Monday, October 29, 2007

Leijonhufvud, Wicksell and Big Finance (fg)

Of course, Axel Leijonhufvud, again writes in his most recent Policy Insight about the danger of financial instability.

Leijonhufvod describes in his compelling way how in Wicksell's model money is demand-determined and why the money stock and , thus, the price level are indetermined unless the central bank controls the direction of price-level changes via its discount rate by hitting the right "natural" rate of interest (page 4).

Today's world resembles Wicksell's world in some way, especially the finance sector's attempt to produce more convient subsitutes for paper currency (just think of the many new financial instruments and deregulation attempts initiated by big banks). Whereas velocity had an upper bound (to put in Leijonhufvud words i.e. how fast a messanger boy could run) in fomer times, a reasonable stable demand function on part of the private sector does not hold in times where rates of returns on non-money assets affect money holdings and the financial sector shifts the money-aggregate demand nexus by finding new ways to substitute for a controlled (monetary) aggregate or a (controlled) asset price, i.e. the inverse of the discount rate.

Leijonhufvud's point is that today's central bank strategies which can be described as Inflation Targeting do not protect a nation against financial instability. The recent crisis showed that although goods inflation was supposed to be under control, asset price inflation caused by massive liquidity and strenghted by lowering credit standards and decreasing risk premia was the result. The old wisdom of maturity mismatch as well as leverage opportunities center financial market behaviour seeking for high profits.

To conlucde, the author recommend to re-think financial regulation and the market-power concentration of hugh banking conglomerates (see for example amv's comment on Hank Paulson Superfund project to bail-out bank losses). Leijonhuvfud concludes:
But when we find the government repeatedly aiding and abetting the collusion of these financial behemoths, which we have allowed to grow too big to fail, some rethinking of the relationship between government and big finance would seem to be in order.
D'accord! When analyzing recent monetary policy, awash in liquidity was the main reason for mispricing of various asset classes. And I agree that the considerable lowering of credit standards made events worse. As I previously stated, let the banks suffer with shrinking equity and don't let them escape with this ugly Superfund! Obviously, this process would go hand in hand with real economic costs. However, the "de-leveraging" of big finance would have to come anyway.