So Wrong?<font style=""> </font>U.S. Monetary and Fiscal Policies, 2008-2009 (continued)<o:p></o:p></font></i></font></p> <p class="MsoNormal"><font size="3"><b style="">4. Excess reserves again</b></font><font size="3"><o:p></o:p></font></p> <p style="margin: 6pt 0in 0.0001pt; line-height: 150%;"><font style="line-height: 150%;" size="3">The unprecedented increase in excess reserves during past year is shown in the figure.<font style=""> </font>They are due to the increase in the Federal Reserve credit.<font style=""> </font>Concerns have been expressed for their inflationary potential when loan demand turns up, but Chairman Bernanke says not to fear.<font style=""> </font>He has an exit strategy.<o:p></o:p></font></p> <p style="margin: 6pt 0in 0.0001pt 0.25in;"><font size="3">… at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize…. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy….<o:p></o:p></font></p> <p style="margin: 6pt 0in 0.0001pt 0.25in; text-indent: 0.25in;"><font size="3"><font style=""> </font>A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.<o:p></o:p></font></p> <p style="margin: 0in 0in 0.0001pt 0.25in; text-align: right;" align="right"><font size="3">Ben Bernanke, Stamp Lecture, <st1:city st="on">London</st1:city> <st1:place st="on"><st1:placetype st="on">School</st1:placetype> of <st1:placename st="on">Economics</st1:placename></st1:place>, Jan. 13, 2009.<o:p></o:p></font></p> <p class="MsoNormal"><font size="3"><o:p> </o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3">Easier said than done.<font style=""> </font>There is no reason to believe that the Fed will do any less damage than when it “shrunk” excess reserves in 1936-37.<font style=""> </font>The monetary base grew 49% between May 1933 and May 1936, almost entirely due to inflows and the revaluation of gold.<font style=""> </font>M2 rose 42% but half the increase in bank reserves was held as excess, which rose (in millions) from $319 to $2800, compared with the increase in requirements from $1806 to $2838.<font style=""> </font>The rising ratio may be seen in the figure.<font style=""> </font>The FOMC saw the large excess reserves as a threat to monetary stability that needed to be “mopped up.”<font style=""> </font>It adopted the following resolution in October 1935:<o:p></o:p></font></p> <p class="MsoNormal" style="margin: 6pt 0in 6pt 0.5in; text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">It was the unanimous opinion of the Committee that the primary objective of the System at the present time is still to lend its efforts towards the furtherance of recovery…. But the Committee cannot fail to recognize that the rapid growth of bank deposits and bank reserves in the past year and a half is building up a credit base which may be very difficult to control if undue credit expansion should become evident.<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font style="line-height: 150%;" size="3"><font style=""> </font>The Banking Act of 1935 had given the Fed the power to raise reserve requirements up to twice the levels then existing, and that power was used to its full extent, in three steps, between August 1936 and May 1937.<font style=""> </font>The resulting fall in excess reserves is shown in the figure.<font style=""> </font>Although the Fed claimed that the excess reserves thus eliminated had been superfluous, it was soon revealed that banks thought otherwise.<font style=""> </font>Having come through the great downturn of 1929-33, with massive runs and record failures, banks were cautious.<font style=""> </font>Their cut-back in loans to restore their excess reserves contributed to the severe 1937-38 recession.<font style=""> </font><o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">The figure indicates that the task is much greater today.<font style=""> </font>As we learned (or should have), “excess” is a legal term that tells us nothing of desires.<font style=""> </font>A policy of shrinking slowly, as Bernanke suggests, may not be an improvement.<font style=""> </font>It may not be possible.<font style=""> </font>If banks want these excess reserves, and they apparently do, they will restrict lending in anticipation of reserve losses.<font style=""> </font>Things can seldom be done “on schedule” in the financial markets, which are characterized by arbitrage across time.<font style=""> </font>We do not know what will happen.<font style=""> </font>The problem is unnecessary and may come back to haunt us.<o:p></o:p></font></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">It is made more complex by the recent decision to pay interest on reserves, another example of the tendency of policymakers to enforce gratuitous changes in the environment that increase the uncertainty of their policies.<o:p></o:p></font></p> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><font style="line-height: 150%;" size="3">…………………<o:p></o:p></font></p> <p class="MsoNormal" style="line-height: 150%;"><font size="3"><i><font style="line-height: 150%;">References<o:p></o:p></font></i></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">Milton Friedman and Anna J. Schwartz. <i>A Monetary History of the United States, 1867-1960</i>. Princeton Univ. Press, 1963, pp. 520-32.<o:p></o:p></font></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><font style="line-height: 150%;" size="3">Clay J. 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mso-ascii-theme-font:minor-latin; mso-fareast-font-family:SimSun; mso-fareast-theme-font:minor-fareast; mso-hansi-font-family:Calibri; mso-hansi-theme-font:minor-latin; mso-bidi-font-family:Arial; mso-bidi-theme-font:minor-bidi;} </style> <![endif]--> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><i><span style="line-height: 150%;font-size:11;" >How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)</span></i><span style="line-height: 150%;font-size:11;" ><o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="line-height: 150%;font-size:11;" >This should have been my second critique of government reactions to the economic downturn.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-bottom: 6pt;"><b style=""><span style="font-size:11;">2. Operation twist again<o:p></o:p></span></b></p> <p class="MsoNormal" style="margin-left: 0.5in; text-indent: 0.25in; line-height: 150%;"><span style="line-height: 150%;font-size:11;" >After its March 18 meeting, the FOMC stated that it had decided to purchase “up to $300 billion of longer-term Treasury securities over the next six months.”<span style=""> </span>This decision followed a speech by Chairman Bernanke on Dec. 1, 2008, indicating that “the Fed could purchase longer-term Treasury securities … in substantial quantities.<span style=""> </span>This approach might influence the yields on these securities, thus helping to spur aggregate demand.” <o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 12pt 0.5in; text-align: right; text-indent: 0.25in;" align="right"><span style="font-size:11;">DanielThornton, The effect of the Fed’s purchase of long-term securities on the yield curve,” Federal Reserve Bank of St. Louis <i>Economic Synopses</i>, May 18, 2009.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="line-height: 150%;font-size:11;" >There was a brief decline in long rates, but the yield curve soon regained, and surpassed, the steep slope of mid-March.<span style=""> </span>The Fed’s failure to alter relations between yields on these highly substitutable securities has a long history.<span style=""> </span>In 1961, President Kennedy indicated the importance of “increasing the flow of credit into the capital markets at declining long-term rates of interest to promote domestic recovery” while “checking declines in the short-term rates that directly affect the balance of payments” (<i>Economic Report of the President</i>, 1962, p. 50).<span style=""> </span>The Federal Reserve was directed to twist the yield curve by buying long-term securities to lower long rates while selling short-term securities to raise short rates.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="line-height: 150%;font-size:11;" >This policy flew in the face of the expectations theory of the term structure, according to which investors maximize expected returns.<span style=""> </span>In a linear approximation of the simple case of default-free U.S. securities, investors are indifferent between <i style="">1-</i> and <i style="">n-</i>year securities if <o:p></o:p></span></p> <p class="MsoNormal"><span style="font-size:11;"><o:p> </o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5xlwu3DAIJ7Q-HF4_AdtDXr5LaKXxbOBupbghZJpQv6bYo_CST7MduygyuZRZG_0GEs-aMFAWi9TFKReE5tjBSHmJY8mvFW_qph2k7bxGU8hQGcliOe1LxRbleVe17RfEll92kly0zZYr/s1600-h/ExpectationsTheoryEq.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 147px; height: 32px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5xlwu3DAIJ7Q-HF4_AdtDXr5LaKXxbOBupbghZJpQv6bYo_CST7MduygyuZRZG_0GEs-aMFAWi9TFKReE5tjBSHmJY8mvFW_qph2k7bxGU8hQGcliOe1LxRbleVe17RfEll92kly0zZYr/s400/ExpectationsTheoryEq.jpg" alt="" id="BLOGGER_PHOTO_ID_5387991542764564642" border="0" /></a></p> <p class="MsoNormal"><span style="font-size:11;"><o:p> </o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="line-height: 150%;font-size:11;" ><span style=""> </span>Long rates are averages of current and expected short rates, where prescripts denote expected 1-year rates <i style="">i</i> = 1, 2, … periods in the future.<span style=""> </span>Relations between current long and short rates depend on expectations.<span style=""> </span>Given expectations, a fall in <i>Y<sub>n</sub></i> while <i>Y<sub>1</sub></i> rises must be reversed as investors shift to the suddenly more profitable shorts.<span style=""> </span>Operation twist could have worked only if expectations of future rates were simultaneously lowered, contradicting the announced policy of higher short rates.<span style=""> </span>Uncertainty interferes with perfect substitutability, but the policy was inconsistent and impossible.<span style=""> </span><o:p></o:p></span></p> <p class="MsoNormal" style="text-indent: 0.25in; line-height: 150%;"><span style="line-height: 150%;font-size:11;" >The administration indicated its satisfaction with the yield curve’s twist (<i>Economic Report of the President</i>, 1966, p. 86), but the figure shows that it behaved normally (or twisted a little less than usual) during the 1961-65 economic expansion.<span style=""> </span>The tendency of yield curves to flatten during expansions (because long rates are less variable than short rates) has continued in recent years.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><span style="line-height: 150%;font-size:11;" ><span style=""> </span>An example of the lengths to which the Fed must go if it is determined to influence the yield curve contrary to expectations was given by the interest-rate peg of World War II.<span style=""> </span>The Fed stood ready to buy and sell 3-month and long-term governments for 0.375% and 2%, respectively.<span style=""> </span>At the peg’s end, the Fed held no long-terms and virtually all the short-terms.<span style=""> </span>Official efforts to manipulate relative prices are futile, and destroy markets if pursued vigorously. <o:p></o:p></span></p> <p class="MsoNormal" style="text-align: center; line-height: 150%;" align="center"><span style="line-height: 150%;font-size:11;" >……………………………<o:p></o:p></span></p> <p class="MsoNormal" style="line-height: 150%;"><i><span style="line-height: 150%;font-size:10;" >References<o:p></o:p></span></i></p> <p class="MsoNormal" style="line-height: 150%;"><span style="line-height: 150%;font-size:10;" >John Wood and Norma Wood. <i>Financial Markets</i>. Harcourt Brace Jovanovich, 1985.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: -0.25in; line-height: 150%;"><span style="line-height: 150%;font-size:10;" >Elmus Wicker. “The World War II policy of fixing a pattern of interest rates,” <i>J. Finance</i>, June 1969.<o:p></o:p></span></p> <p class="MsoNormal"><o:p><br /></o:p></p> <p class="MsoNormal"><b><span style=""><o:p> </o:p></span></b></p> <p class="MsoNormal"><b><span style=""><o:p> </o:p></span></b></p> <p class="MsoNormal"><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjSGG2ekVvc1C6L_fB6FrG6SCkXHMHlIJecuUg4JLAQdOtSGl2-woLfxQ3hwuKYKC2S_GmjosEnAPrRSNXMy4eDteEO_GaoHukT_VIib-ULSQ1rX2jIGmUPscpRRBcm8WnL0T6Qdjnkaj73/s1600-h/YieldCurves.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer; width: 400px; height: 237px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjSGG2ekVvc1C6L_fB6FrG6SCkXHMHlIJecuUg4JLAQdOtSGl2-woLfxQ3hwuKYKC2S_GmjosEnAPrRSNXMy4eDteEO_GaoHukT_VIib-ULSQ1rX2jIGmUPscpRRBcm8WnL0T6Qdjnkaj73/s400/YieldCurves.jpg" alt="" id="BLOGGER_PHOTO_ID_5387989079727314514" border="0" /></a></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-9119560067590274562009-09-29T10:23:00.001-04:002009-09-29T10:23:39.141-04:00<p class="MsoNormal" style="margin-bottom:9.6pt;line-height:17.55pt;mso-outline-level: 1"><b><span style="font-size:16.5pt;font-family:"Georgia","serif";mso-fareast-font-family: "Times New Roman";color:#333333;mso-font-kerning:18.0pt">Capital replenishments and requirements<o:p></o:p></span></b></p> <p class="MsoNormal" align="center" style="text-align:center;line-height:15.05pt"><i><span style="mso-fareast-font-family:"Times New Roman";color:#333333">How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)</span></i><span style="mso-fareast-font-family:"Times New Roman";color:#333333"><o:p></o:p></span></p> <p class="MsoNormal" style="line-height:15.05pt"><b><span style="mso-fareast-font-family: "Times New Roman";color:#333333">3. Capital replenishments and requirements</span></b><span style="mso-fareast-font-family:"Times New Roman";color:#333333"><o:p></o:p></span></p> <p class="MsoNormal" style="line-height:15.05pt"><span style="mso-fareast-font-family: "Times New Roman";color:#333333">I consider two mistaken policies: (<b>A)</b> The recent emergency infusions of capital and (<b>B</b>) the use of capital as a regulatory guide in general.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:20.4pt;text-indent:-.25in"><b><span style="mso-fareast-font-family:"Times New Roman";color:#333333">A.</span></b><span style="mso-fareast-font-family:"Times New Roman";color:#333333"><o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:20.4pt"><span style="mso-fareast-font-family: "Times New Roman";color:#333333">Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-top:0in;margin-right:0in; margin-bottom:6.0pt;margin-left:20.4pt;text-align:right"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Paul Krugman, “Cash for trash,” <i>New York Times,</i> Sept. 22, 2008.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:20.4pt;text-indent:.25in"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Isn’t it shameful that financial institutions receive capital infusions from the government, and instead of lending it out, they hoard it? I hear this complaint a lot.<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-left:20.4pt;text-align:right"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Jack Guttentag, “Why banks ‘hoarding’ bailout funds is good,” <i>Washington Post</i>,<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-top:0in;margin-right:0in; margin-bottom:6.0pt;margin-left:38.4pt;text-align:right;text-indent:-.25in"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Jan. 24, 2009.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height:15.05pt"><span style="mso-fareast-font-family: "Times New Roman";color:#333333">The government’s capital infusions to financial institutions were rationalized as help to home-buyers.However, distressed institutions avoided further risky investments. This was desirable as well as understandable, Guttentag wrote: “The justification for the capital infusions is [or ought to be] that they will increase capital, not loans [as critics in and out of Congress complained]. The goal is to avoid future shocks from the failure of undercapitalized firms. The fundamental purpose is to prevent the crisis from getting worse. Other measures are needed to cure it.”<o:p></o:p></span></p> <p class="MsoNormal"><b><span style="mso-fareast-font-family:"Times New Roman"; color:#333333">B.</span></b><span style="mso-fareast-font-family:"Times New Roman"; color:#333333"><o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:20.4pt;text-indent:.25in"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Obviously, the U.S. financial sector’s condition today is excellent. Capital ratios stand at levels we have not seen in sixty years, credit quality has been strong, and innovative financial instruments can spread risks more broadly than ever before…. Supervisory reforms also deserve substantial credit, particularly those aimed at raising bank equity ratios.<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-top:0in;margin-right:0in; margin-bottom:12.0pt;margin-left:20.4pt;text-align:right;text-indent:.25in"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Mark Flannery, “Supervising bank safety and soundness,” Federal Reserve Bank of Atlanta <i>Economic Rev.,</i> 1<sup>st</sup> and 2<sup>nd</sup> quarters, 2007.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height:15.05pt"><span style="mso-fareast-font-family: "Times New Roman";color:#333333">It sounds reasonable that, since a bank’s <i>Assets</i> = <i>Liabilities </i>(mostly deposits) + <i>Capital</i> (equity or new worth), large capital relative to assets protects depositors against falls in the value of assets.This simple observation is the foundation of most bank regulation, including the international capital requirements agreed at Basel, Switzerland. There are several problems with the capital approach to bank regulation: (i) The capital measures used by regulators are of doubtful meaning; (ii) however measured, capital has not been a good predictor of bank failure; and (iii) capital cannot be imposed independently of the overall portfolio choice.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height:15.05pt"><span style="mso-fareast-font-family: "Times New Roman";color:#333333">Regarding the first, regulators look mainly at book (accounting) rather than market values. This misses the information contained in market prices but is simple because capital requirements are preserved from stock-price fluctuations.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent:.25in;line-height:15.05pt"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">A primary reason for the second problem is that assets are sensitive to economic conditions and can deteriorate quickly. This was evidenced in the recent decline in house prices, as in the falls of agricultural and oil prices in the 1980s and the deflations of 1920-21 and 1929-33. Regulators try to adjust capital needs by the riskiness of assets, but this is difficult for at least two reasons: regulators are not competent to judge risks at any given time except in the most egregious cases, and conditions can change rapidly and substantially.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent:.25in;line-height:15.05pt"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Third, large capital might be more a consequence of risk that a guarantee of safety. Credibly low-risk operations need little capital to satisfy creditors. U.S. bank capital ratios were high, and so was the rate of bank failures, in the volatile 19<sup>th</sup> century. Whether increased capital requirements (even if properly measured) reduce risk-taking depends on bankers’ preferences. For a bank that maximizes expected profit subject to a given probability of failure, more capital leaves that probability unchanged as it is directed to risky assets.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent:.25in;line-height:15.05pt"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">The most common message of the Basel Committee on Bank Supervision is that its measures of bank risk have failed – but they’re working on the problem. Never discussed is evidence for the usefulness of the approach even if it could be done.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height:15.05pt"><span style="mso-fareast-font-family: "Times New Roman";color:#333333">When Sam Peltzman found that deposit insurance had induced banks to take on more risk, he observed:<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:20.4pt"><span style="mso-fareast-font-family: "Times New Roman";color:#333333">Bank examiners devote the greater part of their efforts to a determination of the “riskiness” of a bank’s assets, on the one hand, and the “adequacy” of its capital, on the other…. However, the preponderant emphasis is placed on regulating bank capital rather than the details of the asset portfolio. While there is no specific reason for this emphasis on capital adequacy, it can be explained on institutional grounds. It is surely difficult for a bank examiner to judge accurately the riskiness of the many different asset items he comes across, since they reflect a great variety of [changing] local [and national] market conditions, bank management judgments, and special circumstances. Instead of attempting an independent assessment of these details, a much easier course of action is to accept bank management judgment while substituting for this acquiescence a strong insistence that depositors be protected with adequate capital against the consequences of mistakes.<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-left:20.4pt;text-align:right"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">“Capital investment in commercial banking and its relationship to portfolio regulation,”<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-top:0in;margin-right:0in; margin-bottom:12.0pt;margin-left:20.4pt;text-align:right"><i><span style="mso-fareast-font-family:"Times New Roman";color:#333333">J. Political Economy,</span></i><span style="mso-fareast-font-family:"Times New Roman"; color:#333333"> Jan-Feb 1970.<o:p></o:p></span></p> <p class="MsoNormal" style="text-indent:.25in;line-height:15.05pt"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">Nothing has changed. Rules at variance with preferences can still be satisfied without achieving regulators’ objectives (such as reducing risk). The only potentially effective regulation of complex operations must be aimed at results, with penalties for defaulters. Public policies that bail them out do the opposite.<o:p></o:p></span></p> <p class="MsoNormal" align="center" style="text-align:center;line-height:15.05pt"><span style="mso-fareast-font-family:"Times New Roman";color:#333333">…………………………<o:p></o:p></span></p> <p class="MsoNormal"><o:p> </o:p></p>John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0tag:blogger.com,1999:blog-8281725619823319547.post-84848716613780605332009-09-23T19:38:00.003-04:002009-09-23T19:43:47.991-04:00Stimulus Package<div><p class="MsoNormal" align="center" style="text-align:center;line-height:150%"><i><span style="line-height:150%;mso-bidi-font-weight:boldfont-size:11.0pt;">How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)</span></i><span style="line-height:150%;mso-bidi-font-weight:boldfont-size:11.0pt;"><o:p></o:p></span></p> <p class="MsoNormal" style="line-height:150%"><span style=" line-height:150%;mso-bidi-font-weight:boldfont-size:11.0pt;">This is the first of the critiques of government reactions to the current economic downturn that were promised in my previous blog.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:.25in"><span style="mso-bidi-font-weight:bold;font-size:11.0pt;">The [tax] surcharge of 1968 … should never, on basic theoretical grounds, have been considered an effective anti-inflationary device.<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-left:.5in;text-align:right; text-indent:-.25in"><span style="mso-bidi-font-weight:bold;font-size:11.0pt;">Robert Eisner, “Fiscal and monetary policy reconsidered,” <i>American Economic Review</i>, <o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-top:0in;margin-right:0in; margin-bottom:6.0pt;margin-left:.5in;text-align:right;text-indent:-.25in"><span style="mso-bidi-font-weight:bold;font-size:11.0pt;">Dec. 1969.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:.25in"><span style="font-size:11.0pt;">The income of Americans unexpectedly surged [0.5%] in April, elevated by the economic stimulus package, while spending declined [0.1%].<o:p></o:p></span></p> <p class="MsoNormal" align="right" style="margin-bottom:6.0pt;text-align:right; text-indent:.25in"><i style="mso-bidi-font-style:normal"><span style="font-size:11.0pt;">Wall Street J.</span></i><span style="font-size:11.0pt;">, June 1, 2009.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height:150%"><b style="mso-bidi-font-weight: normal"><span style="line-height:150%;font-size:11.0pt;">1. The tax rebates and relief in the Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 may be seen in the spikes in Disposable (after taxes) Personal Income in the figure.</span></b><span style="line-height:150%; mso-bidi-font-weight:boldfont-size:11.0pt;"><o:p></o:p></span></p> <p class="MsoNormal" style="line-height:150%"><span style=" line-height:150%;font-size:11.0pt;">Not seen, however, are positive responses of personal outlays (consumption expenditures and interest payments).<span style="mso-spacerun:yes"> </span>The failure of spending to respond to obviously temporary changes in income is well known, and has been seen on several occasions, including the ineffective tax rebate of 2001 and the income-tax surcharge of 1968.<span style="mso-spacerun:yes"> </span>The latter was a compromise by which the Johnson administration secured funding for the Vietnam War that would not be inflationary because the fall in consumption would offset the rise in government spending.<span style="mso-spacerun:yes"> </span>Consumers’ spending was not repressed, however, as they continued to make decisions on the basis of expected future income available through the capital markets. <span style="mso-spacerun:yes"> </span>The policy’s failure should have been anticipated, Eisner wrote (see the quotation above). <o:p></o:p></span></p> <p class="MsoNormal" style="line-height:150%"><span style=" line-height:150%;font-size:11.0pt;"><span style="mso-tab-count:1"> </span>The smoothness of consumption relative to income in the figure is explained by the <i>permanent income hypothesis</i> (PIH)<i>,</i> which is often associated with Milton Friedman (1957), but was well-known before him, for example by David Ricardo (1819) and Irving Fisher (1906).<span style="mso-spacerun:yes"> </span>The hypothesis states that individuals plan consumption over time in light of their perceived wealth, which consists primarily of expected income.<o:p></o:p></span></p> <p class="MsoNormal" style="line-height:150%"><span style=" line-height:150%;font-size:11.0pt;"><span style="mso-tab-count:1"> </span>The Keynesian (1936) consumption function, which still dominates the textbooks and is the theoretical basis of the stimulus packages, asserts that spending depends solely on current income.<span style="mso-spacerun:yes"> </span>This makes sense for impoverished individuals or even societies in deep depression, but is impossible to teach with a straight face to students who are in the midst of carrying out long-term plans involving large consumption (college expenses and foregone earnings) in anticipation of future income.<span style="mso-spacerun:yes"> </span><o:p></o:p></span></p> <p class="MsoNormal" style="line-height:150%"><span style=" line-height:150%;font-size:11.0pt;"><span style="mso-tab-count:1"> </span>Income fluctuations affect consumption under the PIH to the extent that income expectations respond to income changes.<span style="mso-spacerun:yes"> </span>But the hypothesis implies that consumption is unresponsive to changes known to be temporary and even reversible.<span style="mso-spacerun:yes"> </span>The apparently perverse effect of the recent stimulus packages, when consumption has actually fallen instead of being merely unresponsive, could be due to the administration’s warnings of future tax increases.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-bottom:6.0pt;line-height:150%"><span style="line-height:150%;font-size:11.0pt;"><span style="mso-tab-count:1"> </span>Research has qualified the PIH in light of uncertainty and psychology, but the ineffectiveness of stimulus packages implied by the simplest form of the theory continues to hold.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:-.25in"><b><span style="font-size:11.0pt;">References<o:p></o:p></span></b></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:-.25in"><span style="font-size:11.0pt;">G. Angeletos, et.al. “The hyperbolic consumption model,” <i>J. Economic Perspectives</i>, Summer 2001.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:-.25in"><span style="font-size:11.0pt;">Irving Fisher. <i>The Nature of Income and Capital</i>. Macmillan, 1906.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:-.25in"><span style="font-size:11.0pt;">Milton Friedman. <i>A Theory of the Consumption Function.</i> Princeton Univ. Press, 1957.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:-.25in"><span style="font-size:11.0pt;">J.M. Keynes. <i>The General Theory of Employment, Interest and Money</i>. Macmillan, 1936.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:-.25in"><span style="font-size:11.0pt;">David Ricardo. <i>The Principles of Political Economy and Taxation.</i> John Murray, 1819.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left:.25in;text-indent:-.25in"><span style="font-size:11.0pt;">Matthew Shapiro and Joel Slemrod. “Consumer response to tax rebates,” <i>American Economic Rev</i>., March 2003.<o:p></o:p></span></p></div><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivKz_N1fMvetlHts1MLp3PU3bwbInU1MtRrib9n6ZS5dEC0J54ASaRqVq1936OZBl6rOBo99Pch00Vchs0Xv5podJZUhyVGPg7-TCqjHusUVHCxAfDOasilv7F8F_fBltocPa_J_IRHmq0/s1600-h/clip_image002.gif" style="text-decoration: none;"><img style="display:block; margin:0px auto 10px; text-align:center;cursor:pointer; cursor:hand;width: 400px; height: 369px;" 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</v:shapetype><v:shape id="Picture_x0020_10" o:spid="_x0000_i1025" type="#_x0000_t75" alt="http://www.library.hbs.edu/hc/collections/kress/kress_img/adam_smith2.jpg" style='width:117.75pt;height:153pt;visibility:visible;mso-wrap-style:square'> <v:imagedata src="file:///C:\temp\msohtmlclip1\01\clip_image001.jpg" o:title="adam_smith2"/> </v:shape></span><span style='font-size:10.5pt;font-family:"Cambria","serif"; mso-ascii-theme-font:major-latin;mso-fareast-font-family:SimSun;mso-fareast-theme-font: major-fareast;mso-hansi-theme-font:major-latin;mso-bidi-font-family:"Times New Roman"; mso-bidi-theme-font:major-bidi'><o:p></o:p></span></p> <table class=MsoNormalTable border=0 cellpadding=0 width=648 style='width:6.75in;mso-cellspacing:1.5pt;mso-yfti-tbllook:1184'> <tr style='mso-yfti-irow:0;mso-yfti-firstrow:yes'> <td style='padding:.75pt .75pt .75pt .75pt'></td> <td style='padding:.75pt .75pt .75pt .75pt'></td> </tr> <tr style='mso-yfti-irow:1;mso-yfti-lastrow:yes'> <td style='padding:.75pt .75pt .75pt .75pt'></td> <td style='padding:.75pt .75pt .75pt .75pt'></td> </tr> </table> <p class=MsoNormal><span style='font-size:10.0pt;font-family:"Cambria","serif"; mso-ascii-theme-font:major-latin;mso-fareast-font-family:SimSun;mso-fareast-theme-font: major-fareast;mso-hansi-theme-font:major-latin;mso-bidi-font-family:"Times New Roman"; mso-bidi-theme-font:major-bidi'>I am Reynolds Professor of Economics at Wake Forest University, formerly Professor of Finance, the Kellogg School, Northwestern University; Associate Professor of Finance, the Wharton School, University of Pennsylvania; Lecturer in Economics and Esmeé Fairbairn Professor of Investment, Birmingham University, UK; and Economist, Board of Governors of the Federal Reserve System.<span style='mso-spacerun:yes'> </span>I have consulted or been a visiting scholar at the National University of Singapore, Clare Hall, Cambridge, and the Federal Reserve Banks of Chicago, Dallas, and Philadelphia.<span style='mso-spacerun:yes'> </span>Recent books are <i>A History of Monetary Policy in G.B. and the U.S. </i>(Cambridge) and <i>A History of Macroeconomic Policy in the U.S. </i>(Routledge).<o:p></o:p></span></p> </div> <![if !mso]></td> </tr> </table> <![endif]></v:textbox> <w:wrap type="square" anchorx="page" anchory="page"/> </v:shape><![endif]--><!--[if !vml]--><!--[endif]--><i><span style="font-size: 11pt; line-height: 150%;">September 14, 2009<o:p></o:p></span></i></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">The consequences of economic decisions depend on the incentives of those affected.<span style=""> </span>Unfortunately, this fundamental truth has been overlooked by government reactions to the recent downturn – which is my reason for starting this blog.<span style=""> </span>As an economist I have an interest in economic theory, and am disturbed when officials, cheered on by their economic advisors, disregard or violate economic truths that rest on the best theory and have been confirmed by experience.<span style=""> </span>They raise problems for teachers who would like to be able to consider applications of theory to policy.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-top: 6pt; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">The next several (weekly) issues of this blog ask: <o:p></o:p></span></p> <p class="MsoNormal" style="margin-bottom: 6pt; text-align: center;" align="center"><i><span style="font-size: 11pt;">How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-09<o:p></o:p></span></i></p> <p class="MsoNormal" style="line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">with Contents, or <i>Menu of Mistakes:<o:p></o:p></i></span></p> <p class="MsoListParagraphCxSpFirst" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">1.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">The stimulus packages<o:p></o:p></span></p> <p class="MsoListParagraphCxSpMiddle" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">2.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">Operation twist again<o:p></o:p></span></p> <p class="MsoListParagraphCxSpMiddle" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">3.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">Capital replenishments and requirements<o:p></o:p></span></p> <p class="MsoListParagraphCxSpMiddle" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">4.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">Excess reserves again<o:p></o:p></span></p> <p class="MsoListParagraphCxSpMiddle" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">5.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">Confusion of liquidity and risk<o:p></o:p></span></p> <p class="MsoListParagraphCxSpMiddle" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">6.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">We need more regulation<o:p></o:p></span></p> <p class="MsoListParagraphCxSpMiddle" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">7.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">We’ve got to do something<o:p></o:p></span></p> <p class="MsoListParagraphCxSpLast" style="text-indent: -0.25in; line-height: 150%;"><!--[if !supportLists]--><span style="font-size: 11pt; line-height: 150%;"><span style="">8.<span style="font-family: "Times New Roman"; font-style: normal; font-variant: normal; font-weight: normal; font-size: 7pt; line-height: normal; font-size-adjust: none; font-stretch: normal;"> </span></span></span><!--[endif]--><span dir="ltr"></span><span style="font-size: 11pt; line-height: 150%;">Monetary policy as credit controls<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 6pt 0in; line-height: 150%;"><span style="font-size: 11pt; line-height: 150%;">The failures of these policies are explained by their inconsistencies with theory (even of logic) and experience.<span style=""> </span>It is hard to comprehend them except as products of the hysterical atmosphere that pervades the centers of power:<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in;"><span style="font-size: 10.5pt;"><o:p> </o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in;"><span style="font-size: 10.5pt;"><o:p> </o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in;"><span style="font-size: 10.5pt;"><o:p> </o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in;"><span style="font-size: 10.5pt;">We heard from the chairman of the Federal Reserve that unless we act the financial system of this country and perhaps the world will melt down…. There was complete silence for twenty seconds.<span style=""> </span>The oxygen left the room.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.5in; text-align: right; text-indent: -0.25in;" align="right"><span style="font-size: 10.5pt;">Senate Banking Committee Chairman Christopher Dodd on a meeting of legislative leaders leading to the $700 billion Emergency Economic Stabilization Act of 2008.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><span style="font-size: 10.5pt;">If we don’t do this [authorize $700 billion] tomorrow, we won’t have an economy on Monday.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-align: right; text-indent: 0.25in;" align="right"><span style="font-size: 10.5pt;">Federal Reserve Board Chairman Ben Bernanke.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.25in; text-indent: 0.25in;"><span style="font-size: 10.5pt;">We were looking at the abyss.<o:p></o:p></span></p> <p class="MsoNormal" style="margin-left: 0.5in; text-align: right;" align="right"><span style="font-size: 10.5pt;">New York Federal Reserve Bank President (later Treasury Secretary) Timothy Geithner.<o:p></o:p></span></p> <p class="MsoNormal" style="margin: 0in 0in 6pt 0.25in; text-indent: 0.25in;"><span style="font-size: 11pt;"><o:p> </o:p></span></p> <p class="MsoNormal" style="text-align: center;" align="center"><span style="font-size: 11pt;">………………….<o:p></o:p></span></p> John Woodhttp://www.blogger.com/profile/07443343800965618980noreply@blogger.com0