“To some extent, commercial bankers lend out their own capital and money acquired by CDs (certificates of deposit). But most commercial banking is "deposit banking" based on a gigantic scam: the idea, which most depositors believe, that their money is down at the bank, ready to be redeemed in cash at any time. If Jim has a checking account of $1,000 at a local bank, Jim knows that this is a "demand deposit," that is, that the bank pledges to pay him $1,000 in cash, on demand, anytime he wishes to "get his money out." Naturally, the Jims of this world are convinced that their money is safely there, in the bank, for them to take out at any time.” Murray N Rothbard, ‘Fractional Reserve Banking’.
When my friend Jim asked my reaction to this quote, I said that I didn’t know that he knew Murray Rothbard. Jim replied: “I didn’t know that he knew me, but I think he is making a good point.”
I asked Jim whether he thought most people really believed that banks were like warehouses that kept the money deposited with them until people wanted to withdraw it. Jim said: “Most people know that banks lend the funds deposited with them to other people, but the point is that banks do promise to repay deposits on demand. They know that they can’t keep this promise if everyone wants their money back at the same time. Banks shouldn’t be allowed to make promises they can’t keep.”
I tried to argue that the financial system generally works well even though exceptional circumstances can arise where financial intermediaries make promises that they cannot keep. I suggested that it is very rare for situations to arise when a high proportion of borrowers do not meet their commitments and the value of the security held by banks falls below the value of loans outstanding.
Jim said: “Look, you can’t pretend that these situations where banks can’t keep their promises occur so infrequently that they should be ignored. Democratic governments don’t just look the other way when banks go bust. Do you think that the best solution for this problem is for governments to get involved by offering deposit insurance, guarantees that banks will not be allowed to fail and close supervision and regulation to ensure that such guarantee do not result in irresponsible behaviour? Don’t you see that this government intervention has arisen because banks are allowed to make promises that they can’t keep.”
I asked Jim whether he was suggesting that instead of promising to repay deposits on demand, banks should convert themselves into unit trusts. That would mean that the amount that investors could get back on demand would vary according to the market value of the financial institution’s loan portfolio.
Jim replied: “I don’t think many people would view that system as a good substitute for conventional bank deposits that are repayable on demand. What I have in mind is that a bank would specify in its agreement with depositors that in the event that it could not meet its promise to repay deposits in full within, say, a month of the request being made, then equity holdings in the bank would immediately be cancelled and re-issued to depositors in proportion to the nominal value of their deposits. The former depositors could decide whether they wanted to liquidate these equity holdings immediately by selling them on the stock market, or to hold on in the hope that the bank’s financial situation would improve.”
I have been thinking about Jim’s proposal. I do not imagine that the conversion of deposits in a troubled bank into equity holdings would be as quick and simple as Jim envisages. Nevertheless his proposal seems to me to be preferable to the current shambles that has arisen as government regulators have sought to substitute their assurances for dodgy promises that financial institutions are not able to keep.
Friday, March 20, 2009
Thursday, March 12, 2009
What is the best analogy to help us understand the financial crisis?
In attempting to understand the current financial crisis I don’t have the benefit of a great deal of knowledge of macroeconomics. Nevertheless, I can understand only too well what many macroeconomists are saying about fiscal stimulus and multipliers because they are using Keynesian language that I learned in my first year at university 45 years ago.
During the 1970s nearly all macroeconomists seemed to abandon the crude Keynesianism that I learned about at university. Why have so many reverted to it at this time? The answer might have more to do with the desire for a comfort blanket in times of uncertainty than with the merits of Keynes’ approach. The Keynesian remedy does not seem to me to be much more relevant to the current situation than it was to the stagflation of the 1970s. It suggests that when you wake up with a debt-induced hangover, then you will soon feel better if you get the government to take on some more debt on your behalf. That doesn’t sound to me like a recipe for a more healthy world economy.
So I have been looking for articles which will help me to understand why the world is in recession and what can be done about it. The best aid to understanding that I have found so far is John Cochrane’s refinery analogy:
“Imagine by analogy that several major refineries had blown up. There would be tankers full of oil sitting in the harbor, and oil prices would be low, yet little gasoline would be available and gas prices would be high. Stimulating people to drive around would not revive gas sales. Borrowing gasoline and using it on infrastructure projects would be worse. The right policy action would obviously be to run whatever government or military refineries could be cobbled together on short notice at full speed, and focus on rebuilding the private ones.” John H Cochrane, ‘Fiscal Stimulus, Fiscal Inflation or Fiscal Fallacies’.
The “major refineries” correspond to the banks that have loaded themselves with toxic assets. The oil tankers sitting in the harbour correspond to the savings that are going to government securities paying low interest rates and the high gas prices correspond to the high price of credit to businesses and consumers (in many countries). The running of government and military refineries at full speed corresponds to the government raising funds by issuing debt and lending it to businesses and consumers.
Cochrane recognizes that this analogy does not give a complete picture of the current situation. He explains that if we just had a shock to the supply of credit (blown up refineries) we would expect to see stagflation – lower quantities of goods and services sold, but upward pressure on prices. Instead we are seeing lower quantities sold and lower inflation. So, we are also seeing a demand shock as a result of people becoming much more averse to holding risks. (The refinery analogy could possibly be stretched to accommodate this. If several major refineries were blown up then investors could be expected to seek to reduce the exposure of their portfolios to other firms that might also be at risk of “blowing up”.)
Would the situation be resolved if the central banks were to target a specific rate of growth in nominal GDP (as I discussed in an earlier post)? The answer might depend on what assets the central banks purchase from the public in pursuit of this objective. If they buy government bonds this will help satisfy the increased demand for money, but not address the supply shock in the credit market. It is possible that the market could take care of this problem e.g. major firms may be able to by-pass the damaged banks by raising funds directly from the public. However, when central banks buy newly-issued commercial paper and securitized debt they are acting directly in place of the injured banks.
As a stop-gap measure this kind of by-pass intervention has the important merit of being a lot easier to unwind than alternative approaches. If central banks confine their purchases to quality assets they will not have any difficulty selling them when inflation begins to rise and people get tired of holding so much money. The effects of fiscal stimulus involving cash splashes by governments are likely to be much more difficult to unwind without a decade or more of high-tax and low-growth stagflation.
It seems to me that current debates about the effectiveness of stimulus packages in lifting aggregate demand tend to miss a more important point about consequences beyond the immediate short term (i.e. long before Keynes’ long run when we will all be dead). John Cochrane makes the point as follows in relation to the U.S. economy:
“If the resources are not there to unwind our current operations, to quickly retire ... newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory.”
During the 1970s nearly all macroeconomists seemed to abandon the crude Keynesianism that I learned about at university. Why have so many reverted to it at this time? The answer might have more to do with the desire for a comfort blanket in times of uncertainty than with the merits of Keynes’ approach. The Keynesian remedy does not seem to me to be much more relevant to the current situation than it was to the stagflation of the 1970s. It suggests that when you wake up with a debt-induced hangover, then you will soon feel better if you get the government to take on some more debt on your behalf. That doesn’t sound to me like a recipe for a more healthy world economy.
So I have been looking for articles which will help me to understand why the world is in recession and what can be done about it. The best aid to understanding that I have found so far is John Cochrane’s refinery analogy:
“Imagine by analogy that several major refineries had blown up. There would be tankers full of oil sitting in the harbor, and oil prices would be low, yet little gasoline would be available and gas prices would be high. Stimulating people to drive around would not revive gas sales. Borrowing gasoline and using it on infrastructure projects would be worse. The right policy action would obviously be to run whatever government or military refineries could be cobbled together on short notice at full speed, and focus on rebuilding the private ones.” John H Cochrane, ‘Fiscal Stimulus, Fiscal Inflation or Fiscal Fallacies’.
The “major refineries” correspond to the banks that have loaded themselves with toxic assets. The oil tankers sitting in the harbour correspond to the savings that are going to government securities paying low interest rates and the high gas prices correspond to the high price of credit to businesses and consumers (in many countries). The running of government and military refineries at full speed corresponds to the government raising funds by issuing debt and lending it to businesses and consumers.
Cochrane recognizes that this analogy does not give a complete picture of the current situation. He explains that if we just had a shock to the supply of credit (blown up refineries) we would expect to see stagflation – lower quantities of goods and services sold, but upward pressure on prices. Instead we are seeing lower quantities sold and lower inflation. So, we are also seeing a demand shock as a result of people becoming much more averse to holding risks. (The refinery analogy could possibly be stretched to accommodate this. If several major refineries were blown up then investors could be expected to seek to reduce the exposure of their portfolios to other firms that might also be at risk of “blowing up”.)
Would the situation be resolved if the central banks were to target a specific rate of growth in nominal GDP (as I discussed in an earlier post)? The answer might depend on what assets the central banks purchase from the public in pursuit of this objective. If they buy government bonds this will help satisfy the increased demand for money, but not address the supply shock in the credit market. It is possible that the market could take care of this problem e.g. major firms may be able to by-pass the damaged banks by raising funds directly from the public. However, when central banks buy newly-issued commercial paper and securitized debt they are acting directly in place of the injured banks.
As a stop-gap measure this kind of by-pass intervention has the important merit of being a lot easier to unwind than alternative approaches. If central banks confine their purchases to quality assets they will not have any difficulty selling them when inflation begins to rise and people get tired of holding so much money. The effects of fiscal stimulus involving cash splashes by governments are likely to be much more difficult to unwind without a decade or more of high-tax and low-growth stagflation.
It seems to me that current debates about the effectiveness of stimulus packages in lifting aggregate demand tend to miss a more important point about consequences beyond the immediate short term (i.e. long before Keynes’ long run when we will all be dead). John Cochrane makes the point as follows in relation to the U.S. economy:
“If the resources are not there to unwind our current operations, to quickly retire ... newly created debt, a large inflation will result as people dump government debt. If history is any guide, this outcome will unleash economic dislocations on a scale to make our current troubles look like a pleasant memory.”
Thursday, March 5, 2009
Can the perceptions of participants influence market fundamentals?
“Reflexivity can be interpreted as a circularity, or two way feedback loop, between the participants’ views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation ... and changes in the situation are liable to change their perceptions ... . The two functions operate concurrently, not sequentially” (George Soros, “The New Paradigm for Financial Markets”, 2008, p 10).
“Many critics of reflexivity claimed that I was merely belabouring the obvious, namely that the participants’ biased expectations influence market prices. But the crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets are always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process” (Soros, op cit, p 57-8).
Does George Soros know what he is talking about? The fact that he has operated successfully in financial markets for a long time suggests to me that he might have a few clues about how they work. But I struggle to understand him.
As is the case with many other problems of understanding, I think my problem in this instance relates to definition of terms. What does Soros mean by fundamentals? If a process is eventually self-defeating then it seems to me that this means that it is inconsistent with the fundamentals of the real world – i.e. it is inconsistent with what we know to be true about such things as resource availability, technology or human nature.
When Soros suggests that market prices can influence the fundamentals he may have something less fundamental in mind such as widely accepted perceptions of investors and credit providers about particular markets or the wider economic situation. It seems plausible that a widespread view that housing was a very safe investment, for example, could be reinforced if house prices began to increase more rapidly and if credit providers perceived that this made lending more secure. Under some circumstances that might, perhaps, result in a self-reinforcing process of increases in house prices that would eventually become self-defeating, for example because increasing numbers of people might decide that they would be better off renting rather than owning a house.
If this is what Soros means by reflexivity, does it help to explain the current financial turmoil? In explaining his super-bubble hypothesis Soros writes:
“The belief that markets tend toward equilibrium is directly responsible for the current turmoil; it encouraged the regulators to ... rely on the market mechanism to correct its own excesses. The idea that prices, although they may take random walks, tend to revert to the mean served as the guiding principle for the synthetic financial instruments and investment practices which are currently unravelling” (Soros, op cit, p 102).
It seems to me that the second part of that statement, relating to synthetic financial instruments, may help to explain the current financial turmoil. With the benefit of hindsight it is apparent that the world economy is suffering from, among other things, the development of a self-reinforcing belief system which led many financial firms to over-value synthetic financial instruments.
However, the first part of Soros’ statement doesn’t make sense. Regulators have not relied on the market mechanism to correct its own excesses. The current turmoil is partly a consequence of a history of financial firms being bailed out by regulators on the grounds that they were too big to be allowed to fail. George Soros is on much firmer ground when he recognises that most reflexive processes involve an interplay between market participants and regulators (p77).
Hopefully, the regulatory environment that emerges from the current turmoil will recognise that participants in financial markets are human. It should not surprise anyone that when financiers are given incentives to behave imprudently they tend to act accordingly.
“Many critics of reflexivity claimed that I was merely belabouring the obvious, namely that the participants’ biased expectations influence market prices. But the crux of the theory of reflexivity is not so obvious; it asserts that market prices can influence the fundamentals. The illusion that markets are always right is caused by their ability to affect the fundamentals that they are supposed to reflect. The change in the fundamentals may then reinforce the biased expectations in an initially self-reinforcing but eventually self-defeating process” (Soros, op cit, p 57-8).
Does George Soros know what he is talking about? The fact that he has operated successfully in financial markets for a long time suggests to me that he might have a few clues about how they work. But I struggle to understand him.
As is the case with many other problems of understanding, I think my problem in this instance relates to definition of terms. What does Soros mean by fundamentals? If a process is eventually self-defeating then it seems to me that this means that it is inconsistent with the fundamentals of the real world – i.e. it is inconsistent with what we know to be true about such things as resource availability, technology or human nature.
When Soros suggests that market prices can influence the fundamentals he may have something less fundamental in mind such as widely accepted perceptions of investors and credit providers about particular markets or the wider economic situation. It seems plausible that a widespread view that housing was a very safe investment, for example, could be reinforced if house prices began to increase more rapidly and if credit providers perceived that this made lending more secure. Under some circumstances that might, perhaps, result in a self-reinforcing process of increases in house prices that would eventually become self-defeating, for example because increasing numbers of people might decide that they would be better off renting rather than owning a house.
If this is what Soros means by reflexivity, does it help to explain the current financial turmoil? In explaining his super-bubble hypothesis Soros writes:
“The belief that markets tend toward equilibrium is directly responsible for the current turmoil; it encouraged the regulators to ... rely on the market mechanism to correct its own excesses. The idea that prices, although they may take random walks, tend to revert to the mean served as the guiding principle for the synthetic financial instruments and investment practices which are currently unravelling” (Soros, op cit, p 102).
It seems to me that the second part of that statement, relating to synthetic financial instruments, may help to explain the current financial turmoil. With the benefit of hindsight it is apparent that the world economy is suffering from, among other things, the development of a self-reinforcing belief system which led many financial firms to over-value synthetic financial instruments.
However, the first part of Soros’ statement doesn’t make sense. Regulators have not relied on the market mechanism to correct its own excesses. The current turmoil is partly a consequence of a history of financial firms being bailed out by regulators on the grounds that they were too big to be allowed to fail. George Soros is on much firmer ground when he recognises that most reflexive processes involve an interplay between market participants and regulators (p77).
Hopefully, the regulatory environment that emerges from the current turmoil will recognise that participants in financial markets are human. It should not surprise anyone that when financiers are given incentives to behave imprudently they tend to act accordingly.
Thursday, February 26, 2009
What will it take to get sustainable recovery?
As readers of this blog will know already, Jim often asks me questions that I can’t answer. This morning he asked me how long it will take for the Australian economy to get back on a sustainable growth path. I was not able to answer directly. I suggested that what happens to economic growth in Australia will depend on what happens in the rest of the world. I added that if the U.S. starts to grow again in 2010 then that will have a positive impact on growth prospects for Japan and China and for commodity exporters like Australia.
Jim asked: “How confident are you about the U.S. starting to grow in 2010?” I started making excuses about my lack of knowledge of the U.S. economy and my poor knowledge of short term macroeconomics. That was when Jim said: “You know that political leaders all over the world have been saying that they will do what it takes to restore confidence and get sustainable recovery.” I nodded as Jim went on: “What they seem to be implying is that they will just keep increasing government spending until people become more confident. Does that make you feel confident?”. I shook my head. Jim then asked: “So what will it take to restore investor and consumer confidence and get sustained recovery?”
I told Jim that was a very good question. That only bought me about a second to gather my thoughts. The only sensible answer that I could think of was that restoring confidence was a matter of establishing a general expectation in the U.S. (and other major economies) that GDP would grow at about the same rate as the trend rate of growth in their productive capacity.
Jim interrupted: “That means boosting aggregate demand. Isn’t that what governments are trying to do now?” My response was that our focus should be on establishing the expectation of sustainable growth in the monetary aggregates rather than just a short-term boost in aggregate demand, with the expectation of a subsequent contraction as soon as inflation raises its ugly head again.
Jim interrupted again: “Next you will be telling me that Milton Friedman was right and what we need is a rule requiring the monetary authority to maintain a specified rate of growth in the stock of money.” I admitted that I still thought Friedman was on the right track, but technical difficulties involved in targeting the money supply would make it more sensible to target growth in nominal GDP (i.e. PY rather than M).
Jim said: “So what you are saying is that if the U.S. central bank were to announce a target rate of growth of nominal GDP and start making appropriate adjustments in monetary policy to achieve that target, then this would restore confidence and promote a sustainable recovery.”
I wish I had sufficient confidence to tell Jim that he had hit the nail on the head. Instead I suggested that rather than trying to put words in my mouth he should take a look at Scott Sumner’s blog: TheMoneyIllusion.
Postscript:
I particularly liked the following posts on Sumner's blog: Why did monetary policy fail?; and The Economics Babel.
Jim asked: “How confident are you about the U.S. starting to grow in 2010?” I started making excuses about my lack of knowledge of the U.S. economy and my poor knowledge of short term macroeconomics. That was when Jim said: “You know that political leaders all over the world have been saying that they will do what it takes to restore confidence and get sustainable recovery.” I nodded as Jim went on: “What they seem to be implying is that they will just keep increasing government spending until people become more confident. Does that make you feel confident?”. I shook my head. Jim then asked: “So what will it take to restore investor and consumer confidence and get sustained recovery?”
I told Jim that was a very good question. That only bought me about a second to gather my thoughts. The only sensible answer that I could think of was that restoring confidence was a matter of establishing a general expectation in the U.S. (and other major economies) that GDP would grow at about the same rate as the trend rate of growth in their productive capacity.
Jim interrupted: “That means boosting aggregate demand. Isn’t that what governments are trying to do now?” My response was that our focus should be on establishing the expectation of sustainable growth in the monetary aggregates rather than just a short-term boost in aggregate demand, with the expectation of a subsequent contraction as soon as inflation raises its ugly head again.
Jim interrupted again: “Next you will be telling me that Milton Friedman was right and what we need is a rule requiring the monetary authority to maintain a specified rate of growth in the stock of money.” I admitted that I still thought Friedman was on the right track, but technical difficulties involved in targeting the money supply would make it more sensible to target growth in nominal GDP (i.e. PY rather than M).
Jim said: “So what you are saying is that if the U.S. central bank were to announce a target rate of growth of nominal GDP and start making appropriate adjustments in monetary policy to achieve that target, then this would restore confidence and promote a sustainable recovery.”
I wish I had sufficient confidence to tell Jim that he had hit the nail on the head. Instead I suggested that rather than trying to put words in my mouth he should take a look at Scott Sumner’s blog: TheMoneyIllusion.
Postscript:
I particularly liked the following posts on Sumner's blog: Why did monetary policy fail?; and The Economics Babel.
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