These are times where policy coordination between central banks and fiscal authorities seems to be particularly welcome. For one, monetary policy, which seems to be the only sustained and coherent policy, cannot right the ship beyond the short term, and the short term is shorter than the current crisis. For two, fiscal authorities are completely stuck in political wars exactly at the wrong moment. Upcoming elections in Europe and the United States certainly do not help in that. Central bankers have been rather frustrated with the political climate, yet they are still willing scape goats to deflect the furor of the public about unpopular policies.
But sometimes, enough is enough. One such case has been the open criticism of the central banker of Cyprus, who railed against the ineptitude of its government which has completely ignored his advice. Cyprus may not seem a big deal, yet it is a major banking center that may go down with Greece depending on how things unravel there. And this central banker, whose mandate was not renewed, is also not a nobody, as he was previously a senior official at the Board of Governors of the US Fed.
In probably his last paper while in Cyprus, Athanasios Orphanides summarizes all what is wrong with central banking in Europe (Cyprus is part of the monetary union). He recognizes that banking supervision must be taken much more seriously by central bankers, as the stability mandate that was typically meant for prices and sometimes employment or output is now interpreted to include the financial sector as well. Of course, this implies that central banks need to take more responsibilities in supervising the financial all the way to regulating individual institutions, an authority they do not always have at this point. But foremost, Orphanides argues that the biggest liability is economic governance. This is especially important within a monetary union where several governments need to agree. A more uniform fiscal policy would help tremendously, especially when monetary policy, in its more rudimentary form, is applied uniformly across the union. Worse, problems from fiscal policies that are not sustainable in the long term are magnified in a monetary union. You need rules and you need to adhere to them. Politicians are rather bad at this. Central bankers much better.
Showing posts with label money. Show all posts
Showing posts with label money. Show all posts
Cashless banking in informal economies
We are used now to playing with plastic, yet we still hold cash. The fact is that there are still plenty of occasion where only cash can be used for transactions, either because the amount is very small, or because for some reason the merchant does not want to accept plastic. Not infrequently, it is because of the fear of a paper trail, or rather an electronic trail, or because of some tax avoidance. The fact that plastic money discourages the latter should be seen as beneficial, right?
Victor Olajide thinks that is not necessarily the case when the informal sector is substantial. Taking the example of Nigeria, he points out that if the informal sector cannot use cash anymore, then this could have strong implications for banking, as reserve requirements rely on deposits, and those could go missing. That does not seem to be a major problem to me, as reserve requirements can be changed or redefined. I find more problematic that the Central Bank of Nigeria is pushing for a cashless economy while many of the market participants simply do not have the means to tool up for it. I think there are more important issues to tackle in Nigeria than going cashless.
Victor Olajide thinks that is not necessarily the case when the informal sector is substantial. Taking the example of Nigeria, he points out that if the informal sector cannot use cash anymore, then this could have strong implications for banking, as reserve requirements rely on deposits, and those could go missing. That does not seem to be a major problem to me, as reserve requirements can be changed or redefined. I find more problematic that the Central Bank of Nigeria is pushing for a cashless economy while many of the market participants simply do not have the means to tool up for it. I think there are more important issues to tackle in Nigeria than going cashless.
Do people know what the Taylor Rule is?
The current doctrine in monetary policy is that central bank need to be very clear about their policy rule so that economic agents can form good expectations about the future path of interest rates and inflation. Whether this communication policy can be questioned, at least from anecdotal evidence, as many people are currently convinced that inflation is currently close to double digits and we are heading towards hyperinflation. But that is only anecdotal. There is better evidence, from the Michigan Survey on Consumers, which ask questions about expectations of future economic conditions.
Carlos Carvalho and Fernanda Nechio ask whether those expectations are consistent with the Taylor Rule that underlies much of monetary policy (at least when the nominal interest is not bound by zero). It turns out that by and large, they are, expect for those with lower education. Surprisingly, the Survey of Professional Forecasters yields less consistent predictions of interest rates and inflation, as if those professional were not believing in the Taylor Rule. It is rather puzzling that the public knows better the monetary policy than the professionals, or is it that the Fed manages to fool the general public, but not the forecasters?
Carlos Carvalho and Fernanda Nechio ask whether those expectations are consistent with the Taylor Rule that underlies much of monetary policy (at least when the nominal interest is not bound by zero). It turns out that by and large, they are, expect for those with lower education. Surprisingly, the Survey of Professional Forecasters yields less consistent predictions of interest rates and inflation, as if those professional were not believing in the Taylor Rule. It is rather puzzling that the public knows better the monetary policy than the professionals, or is it that the Fed manages to fool the general public, but not the forecasters?
I do not understand US policy
The current situation in the US can be summarized in the following way: the economy is growing again, although not yet as fast as steady state, and unemployment is still high. Most sectors are doing kind of OK except for the construction sector, which operates roughly at half capacity. Budgets deficits are very high, but not at record level once you factor in cyclical effects. Inflation is moderate and on target around 2%, including its expectations. Everyone is sitting on a lot of cash and nominal interest rates are minimal. The crisis has been going on since 1997, 4.5 years.
What is the Federal Reserve doing? Keep in mind that it cannot address structural issues in the economy and cannot only boost the economy in the short term, if at all. Bernanke and co. are keeping interest rates rock bottom until at least 2014. That would be seven years of emergency measures. If you want to instill some confidence in the economy, you do not go about telling everyone the economy needs to stay in the emergency room three more years.
And by the way, if inflation is targeted at 2% and nominal interest rates are at zero for the foreseeable future, that means real interest rates are negative. Take any model and throw in negative real interest rates. The result are pretty ugly, especially if this is more than temporary. Yet this is what the Fed seems to be advocating.
And why would you need such low interest rates? A Taylor rule would call for low interest rates if inflation (or inflation expectations) are too high (correction: too low). They are not. Or if output is below potential. That may well be the case, but I do not think it is to the extend that the Fed believes it is. The rhetoric coming from the Board indicates that the potential output is simply a continuation of the trend line from before the crisis. I do not think it is adequate. The construction sector is gone, and is going to be gone for a while because of an oversupply of residences and structures. Most households suffered a significant wealth shock that is not going to recuperate soon, and consumption has shifted down. Long time unemployed are simply not employable because of sectoral reallocation. Potential GDP has suffered a permanent shock, and while it will get back to the usual trend growth, it will not get back of the previous path.
For the Fed, this means that it is currently chasing a target it will never be able to reach. Its estimate of potential GDP is much too excessive. And the difference is due to structural issues the Fed does not have the means to address.
Which brings us to fiscal policy. Temporary tax cuts of various sorts are good to address temporary weaknesses in consumption. They work best when targeted towards people with high propensities to consume. These are the poor, and more generally the liquidity constrained. These are not the rich, and certainly not everyone. And if the loss in consumption is permanent, then this cannot be address with such temporary measures. You just have to accept it and live with it. Thus: taxes need to go back up, especially for the rich, also because they got an unnecessary free ride in the past years.
And then there is the sectoral problem. Construction is in the dumps. If you want to do something about it, you target public spending towards construction. Not general tax cuts, not across the board stimulus. And the US could actually need some serious infrastructure replacement and improvements. Actually, it is the perfect time to catch up on lost time here: costs are low, interest rates are low.
Now there is of course the stimulus package. But it has had no impact because it was not sufficiently targeted towards infrastructure, It went to state governments, which just used this manna to avoid getting into debt. It went into all sort of pet projects, very few of which had anything to do with construction. And if there was some construction, it went into initiatives that have such long horizons that they are not going to help anytime soon.
So what needs to be done? Washington needs to acknowledge that the targeted path is too ambitious. Bring interest rates back up, This will entice people and businesses to do something with all the cash they are sitting on. The US Treasury needs to focus on infrastructure spending and restructure tax rates. And do not tell me we first have to wait until the presidential election is over.
What is the Federal Reserve doing? Keep in mind that it cannot address structural issues in the economy and cannot only boost the economy in the short term, if at all. Bernanke and co. are keeping interest rates rock bottom until at least 2014. That would be seven years of emergency measures. If you want to instill some confidence in the economy, you do not go about telling everyone the economy needs to stay in the emergency room three more years.
And by the way, if inflation is targeted at 2% and nominal interest rates are at zero for the foreseeable future, that means real interest rates are negative. Take any model and throw in negative real interest rates. The result are pretty ugly, especially if this is more than temporary. Yet this is what the Fed seems to be advocating.
And why would you need such low interest rates? A Taylor rule would call for low interest rates if inflation (or inflation expectations) are too high (correction: too low). They are not. Or if output is below potential. That may well be the case, but I do not think it is to the extend that the Fed believes it is. The rhetoric coming from the Board indicates that the potential output is simply a continuation of the trend line from before the crisis. I do not think it is adequate. The construction sector is gone, and is going to be gone for a while because of an oversupply of residences and structures. Most households suffered a significant wealth shock that is not going to recuperate soon, and consumption has shifted down. Long time unemployed are simply not employable because of sectoral reallocation. Potential GDP has suffered a permanent shock, and while it will get back to the usual trend growth, it will not get back of the previous path.
For the Fed, this means that it is currently chasing a target it will never be able to reach. Its estimate of potential GDP is much too excessive. And the difference is due to structural issues the Fed does not have the means to address.
Which brings us to fiscal policy. Temporary tax cuts of various sorts are good to address temporary weaknesses in consumption. They work best when targeted towards people with high propensities to consume. These are the poor, and more generally the liquidity constrained. These are not the rich, and certainly not everyone. And if the loss in consumption is permanent, then this cannot be address with such temporary measures. You just have to accept it and live with it. Thus: taxes need to go back up, especially for the rich, also because they got an unnecessary free ride in the past years.
And then there is the sectoral problem. Construction is in the dumps. If you want to do something about it, you target public spending towards construction. Not general tax cuts, not across the board stimulus. And the US could actually need some serious infrastructure replacement and improvements. Actually, it is the perfect time to catch up on lost time here: costs are low, interest rates are low.
Now there is of course the stimulus package. But it has had no impact because it was not sufficiently targeted towards infrastructure, It went to state governments, which just used this manna to avoid getting into debt. It went into all sort of pet projects, very few of which had anything to do with construction. And if there was some construction, it went into initiatives that have such long horizons that they are not going to help anytime soon.
So what needs to be done? Washington needs to acknowledge that the targeted path is too ambitious. Bring interest rates back up, This will entice people and businesses to do something with all the cash they are sitting on. The US Treasury needs to focus on infrastructure spending and restructure tax rates. And do not tell me we first have to wait until the presidential election is over.
The history of negative nominal interest rates
There is much talk about the zero bound on nominal interest rates and how this is constraining the policy options of many central banks. How can of course ask oneself why there would be such a restriction on nominal interest rates. Would it be possible to tax (nominal) money holdings? It is certainly conceivable to have negative interest rates on some bank accounts, and it has happened before. Switzerland and Germany imposed negative rates on non-resident account holders in the 1970's, and the Swiss National Bank is currently contemplating doing this again (New York Times). Sweden imposed them recently on mandatory reserve holdings of commercial banks. There is, however, very little theory on this.
Cordelius Ilgmann and Martin Menner try to make sense of the existing literature on the topic. There are essentially two strands, according to them: the first is started with Silvio Gesell in the 19th century and proposes taxing money, the second lies within the very recent money-search literature.
Gesell was the proponent of an anarchist free-market utopia, the free-economy movement. He proposed that bank notes would need to have a weekly stamp affixed to remain valid, amounting to a 5% tax every year. The stated reason is that while other goods depreciate naturally, money does not and may be withheld from circulation. The tax alleviates that, and should in particular be used in times of crisis, because it increases the velocity of money and prevents its hoarding. That argument can be made for today, but it neglects the influence of inflation on all this, and that is crucial.
The recent money-search literature uses taxes on money holding as a proxy for inflation. My understanding that this is really for analytic convenience but in no way a policy proposal. Indeed, what this literature cares about is the real return on money, not the nominal one. But Ilgmann and Menner run with it and believe there is an endorsement of a Gesell tax.
PS: a third way is discussed in the paper, recently proposed by Willem Buiter. It is based on the silly idea that the various function of money are taken over by separate currencies and backed up by equally silly arguments with money in the utility function.
Cordelius Ilgmann and Martin Menner try to make sense of the existing literature on the topic. There are essentially two strands, according to them: the first is started with Silvio Gesell in the 19th century and proposes taxing money, the second lies within the very recent money-search literature.
Gesell was the proponent of an anarchist free-market utopia, the free-economy movement. He proposed that bank notes would need to have a weekly stamp affixed to remain valid, amounting to a 5% tax every year. The stated reason is that while other goods depreciate naturally, money does not and may be withheld from circulation. The tax alleviates that, and should in particular be used in times of crisis, because it increases the velocity of money and prevents its hoarding. That argument can be made for today, but it neglects the influence of inflation on all this, and that is crucial.
The recent money-search literature uses taxes on money holding as a proxy for inflation. My understanding that this is really for analytic convenience but in no way a policy proposal. Indeed, what this literature cares about is the real return on money, not the nominal one. But Ilgmann and Menner run with it and believe there is an endorsement of a Gesell tax.
PS: a third way is discussed in the paper, recently proposed by Willem Buiter. It is based on the silly idea that the various function of money are taken over by separate currencies and backed up by equally silly arguments with money in the utility function.
Corruption and the exchange rate regime
A fixed exchange rate regime is a sign of an authoritarian and weaselly government nowadays. Letting your currency float lets markets freely show when policies are weak. Governments who are afraid of showing such weakness either get a fixed exchange rate regime or announce a floating one and in practice manage it to make it look stable as a fixed one. This is the so-called fear of floating, common among corrupt governments. This would indicate that the choice of the exchange rate regime could be determined by the political regime. Could the causality run the other way?
Katherina Popkova studies this question and finds the rather striking result that it makes sense to have an fixed exchange rate when you are corrupt and corruption has a strongly positive impact on output. The logic is that in such circumstances taxation is not that much distorting, thus seigniorage can be efficiently replaced by taxes. That said, some may argue that it is a silly idea to mention that corruption may have a positive impact on output. Yet, it is far from empirically settled whether corruption has a positive or negative impact.
Katherina Popkova studies this question and finds the rather striking result that it makes sense to have an fixed exchange rate when you are corrupt and corruption has a strongly positive impact on output. The logic is that in such circumstances taxation is not that much distorting, thus seigniorage can be efficiently replaced by taxes. That said, some may argue that it is a silly idea to mention that corruption may have a positive impact on output. Yet, it is far from empirically settled whether corruption has a positive or negative impact.
Meta-analyzing the price puzzle
Meta-analysis is the analysis of the literature on, say, the estimate of a particular elasticity. This is common in medical studies, where each individual study has usually little statistical significance, but aggregating them may give the results more power. In Economics, there are few meta-analyses (although there is a society on the topic) as study samples are statistically much more sound and each study takes so much time that there is little incentive to do a lot o the same topic. Yet, this happens for some themes.
One such theme is the price puzzle: many vector-autoregression models show that a monetary contraction is immediately followed by a rise in the price level, which is rather counter-intuitive. Marek Rusnák, Tomáš Havránek and Roman Horváth found 70 articles from 31 countries providing 210 estimates of the response at five horizons. Can one then simply do a statistical analysis on these estimates? That is not so easy, as there may be a publication bias. As the puzzle is now well documented, journal editors are not particularly interested in studies that demonstrate it again. The authors claim that there is such a bias, but I have to confess I do not understand how they come to that conclusion.
The price puzzle is on average present, and prices eventually decrease as suggested but all theories. But there is substantial variance in the results, which the authors show can be explained by what variables are included or what variant of a vector-autoregression is run. This unfortunately confirms my frustration with this field: there is a dizzying array of methods and specifications that yield different results, and it is impossible to tell which one is right. Maybe we need a bit more theory to discipline this.
One such theme is the price puzzle: many vector-autoregression models show that a monetary contraction is immediately followed by a rise in the price level, which is rather counter-intuitive. Marek Rusnák, Tomáš Havránek and Roman Horváth found 70 articles from 31 countries providing 210 estimates of the response at five horizons. Can one then simply do a statistical analysis on these estimates? That is not so easy, as there may be a publication bias. As the puzzle is now well documented, journal editors are not particularly interested in studies that demonstrate it again. The authors claim that there is such a bias, but I have to confess I do not understand how they come to that conclusion.
The price puzzle is on average present, and prices eventually decrease as suggested but all theories. But there is substantial variance in the results, which the authors show can be explained by what variables are included or what variant of a vector-autoregression is run. This unfortunately confirms my frustration with this field: there is a dizzying array of methods and specifications that yield different results, and it is impossible to tell which one is right. Maybe we need a bit more theory to discipline this.
About a (partial) return to the gold standard
In difficult times, it is easy to blame central banks for everything. Part of their role, after all, is to play the scape goat for policies the politician do not dare implementing. But then, there is only so much the central banks can do, as Europe and the United States no "nicely" show now. A substantial ingredient in the blame game is a call for a return to the gold standard, a nostalgia for supposedly better and easier times.
Olivier Ledoit and Sébastien Lotz echo this call and study what our current understanding is about the coexistence of fiat and commodity money. In principle, we can start from the idea that currency competition is good: this would force the central bank to be more careful with its fiat money. Indeed, we have learned from money search theory that bad money does not necessarily chase good money (the old Gresham's Law). Also, if the commodity has a positive return, its monetization is beneficial as long as its storage and transaction cost is sufficiently low. The question is then on how to find a commodity that has a real return from just sitting there. There is a larger problem, though, with small denominations. How do you mint coins measured in cents when the commodity is, for example, gold? Either the coins need to be very small or they have very small commodity content, to the point that they become ... fiat money. Monetary policy also becomes tricky, as quite obviously temporary easing becomes difficult if it risks driving fiat money out.
But in the end, isn't a commodity like gold only valuable because people believe it is valuable? Gold, to take an extreme and popular case, has little intrinsic value, as I argued before, and is thus just another fiat currency. It is all a question of perception.
Olivier Ledoit and Sébastien Lotz echo this call and study what our current understanding is about the coexistence of fiat and commodity money. In principle, we can start from the idea that currency competition is good: this would force the central bank to be more careful with its fiat money. Indeed, we have learned from money search theory that bad money does not necessarily chase good money (the old Gresham's Law). Also, if the commodity has a positive return, its monetization is beneficial as long as its storage and transaction cost is sufficiently low. The question is then on how to find a commodity that has a real return from just sitting there. There is a larger problem, though, with small denominations. How do you mint coins measured in cents when the commodity is, for example, gold? Either the coins need to be very small or they have very small commodity content, to the point that they become ... fiat money. Monetary policy also becomes tricky, as quite obviously temporary easing becomes difficult if it risks driving fiat money out.
But in the end, isn't a commodity like gold only valuable because people believe it is valuable? Gold, to take an extreme and popular case, has little intrinsic value, as I argued before, and is thus just another fiat currency. It is all a question of perception.
Was medieval seigniorage welfare improving?
The presence of coins improves social welfare, as it allows for more trades than barter would allow. Coin minting also provides income to the minting authority, as it can buy stuff with coins that have more value than their production cost. This is called seigniorage. This was also the case in medieval times, where "seigneurs" would mint gold or silver coins with somewhat less metal content than indicated and thus get income. One would thus think that these minters would be profit maximizing, and thus enhance welfare only as a by-product.
Angela Redish and Warren Weber say this is not quite true. They build a random matching model of commodity money, where the supply of silver is exogenous. They derive the welfare maximizing size and quantity of coins as a function of the quantity of silver and the probability of acceptance of cash. Using data from medieval Venice and England, they find that the model predictions follow remarkably well the historical record. This probably means that authorities were benevolent. I say probably because they may have acted in the same way out of selfishness, but that is not documented in the paper. Indeed, the model assumes than any holder of silver can mint, while in reality a limited number of people could do that.
Angela Redish and Warren Weber say this is not quite true. They build a random matching model of commodity money, where the supply of silver is exogenous. They derive the welfare maximizing size and quantity of coins as a function of the quantity of silver and the probability of acceptance of cash. Using data from medieval Venice and England, they find that the model predictions follow remarkably well the historical record. This probably means that authorities were benevolent. I say probably because they may have acted in the same way out of selfishness, but that is not documented in the paper. Indeed, the model assumes than any holder of silver can mint, while in reality a limited number of people could do that.
Trust in private money
Money does not have to be supplied by government. Private money could work under some circumstances, and it has in particular been argued that competition should be beneficial. While previous attempts have failed, the wider availability of information, rating agencies (gasp) and information technology could make it happen. So it is of interest to find out what those circumstances are.
Ramon Marimon, Juan Pablo Nicolini and Pedro Teles say that money is an experience good, as you only observes its quality after the exchange is performed. This leads to serious limitations. If issuer of currency cannot commit to not inflate in the future, then competition over currency in the present has no bite. Building a reputation can solve this to some degree, but building the necessary trust means that future rewards must be larger that immediate gains from inflating. That implies that full efficiency cannot be attained: inflation needs to remain positive, while full efficiency implies negative inflation so that money has the same return as a risk-free bond. Unfortunately it also implies that there is indeterminacy and any inflation rate could happen. Oh well, may be the government could step in to help achieve efficiency...
Ramon Marimon, Juan Pablo Nicolini and Pedro Teles say that money is an experience good, as you only observes its quality after the exchange is performed. This leads to serious limitations. If issuer of currency cannot commit to not inflate in the future, then competition over currency in the present has no bite. Building a reputation can solve this to some degree, but building the necessary trust means that future rewards must be larger that immediate gains from inflating. That implies that full efficiency cannot be attained: inflation needs to remain positive, while full efficiency implies negative inflation so that money has the same return as a risk-free bond. Unfortunately it also implies that there is indeterminacy and any inflation rate could happen. Oh well, may be the government could step in to help achieve efficiency...
What if the US looses its reserve currency privilege?
Since the Bretton Woods agreement in 1945, the United States have enjoyed the so-called "Exhorbitant Privilege." During the fixed exchange rate regime, the US could conduct monetary policy without regard to what was happening in other countries. The US dollar was a reserve currency, which also helped the US maintain low interest rates and a guarantee that US dollars (and Treasury bonds) would always find a buyer. With flexible exchange rates, not much has changed. But with the recent shenanigans in a Congress that considered reneging on its debt, the likelihood of this advantage changing has dramatically increased. What would the consequences of the loss of the Exhorbitant Privilege be?
Wenli Cheng and Dingsheng Zhang study this scenario using a general equilibrium model where a peripheral country (say, the Asian economies) pegs its currency to the money of a central country (say, the United States), the latter being used as the vehicle currency for international trade. In addition, the foreign exchange reserves of the periphery are invested in government bonds of the center. This means that no matter what current account deficit of the center, it is always financed by the periphery. Yet the center may be tempted to inflate it away. This limitless and to some extend free borrowing is the Exhorbitant Privilege.
Now remove it by assuming that the periphery does not want to invest in the center, either because it views the Treasury bonds are excessively risky or because it does not peg to the dollar any more. This would lead to a dramatic readjustment of the terms of trade to favor the tradable sector of the center. This decpraciation of the dollar would be more pronounced of the center is incapable of raising taxes and finances its debt with inflation. This already all sounds familiar.
Wenli Cheng and Dingsheng Zhang study this scenario using a general equilibrium model where a peripheral country (say, the Asian economies) pegs its currency to the money of a central country (say, the United States), the latter being used as the vehicle currency for international trade. In addition, the foreign exchange reserves of the periphery are invested in government bonds of the center. This means that no matter what current account deficit of the center, it is always financed by the periphery. Yet the center may be tempted to inflate it away. This limitless and to some extend free borrowing is the Exhorbitant Privilege.
Now remove it by assuming that the periphery does not want to invest in the center, either because it views the Treasury bonds are excessively risky or because it does not peg to the dollar any more. This would lead to a dramatic readjustment of the terms of trade to favor the tradable sector of the center. This decpraciation of the dollar would be more pronounced of the center is incapable of raising taxes and finances its debt with inflation. This already all sounds familiar.
The welfare gain from inflation targeting
It is rather well accepted that transparency is preferred for policy, because it anchors better expectations, people generally do not like uncertainty, and discretion can lead to adverse biases compared to set policy rules. Yet, the United States exhibit little transparancy, with the Federal Reserve being one of the few western central banks not to declare some explicit policy target, and fiscal policy being as uncertain as ever. That would not be a big deal if the welfare costs were low, but you can think that there are high and in the case of fiscal policy are currenctly holding back the recovery.
Giorgio Di Giorgio and Guido Traficante are taking a closer look at the welfare benefits of inflation targeting. For this they use a model where households observe policy interest rates and do not know whether their changes are due to reactions to output gaps or shocks to the inflation target. Households are sophisticated, they use a signal extraction device to estimate the latent, unobservable variable. Yet, they still face substantial costs from the uncertainty. Money is not neutral because of Rotemberg pricing, a variant of Calvo pricing. Oh well, I guess this is what you need to do to get a result with some bite.
Households know there is a policy rule that determines the interest rate from the output gap (unobservable) and the inflation target (stochastic and persistent) as well as known preference and cost-push shocks. In other words, households know a lot about the structure of the economy and the shocks, except for the policy shock, but then somehow cannot figure out what the output gap is. The central bank can, though, but then has for obscure reasons a trembling hand when it comes to set its inflation target. That seems to be quite the opposite of what I would have thought: everyone is confused about the output gap, and only the central bank knows what the inflation target is. Instead of a story of households trying to disentangle output gap and inflation target from the interest rate signal, one would have a story of a central banker not quite sure what to do given the circumstances. Too bad, this could have been an interesting paper.
Giorgio Di Giorgio and Guido Traficante are taking a closer look at the welfare benefits of inflation targeting. For this they use a model where households observe policy interest rates and do not know whether their changes are due to reactions to output gaps or shocks to the inflation target. Households are sophisticated, they use a signal extraction device to estimate the latent, unobservable variable. Yet, they still face substantial costs from the uncertainty. Money is not neutral because of Rotemberg pricing, a variant of Calvo pricing. Oh well, I guess this is what you need to do to get a result with some bite.
Households know there is a policy rule that determines the interest rate from the output gap (unobservable) and the inflation target (stochastic and persistent) as well as known preference and cost-push shocks. In other words, households know a lot about the structure of the economy and the shocks, except for the policy shock, but then somehow cannot figure out what the output gap is. The central bank can, though, but then has for obscure reasons a trembling hand when it comes to set its inflation target. That seems to be quite the opposite of what I would have thought: everyone is confused about the output gap, and only the central bank knows what the inflation target is. Instead of a story of households trying to disentangle output gap and inflation target from the interest rate signal, one would have a story of a central banker not quite sure what to do given the circumstances. Too bad, this could have been an interesting paper.
The shoe-leather cost of inflation is minimal
One popular way to justify the introduction of monetary frictions in macroeconomic models is to assume that there is some cost associated to changing cash holdings, ATM fees or more generally "shoe-leather" cost. Whether these cost matter at all is controversial and settling this requires a two-pronged approach: first find empirically how large these costs are, and second demonstrate that the costs are large enough to matter in a reasonable model.
Alessandro Calza and Andrea Zaghini estimate the shoe-leather cost for the US. This is by far not the first time this is performed, by it can be worth it as data change, and in this case one can suspect that transaction costs indeed have gone down over a few decades. But there is one critical aspect that they take into account: most on US M1 is not held domestically, and this share has increased to currently 60%. Ignoring this seriously biases estimates, first because it overstates domestic demand and second because the shoe-leather cost stemming from inflation is largely borne by foreigners. At an inflation rate of 10%, the cost amounts to negligible 0.05% of total income. At lower inflation rates, it is even negative thanks to foreigners giving up real resources to acquire US money. In other words, you cannot build a monetary theory on this,
Alessandro Calza and Andrea Zaghini estimate the shoe-leather cost for the US. This is by far not the first time this is performed, by it can be worth it as data change, and in this case one can suspect that transaction costs indeed have gone down over a few decades. But there is one critical aspect that they take into account: most on US M1 is not held domestically, and this share has increased to currently 60%. Ignoring this seriously biases estimates, first because it overstates domestic demand and second because the shoe-leather cost stemming from inflation is largely borne by foreigners. At an inflation rate of 10%, the cost amounts to negligible 0.05% of total income. At lower inflation rates, it is even negative thanks to foreigners giving up real resources to acquire US money. In other words, you cannot build a monetary theory on this,
Could the Shadow Open Market Committee have outperfomed the Fed?
Decisions of the Open Market Committee of the US Federal Reserve bank have long been scrutinized, both by market for obvious reasons and by academics. Some of the latter have even formed a Shadow Open Market Committee in reaction to the decision by President Nixon to impose price and wage controls in 1971, with the support of the Fed president. This committee has evaluated Fed policy and criticize Fed actions when due. But would it have done a better job?
William Poole, Robert Rasche and David Wheelock, who are all Fed employees, study how the policies advocated by the SOMC during the period of high inflation in the 1970s would have performed. Those policies where at odds with what the Fed was doing and even with what many academics were proposing. The policy rule was rather simple: reduce the target money growth rate by one percent every year, down to 4%. To evaluate this rule, you need a model, so they take the New-Keynesian model of Clarida, Gali, and Gertler (1999) off the shelf and run various experiments: one with the SOMC rule, one with the historic data (the Fed's action: a one time drop in money growth). While both policies eventually achieve their goal of reducing inflation, the SOMC one does so with less cost in output.
Now things are not that easy. To be fair to the Fed, it had at the time had rather little credibility, and it is not clear it could have gained any more credibility by adopting the SOMC's policy, as it requires some long-term commitment. Also, the Fed had to fight against attempts by Congress to take over monetary policy, and thus its policy choices were limited. And had the SOMC known that it policy would have been actually implemented, I am not convinced it would have taken the same choice. Indeed, it was rather risky, as it was at odds with what most other people were advocating. And markets may have reacted with incredulity to such an odd move.
William Poole, Robert Rasche and David Wheelock, who are all Fed employees, study how the policies advocated by the SOMC during the period of high inflation in the 1970s would have performed. Those policies where at odds with what the Fed was doing and even with what many academics were proposing. The policy rule was rather simple: reduce the target money growth rate by one percent every year, down to 4%. To evaluate this rule, you need a model, so they take the New-Keynesian model of Clarida, Gali, and Gertler (1999) off the shelf and run various experiments: one with the SOMC rule, one with the historic data (the Fed's action: a one time drop in money growth). While both policies eventually achieve their goal of reducing inflation, the SOMC one does so with less cost in output.
Now things are not that easy. To be fair to the Fed, it had at the time had rather little credibility, and it is not clear it could have gained any more credibility by adopting the SOMC's policy, as it requires some long-term commitment. Also, the Fed had to fight against attempts by Congress to take over monetary policy, and thus its policy choices were limited. And had the SOMC known that it policy would have been actually implemented, I am not convinced it would have taken the same choice. Indeed, it was rather risky, as it was at odds with what most other people were advocating. And markets may have reacted with incredulity to such an odd move.
The key to understand money: vacations
Monetary theorists have struggled for decades if not centuries to explain why we use and value money. Modern theory, which needs to be more explicit about its assumptions, has highlighted how silly some axioms of monetary theory are. For example, why would money make any sense in a utility function when future consumption is already taken into account? Or what about cash-in-advance in quarterly models of the business cycle. Money search model bring progress to the table as they model the problem of the absence of double coincidence of wants, although still with some rather crude assumptions. But at least it is going in the right direction.
Andrew Clausen and Carlo Strub come up with a new motivation for money. Suppose that there is a fix cost in production. Unless you want to produce at full capacity every period, you will then choose to close all operations from time to time and take a vacation. But you must live from something when you do not work and you have no savings technology. This is where money comes to the rescue. Without it, it would have been impossible to smooth consumption across periods, and thus money is valued and welfare enhancing. But beyond the possible elegance of the model, is anybody actually believing this story? I do not think in makes sense to discuss the intertemporal allocation of resources in a world without assets, especially if you want to apply it to anything modern.
Andrew Clausen and Carlo Strub come up with a new motivation for money. Suppose that there is a fix cost in production. Unless you want to produce at full capacity every period, you will then choose to close all operations from time to time and take a vacation. But you must live from something when you do not work and you have no savings technology. This is where money comes to the rescue. Without it, it would have been impossible to smooth consumption across periods, and thus money is valued and welfare enhancing. But beyond the possible elegance of the model, is anybody actually believing this story? I do not think in makes sense to discuss the intertemporal allocation of resources in a world without assets, especially if you want to apply it to anything modern.
What influences Fed presidents?
The European Central Bank is still a recent creation, so you can excuse its national governors for putting their country's interest first in the conduct of monetary policy. What about another federal central bank that is much older and whose governors territory does not necessarily coincide with political boundaries, the Federal Reserve System of the US?
Bernd Hayo and Matthias Neuenkirch have analyzed the speeches of Federal Reserve presidents over the span of twelve years and come to the conclusions that they equally represent the national and regional interests, except when it is not their turn to vote, when their region comes first. They find this by trying to fit a Taylor Rule to their positions, using a price index, a national and a regional unemployment rate. Unfortunately (and surprisingly), there are no regional price indexes in the US, which could have reinforced the regional focus of the presidents. Still, I am surprised how much they lobby for the general interest. After all, they are selected to represent their region.
Bernd Hayo and Matthias Neuenkirch have analyzed the speeches of Federal Reserve presidents over the span of twelve years and come to the conclusions that they equally represent the national and regional interests, except when it is not their turn to vote, when their region comes first. They find this by trying to fit a Taylor Rule to their positions, using a price index, a national and a regional unemployment rate. Unfortunately (and surprisingly), there are no regional price indexes in the US, which could have reinforced the regional focus of the presidents. Still, I am surprised how much they lobby for the general interest. After all, they are selected to represent their region.
What inflation target to set
Central banks, implicitly or explicitly, set targets for the inflation rate, usually in the form of an interval. What determines this interval and its mid-point? Theory tells you that larger economic fluctuations should leads to wider intervals and less central bank independence should like to higher targets.
Roman Horváth and Jakub Matějů set out to verify this by way of questionnaires to central bankers and sifting through official publications. They gather data from 19 countries, including how the targets have changed through history and confirm the conjectures above. They also find that targets seem to accommodate inflation expectations and follow world inflation. Interestingly, the party in power does not matter, even for less independent central banks. But one aspect that is not covered and I have always wondered about is how the dominant dogma would matter. Indeed, if a central bank believes in activist policy, it would presumably allow for a wider target interval. Or a neo-classical central banker would want a very low target inflation.
Roman Horváth and Jakub Matějů set out to verify this by way of questionnaires to central bankers and sifting through official publications. They gather data from 19 countries, including how the targets have changed through history and confirm the conjectures above. They also find that targets seem to accommodate inflation expectations and follow world inflation. Interestingly, the party in power does not matter, even for less independent central banks. But one aspect that is not covered and I have always wondered about is how the dominant dogma would matter. Indeed, if a central bank believes in activist policy, it would presumably allow for a wider target interval. Or a neo-classical central banker would want a very low target inflation.
If anything goes wrong, it has to be the central banks
Some institutions are excellent scape goats to impose necessary reforms in a country, such as the International Monetary Fund or the World Bank. Local governments can always blame them if they have to put their fiscal house in order. Other institutions seem to attract conspiracy theorists in large numbers because someone needs to be blamed for some condition and the institution is poorly understood. The prime candidate here is the central bank. Indeed, the best central banks are those that act independently from the government, but people see this apparent lack of accountability as the origin of all trouble in the economy.
A very good example for this sorry confusion is a recent paper by Subhendu Das, with the following abstract:
Where to begin. Central bank governors are typically appointed by the government and are accountable to it (just see how frequently Bernanke is on Capital Hill). The central banker's decisions are independent from the government, and for good reasons: you want to avoid policy actions to be taken for a short term political gain that is detrimental in the longer run through higher inflation. Central banks that are not independent from governments typically have much higher inflation, as the government ends up relying on seigniorage for its expenses instead of taxation. The presence of the independent prevents deficits because governments know they cannot inflate debt away.
Then, central banks most often make profits. These profits are then transfered to the government. That reduces the need for taxes. But this does not absolve the government from raising taxes. If is it taking real resources form the economy (either labor or goods), that needs to be paid for in real terms one way or the other. For a typically government, the central bank would only be able to cover this with excessive inflation.
Do central banks create poverty? A central bank that is independent from the government leads to low inflation, which is good for poor people who are cash based. To repeat myself, a government controlled central bank will create more inflation, and that is when there is a transfer of wealth from poor to rich, who can shield their assets from inflation.
Do central banks have an impact on unemployment and recessions? Honestly, it is open to debate whether they have any significant impact on this. They can certainly mess up things, for example when influenced by the government, but a well-run independent central bank will just make sure the economic is well greased. It cannot fix structural problems. That is up to the government. Central banks cannot control the economy, and in fact in many countries do not even have regulatory authority over the financial sector.
All in all, this paper has everything backwards, except for the fact that money is created out of thin air. But keep in mind that most money is not created by the central bank, but by private banks, and the central bank makes sure not too much is created. So the author still got that wrong.
A very good example for this sorry confusion is a recent paper by Subhendu Das, with the following abstract:
In each country the central bank is a privately owned bank with no transparency and accountability to the government of that country. It is also the only bank that can print the money for that country and does it so out of thin air. At the same time this bank wants that the government returns the money with interest. We show that this structure creates deficit, introduces tax, and causes poverty around the globe. This paper shows how central banks control the economy by manipulating the financial system it has designed. The paper explains how easily the central banks can control the unemployment, create recessions, and transfer wealth from the lower economic group to higher economic group and perpetuate the poverty. The paper also proposes three methods of eliminating central banks.
Where to begin. Central bank governors are typically appointed by the government and are accountable to it (just see how frequently Bernanke is on Capital Hill). The central banker's decisions are independent from the government, and for good reasons: you want to avoid policy actions to be taken for a short term political gain that is detrimental in the longer run through higher inflation. Central banks that are not independent from governments typically have much higher inflation, as the government ends up relying on seigniorage for its expenses instead of taxation. The presence of the independent prevents deficits because governments know they cannot inflate debt away.
Then, central banks most often make profits. These profits are then transfered to the government. That reduces the need for taxes. But this does not absolve the government from raising taxes. If is it taking real resources form the economy (either labor or goods), that needs to be paid for in real terms one way or the other. For a typically government, the central bank would only be able to cover this with excessive inflation.
Do central banks create poverty? A central bank that is independent from the government leads to low inflation, which is good for poor people who are cash based. To repeat myself, a government controlled central bank will create more inflation, and that is when there is a transfer of wealth from poor to rich, who can shield their assets from inflation.
Do central banks have an impact on unemployment and recessions? Honestly, it is open to debate whether they have any significant impact on this. They can certainly mess up things, for example when influenced by the government, but a well-run independent central bank will just make sure the economic is well greased. It cannot fix structural problems. That is up to the government. Central banks cannot control the economy, and in fact in many countries do not even have regulatory authority over the financial sector.
All in all, this paper has everything backwards, except for the fact that money is created out of thin air. But keep in mind that most money is not created by the central bank, but by private banks, and the central bank makes sure not too much is created. So the author still got that wrong.
Heterodox money
Heterodox economics is frustrating because it keeps working in a self-referential vacuum, consistently ignoring advances in orthodox economics. This is not how progress can be made, and in particular this is not how you can get results from heterodox economics accepted or at least considered in the mainstream. It is now as if there were two parallel universes and no portal between them.
A good example is a recent paper by Randall Wray, grandiosely entitled "Money" that is supposed to teach us what money is. It lays on three principles (I quote):
But have we not made some progress since? The only mention of the mainstream in the paper is a criticism of representative agent models where agents pay money to themselves and thus never default. Really? Really? Modern models that try to rationalize the use of money explicitly have heterogeneous agents and explicitly take into account that some may refuse money for payment. And this is not exactly an obscure and recent literature, Kiyotaki and Wright, for example, dates back to 1989 and already has all these ingredients. This money search literature is mentioned nowhere. The same applies to the literature on trading posts, which has rationalized the emergence of particular commodities as money (See recent post).
Also, why this reluctance to use formulas to make arguments and assumptions explicit? In this paper, there is implicit talk about budget constraints and accounting identities, but they are never explicitly laid out, which can make it easy for the author to sweep something under the carpet (I am not saying Wray does, though). But there is something essential about writing an equation: it forces you to define variables precisely, and it forces to use a logical proof of your arguments. Only then will your arguments be water tight.
A good example is a recent paper by Randall Wray, grandiosely entitled "Money" that is supposed to teach us what money is. It lays on three principles (I quote):
- Money buys goods and goods buy money, but goods do not buy goods.
- Money is always debt; it cannot be a commodity from the first proposition because if it were that would mean that a particular good is buying goods.
- Default on debt is possible.
But have we not made some progress since? The only mention of the mainstream in the paper is a criticism of representative agent models where agents pay money to themselves and thus never default. Really? Really? Modern models that try to rationalize the use of money explicitly have heterogeneous agents and explicitly take into account that some may refuse money for payment. And this is not exactly an obscure and recent literature, Kiyotaki and Wright, for example, dates back to 1989 and already has all these ingredients. This money search literature is mentioned nowhere. The same applies to the literature on trading posts, which has rationalized the emergence of particular commodities as money (See recent post).
Also, why this reluctance to use formulas to make arguments and assumptions explicit? In this paper, there is implicit talk about budget constraints and accounting identities, but they are never explicitly laid out, which can make it easy for the author to sweep something under the carpet (I am not saying Wray does, though). But there is something essential about writing an equation: it forces you to define variables precisely, and it forces to use a logical proof of your arguments. Only then will your arguments be water tight.
Fiat money, 1683
We tend to think that fiat money is an invention of the twentieth century and thus does not predate the Italian car industry. But there have been a few experiments before this and in particular a remarkably successful one in the Netherlands starting in 1683.
Stephen Quinn and William Roberds tell the story of the Bank of Amsterdam that in 1683 started limiting the ability of depositors to withdraw coin. At a time where this would have been interpreted as "taking the money and running," this was remarkably well accepted by the depositors, and the Bank of Amsterdam never abused the situation, maintaining stable prices over the next century and greatly facilitating trade in the kingdom. All this without government supervision, basically out of private initiative. Call that almost-private central banking (the bank was sponsored by the city of Amsterdam), even conducting open market operations. Of course, this all ended went the Bank of Amsterdam went bust in 1795: the rest of the world still relying on precious metal, the lack of access to fresh silver during the Fourth Anglo-Dutch War led to a strong depreciation of the guilder, and the experiment ended due to lack of fiat.
Stephen Quinn and William Roberds tell the story of the Bank of Amsterdam that in 1683 started limiting the ability of depositors to withdraw coin. At a time where this would have been interpreted as "taking the money and running," this was remarkably well accepted by the depositors, and the Bank of Amsterdam never abused the situation, maintaining stable prices over the next century and greatly facilitating trade in the kingdom. All this without government supervision, basically out of private initiative. Call that almost-private central banking (the bank was sponsored by the city of Amsterdam), even conducting open market operations. Of course, this all ended went the Bank of Amsterdam went bust in 1795: the rest of the world still relying on precious metal, the lack of access to fresh silver during the Fourth Anglo-Dutch War led to a strong depreciation of the guilder, and the experiment ended due to lack of fiat.
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