Papers We Read: Financial Intermediaries and Monetary Economics (bs)

In our yesterdays session, we discussed another paper of Mister Shin, this time a piece he published with Mister Adrian:

Adrian, T. and Shin, H.S. (2011), "Financial Intermediaries and Monetary Economics", Handbook of Monetary Economics, edition 1, volume 3, pp. 601-650.

Here are some key findings:

It seems to be a stylized fact that shifts in the (short-term) policy rate translate directly into shifts in the slope of the yield curve. For this to hold, longer rates must be somewhat stickier than short rates. This is empirically proven by Figure 1 (p.604, see below), which states an almost 1:1 negative relation between changes in the fed fund rate and the term spread.

A higher term spread has important implications for the banking business because it increases its profitability. Hence, the future risk-taking capacity of the banking industry is fostered and thereby credit supply increases. That is, procyclicality in loan supply is explained by the variation of the slope of the yield curve. The risk-taking channel of financial intermediaries - effective also because the banking system is financed increasingly short-term and market-based - entails the policy implication that the short-rate is an important price variable on its own. This stays in contrast to the widely held view of monetary policy that short-rates are simply an instrument to steer longer rates, ultimately the ones that are relevant for consumption and investement decisions. Incremental variations in short-rates can have detrimental effects on a wide range of transactions made by market-based institutions. As the authors argue, for SIV a difference of a quarter percent in funding costs may make all the difference between a profitable venture and a loss-making one (p.605).

It remains a puzzle why financial intermediaries haven't realized those potential funding risks prior to the crisis. It also poses the question if monetary policy was aware of the amplification mechanism that arise because of bank's active balance sheet management. I assume, it was not. Nevertheless, the FED became increasingly tighter in the run-up to the crisis - argueably practiced some sort of "leaning against the wind policy", at least from  2004-2006.

Sadly enough, this tightening did not wind up risky short-term funding or made the financial system any safer. I guess, there is more to come...

NGDP targeting - we are (almost) there (bs)

Probably not just our dear colleague amv is all excited about the FED's new conditional QE3 program. In contrast to previous rounds of QE, now the FED announced to tailor its asset purchases to explicit targets of economic activity and inflation:

 [...] the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy [...]

As popular proponents of NGDP level targeting posit (here), this step comes very close to the desired policy change.

Market Monetarism - a (dis)equilibrium story? (amv)

You may be interest in my guest post at Kantoos Economics. UPDATE: see also Sumner's discussion. UPDATE II: Also Josh Hendrickson discusses my post. UPDATE III: Nick Rowe weighs in.

The damaged ECB legitimacy (fg)

Please find a worth reading comment of Anne Sibert (© VoxEU.org )on the ECB's changing legitimacy since August 2007. Besides the well-known critic on the ECB's liquidity provisions and Secutrity Market Program, the voting procedure, indeed, seems at odds with procedual transparency

It turns out that votes on policy rates are never taken. Apparently, some small subset of the Governing Council decides, prior to the meeting, what the policy rate will be and this is then presented to the entire Governing Council, which we are to believe always or almost always unanimously approves. This explains how the Governing Council is able to produce the lengthy post-policy meeting statement that Mr Trichet views as the ECB’s major contribution to transparency. With the decision made before the meeting, there is ample time to prepare it.
That this extraordinary decision-making mechanism has gone on for so long with no formal explanation beggars belief. Who gets to make the decision? Why is it that no Governing Council member has ever insisted upon their legal right to a vote on monetary policy? Is there really never any dissent? How can that be? That we are able to ask these questions about an institution that is supposed to be one of the world’s two most important central banks is not good for its legitimacy. Moreover, while this arrangement has functioned well enough so far, what would happen if some future president were a little less like Mr Trichet and a little more like, say, Davíð Oddsson?
In Mr Trichet and the Governing Council’s defence, the ECB is woefully badly designed. The Governing Council has 23 members – a ludicrous size for a decision-making body. If each member gets a ten-minute opening statement, the rate-setting meeting would have gone on for almost four hours before any actual debate begins. With no formal way of reducing the size of the decision-making body, Mr Trichet may have had little choice but to make monetary policy informally.

Liquidity support leads to excessive risk-taking (amv)

Incentive systems play a pivotal role in economics (as I argue here). As already emphasized by Adam Smith, the extent to which markets translate 'individual rationality' into 'collective rationality' (i.e., the extent to which markets are 'efficient') depends on institutional configurations or, more precisely, on the proximity of actual institutions to the 'system of natural liberty'.  Mark Mink (© voxEU.org) applies neat rational-choice reasoning to 'show' that an institutional setting characterized by central bank liquidity support is likely to cause excessive risk-taking and, thus, is likely to cause (future) instability:

"Since the outbreak of the global financial crisis in 2007, and particularly since the bankruptcy of Lehman brothers in September 2008, central banks in their roles as lenders of last resort have provided large-scale liquidity support not only to individual banks, but also to the banking sector as a whole. [...] While these extraordinary measures were deemed inevitable in stabilising the banking sector, in Mink (2011) I show that the prospect of receiving liquidity support may distort banks’ risk-taking incentives to a much larger extent than has been acknowledged up to now. In particular, in addition to stimulating excessive maturity transformation, the prospect of receiving liquidity support provides banks with an incentive to increase their leverage, diversify their asset portfolio, lower their lending standards, and to do so in a procyclical manner."

In other words: there ain't no such thing as a free lunch!

Macro Markets and Risk Sharing (fg)

I highly recommend a set of readings of Bob Shiller on creating new market segments that allow to truely insure and hedge aggregate home country and global economic risk:

Shiller proposes a new set of markets that could in theory provide much better diversification opportunities. These so-called macro markets would be large international markets trading, in the form of futures contracts, long-term claims on major components of incomes shared by a large number of people or organizations. For example, in a macro market for the United States, an investor could buy a claim on the U.S. national income and then receive, for as long as the claim is held, dividends equal to a specified fraction of U.S. national income. Such a claim is comparable to a share in a corporation, except that the dividend would equal a share of national income rather than a share of corporate profits. Such markets might exist for entire countries— the United States, Japan, and Brazil—or for regions— such as the European Union and North America. Even a market for claims on the combined incomes of the entire world could be formed. Prices would rise and fall in these markets as new information about national, regional, or global economies became available, just as prices rise and fall in the stock market as new information
about corporate profits is revealed. The potential future importance of these markets is supported by the most basic principle of finance diversification. People could use macro markets to hedge their own national income risks and to invest in the rest of the world. This investment strategy would reduce income growth uncertainty and lead to a more secure financial future

Good to know Bob Shiller already has a patent on a specification on macro markets with nominal GDP securities ;) . The work on this subject includes

• Bob Shiller (1993), Macro Markets. Creating Institutions for for Mangaing Society's Largest Economic Risk, Oxford.
• Bob Shiller (2003), The New Financial Order. Risk in the 21th Century. Princeton.
• Bob Shiller et al (1999), Macro Markets and Financial Security, FRBNY Economic Policy.

I also refer to the idea of Scott Sumner on using nominal GDP futures to extract market expectations on future nominal GDP as both information and target variable for monetary policy.

Jackson Hole Economic Symposium (fg)

Jackson Hole Economic Policy Symposium 2011.

Papers include topics on 'Assessing Current Trends in Global Growth', 'Balancing Growth with Equity', 'Managing Natural Resources in Developing Economies', 'Regulating Financial Markets and Institutions to Promote Growth, and 'Aligning International Capital Flows with Growth'.

A paper I find worth mentioning is from R. Levine on regulating financial markets and insitutions to promote growth:

A broader, long-run consideration of financial development suggests that financial innovation is essential for growth. [...] Without corresponding innovations in finance that match the increases in complexity associated with economic growth, the quality of the financial services diminishes, slowing future growth

Furthermore, both bank and stock market development are independently
associated with growth, suggesting that the policy debate about whether to promote a bank-based system or a market-based financial system misses the big point. Banks and markets matter for growth.

Nobel Laureate Meeting at Lindau (fg)

Please find some enlightening speeches of Nobel Laureates at this year's meeting at Lindau including R. Mundell, J. Nash, R. Auman, E. Prescott, M. Scholes, W. Sharpe.

Mundell: Curreny Wars, Euro Mania, and the Price of Gold; he proposes an international Dollar/Euro fixed exchange rate system

UPDATE: The Financial Times (FTD) reports on Mundell's idea of a new exchange rate system.

Auman: Challenging Nash Equilibrium and the Role of Rational Expectations in Games; why the Nash equilibrium is flawed

Prescott: The Current State of Aggregate Economics; he reviews aggregate modeling and the role of disutility from work.

Nick Rowe strikes back (amv)

Nick Rowe sent me his response and gave me the permission to post it. You find my remarks at the end of his reply. So here we go:

Thanks for your response. I've got several different things I want to say in response, so i will just number them for clarity:

1. Yes, you understood what I'm saying. That's always a relief. I wasn't sure if I was clear enough. 

2. As you say, my critique about fragility in the limit is different from Peter Howitt's critique about dynamic instability under learning. But my intuition (OK, my "gut") tells me that the two are closely related. That if a model is very fragile in my sense it will be unlearnable in Peter's sense. Because if they haven't learned it yet that will cause big changes in how the model behaves, so what they learn from observing the model will be very different from the RE equilibrium.

3. OK, if half the agents make one mistake, and the other half make the exact opposite mistake, the model might behave exactly like an RE model in aggregate. But what if 49.9% make one mistake, and the other 50.1 make the exact opposite mistake? If it's a robust model, that's no big deal. The predictions will be almost identical to full RE. But if the model is "fragile in the limit", that small difference will cause a big bang in the predictions.

4. OK, I concede your main point! A model that is "fragile in the limit" might still be a "useful" model in some sense. But that's a very different sense from the one that we usually have in mind when we talk about models being "useful". Normally we mean something like "there's some sort of rough correspondence between the world and the model". But models can sometimes be "useful" in another way. The Modigliani Miller Theorem would be my favourite example. Someone could argue that the MM model is totally useless as a theory of how the world works, but is still a really useful theory because it tells us what assumptions we need to reject if we want to understand firms' financing.

5. Now I want to go totally off-topic. Well, not totally, but close. Whatever are you guys doing learning that stuff about stability of equilibrium in a Walrasian (OK, Arrow-Debreu, but same difference) economy? We live in a monetary exchange economy with n-1 markets (2 goods each, one of which is the medium of exchange), not a Walrasian economy with one big market where all n goods are traded simultaneously. So Walras' Law is misspecified, because there are n-1 different excess demands for money. Plus, if prices are at disequilibrium levels, either buyers or sellers will be rationed (they won't be able to buy or sell as much as they want), so will reformulate their notional demands and supplies taking those quantity constraints into account. So Walras' Law can't apply anyway, because their demands and supplies in each market are based on the quantity constraints in all the *other* markets, so the sum of the excess demands don't conform to any unified decision-making process based on a single (budget) constraint. We (old) guys learned that in the 1980's. It was called "disequilibrium macro". Then Lucas came along, and (almost) everyone forgot it. But doing stability proofs in a non-monetary economy with a Walrasian auctioneer with "notional" excess demand functions that ignore quantity constraints....now that really is useless. As well as "fragile in the limit"! ;-)

Since it's quite late in good old Germany, I will only comment on #5. Well, perhaps my recourse to the SMD results becomes more comprehensible if I tell you that I'm a historian of economics. So my job is to cope with the 'wrong ideas of dead men' (or at least quite old men). That may explain my focus on Arrow-Debreu models. Yet note that I used the SMD results only as an example to make my point. You could find other frameworks to make the same point. I'm just writing about SMD, so it seemed natural to use it. Actually, I would be pleased if SMD results would figure more prominently in our curricula. Since it is a highly negative result, applied economists should be aware of it. In particular when you are a Arrow-Debreu sceptic, you should welcome higher awareness of the generic impossibility to establish global uniqueness and stability by means of 'proper microfoundations'. This is because Arrow-Debreu reasoning is not as dead as perhaps it should be. Be it as it may, I'm happy that you concede my main argument (#4).

Actually, I concede your point about Walras' Law. Right because I'm a historian of economics, I'm well aware of the precious results by Clower and Leijonhuvfud that you "(old) guys" studied some hundred years ago (more or less), and that unfortunately disappeared from modern curricula. In concrete, I concede that in a monetary economy it is crucial to distinguish between notational and effective demand and, hence, to know of Clower's dual decision hypothesis. Consequently, I do accept that Walras' Law applies if and only if effective demands coincide with notational demands and that this do not have to be the case. So you preach to the converted!

A response to Nick Rowe: Fragility at the limit (amv)

I promised Nick Rowe to respond to his post on what he calls "fragility at the limit'. It is a follow-up on the debate on Kocherlakota's argument that it is possible to determine long-run inflation expectations by setting nominal yields according to the Fisher relation. Let me start with a disclaimer: I do not believe that central banking is or should be using nominal yields in the way Kocherlakota suggests. I am interested in the theoretical model underlying Kocherlakota's argument. I further believe there is a grain of truth in his statement, since I 'believe' in long-run neutrality. As I mentioned many times before, I side with Sumner & his allies on NGDP- or (at least) price-level targeting.

Nick introduces an interesting argument. If I got him right, he accepts that Kocherlakota's argument is a sound REE-prediction. He however argues that the model is 'fragile'. To show what he means, he partitions the set of agents by defining a fraction f of adaptive agents on [0,1] (and, accordingly, a fraction (1-f) of RE-agents). The same fraction partitions the bahavior of firms, that is, f gives the fraction of sluggish price setters, while (1-f) gives the set of instantaneous price setters.

He starts with f=1 and argues, correctly, that an 1% increase in nominal yields suggests a 1% increase in real yields and, thus, initiates a sluggish deflationary (or disinflationary) process. As f approaches zero, that is, as the fraction of RE-agents who adjust prices instantaneously increases, the same 1% increase in nominal yields results in ever faster deflationary processes. As f approaches zero, increasing nominal yields suggests "instant explosive deflation". At the limit, however, that is, for f=0, Kocherlakota's model applies, that is, a 1% increase in nominal yields suggest 1% higher inflation expectations.

Nick concludes: "Suppose that the predictions in the limit (as the assumptions approached the model's assumptions) were totally different from the predictions at the limit. That would be a model that is fragile in the limit. And that, to my mind, would be a totally useless model."

Now, in this post I do not want to talk about monetary policy. As I mentioned before (in some comment section), I dislike DeGrauwe-type models, because they suggest that RE is a restriction on individual behavior. I rather side with Arrow, who convincingly argues that RE as an individual assumption is prohibitively restrictive. RE is a general equilibrium notion; REE defines a class of GE models; REE-price systems reflect information as if agents had the super-human capabilities Arrow is referring to. What is needed, of course, is some kind of mechanism, like Sandroni's market selection process, that establishes convergence in case of agents with bounded cognitive and information-processing capabilities. In case of monetary macro models, other learning processes are relevant, like Howitt's, who argues that if QTM-logic applies, and if central banks can manipulate nominal interest rates only by adjusting monetary base in the inverse direction, then a Kocherlakota-type REE is unlearnable. Note, however, that this is about the REE's dynamic stability and not about Nick's concept of 'fragility at the limit'.

To show what I mean, let me take an example that is totally unrelated to monetary policy. Let me talk about the Sonnenschein-Mantel-Debreu results (SMD). The Debreu version (1974) claims that given any function, say g, from the unit price simplex to a k-dimensional commodity space satisfying continuity, homogeneity, Walras's Law, and a boundary condition, then for every compact subset of the price simplex there exists an exchange economy with k 'well-behaved' agents such that the aggregate excess demand of that economy is equal to g(p) on the compact subset. Thus, if structure is imposed by restrictions on individuals (those restrictions that suggest utility and profit maximization),  most of it is lost by aggregation (only continuity, homogeneity, and Walras' Law survive the adding-up of individual demands). Thus, sufficiency conditions for global uniqueness and global stability imposed on the system like gross substitutionality do not have microfoundations.

The SMD results are true for arbitrary dispersions of individual characteristics like preference and endowments. Imagine a convergent sequence of Arrow-Debreu exchange economies with a large but finite number of agents and commodities, decreasing in the dispersions of such primitives. States differently: for any sufficiently large n in the index set we have arbitrary dispersions of primitives; as n increases, dispersion decreases; in the limit, all agents have identical preferences and endowments. The last such economy in the sequence before we reach the limit is one with identical preferences and collinear endowments. As shown by Kirman and Koch (1986), the SMD results still apply. Up to this economy, there is no hope for global uniqueness and stability. But this is evidently not true for the limit economy, which in fact is a quasi-Crusoe economy. Global uniqueness and stability is trivial. Thus, as in Nick's framework, the sequence is discontinuous, that is, it jumps at the limit.

According to Nick's definition, we can say that the SMD results are 'fragile at the limit'. But his core statements that this implies 'uselessness' does not follow. It just tells us if we find an economy with strictly identical agents, we can hope for global uniqueness and stability. Otherwise, we have to make other restrictions than those on individuals (see Werner Hildenbrand on this). What this shows is that Nick's argument is not generically true as it is implied to be. An even though the SMD results tell us something about global stability of each economy in our sequence (or rather the lack thereof), Nick's notion of 'fragility at the limit' is about the continuity properties of a sequence of models (or rather about the lack thereof). As he insists, many economist do not pay enough attention to stability properties. I also believe that this is important. But as I tried to argue, his notion of 'fragility at the limit' is not concerned with dynamic stability issues.

The economy as a complex adaptive system (amv)

Herbert Gintis discusses Eric Beinhocker's Origin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics and thereby provides the basics of complex adaptive systems. Highly recommended.

Otmar Issing on consensus views (fg)

Quote from Otmar Issing's speech 'Lessons for Monetary Policy. What should be Consensus' at IMF.

My question is—always, and not only from hindsight–whether this [Sticking to Inflation Targeting and to the benign neglect view of dealing with asset prices] is all. Because if this is your position, that monetary policy should deal with asset prices only on the way down, it is a totally asymmetric approach. It implies that as long as asset prices go up, the central bank is saying, it's not our business. If asset prices collapse after a bubble bursts, then the central banks have to come to the rescue. They are the savior. I think this asymmetric approach implies the risk of a series of ever-increasing bubbles, because you never correct the causes that have led to the bubble.

Leijonhuvud on adaptive systems, volatility and endogenous behavioral time horizons (fg)

A. Leijonhuvud gives a further insight on the state of macro research. Starting from the critique on rational expectations, he emphasizes the importance of agents adapting to an open system where agents must refine and adapt to events whose probability had not been estimated correctly. Intertemporal optimization cannot be the true representation of behavior, but it represents an approximation. In volatile times, however, agents are forced to react to current events. Volatility shortens time hoirzons in which short-sighted adaptive behavior generates non-linear dynamics with positive feedback.

Furthermore, Leijonhuvud distinguishes between three forms of feedback regions: region (1) with exclusive negative feedback dynamics and equilibrim outcomes, region (2) with tightly bounded positive feedback loops and business cycle fluctuations, for instance generated by the multiplier concept or the financial accelerator; and region (3) with dangerous instabilites and high positive feedback loops (Fisherian debt-deflation). Region 3 ist reached when budget constraints are violated; whereas the transformation from region (2) to region (3) is caused by leverage and financial budget constraint violations. The slow build-up of leverage in the economy increases the connectivity of the network of debts and claims, and combined with underlying maturity mismatch, it makes the system more fragile.

His main conclusion:

• The first is that we have to think of an economy as an “open system” in the ontological sense of Tony Lawson (this will require us to adapt out methods to the nature of an economy – to change how we do economics).
• The second is that the economy is not globally stable but harbors instabilities
  

Roman Frydman on REH (amv)

Noble Prize 2010 (amv)

This year's winners: Peter A. Diamond, Dale T. Mortensen, Christopher A. Pissarides "for their analysis of markets with search frictions". Good choice. More information here.

As always: all predictions failed.

Ach Olaf (amv)

Da hat es sich jemand aber einfach gemacht: Leben in einer Scheinwelt.

Pretense of knowledge (amv)

Pretense of knowledge is the title of Hayek's Prize lecture back in 1974. It's a critique of economics prevailing at that time. Now, MIT's Ricardo J. Caballero has a working paper called "Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome"  Here, the abstract:

In this paper I argue that the current core of macroeconomics—by which I mainly mean the so-called dynamic stochastic general equilibrium approach—has become so mesmerized with its own internal logic that it has began to confuse the precision it has achieved about its own world with the precision that it has about the real one. This is dangerous for both methodological and policy reasons. On the methodology front, macroeconomic research has been in “fine-tuning” mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in “broad-exploration” mode. We are too far from absolute truth to be so specialized and to make the kind of confident quantitative claims that often emerge from the core. On the policy front, this confused precision creates the illusion that a minor adjustment in the standard policy framework will prevent future crises, and by doing so it leaves us overly exposed to the new and unexpected.

I like it. Especially this (p. 7):

We are digging ourselves, one step at a time, deeper and deeper into a Fantasyland, with economic agents who can solve richer and richer stochastic general equilibrium problems containing all sorts of frictions. Because the “progress” is gradual, we do not seem to notice as we accept what are increasingly absurd behavioral conventions and stretch the intelligence and information of underlying economic agents to levels that render them unrecognizable.

Nobel Prize predictions 2010 (amv)

Here, the 2010 Thomson Reuters Predictions:

Alberto Alesina: Nathaniel Ropes Professor of Political Economics, Department of Economics, Harvard University, Cambridge, MA USA

Why: for theoretical and empirical studies on the relationship between politics and macroeconomics, and specifically for research on politico-economic cycle

Nobuhiro Kiyotaki: Professor of Economics, Department of Economics, Princeton University, Princeton NJ USA

Why: for formulation of the Kiyotaki-Moore model, which describes how small shocks to an economy may lead to a cycle of lower output resulting from a decline in collateral values that creates a restrictive credit environment

John H. Moore: George Watson’s and Daniel Stewart’s Professor of Political Economics, University of Edinburgh, Edinburgh, Scotland, and Professor of Economics, Department of Economics, London School of Economics, London, England

Why: for formulation of the Kiyotaki-Moore model, which describes how small shocks to an economy may lead to a cycle of lower output resulting from a decline in collateral values that creates a restrictive credit environment

Kevin M. Murphy: George J. Stigler Distinguished Service Professor of Economics, University of Chicago Booth School of Business, Chicago, IL USA, and Senior Fellow, Hoover Institution, Stanford CA USA

Why: for pioneering empirical research in social economics, including wage inequality and labor demand, unemployment, addiction, and the economic return of investment in medical research, among other topics
 
I think Kiyotaki-Moore would be fine. I would give it to Werner Hildenbrand, Hugo Sonnenschein, and Roy Radner, for obvious reasons. But this will not happen.
 
Check also the market predictions here. Shiller is #3.

Sargent, the Great, on modern macro (amv)

Here. Fg will like it.

On the economists' failure to predict crises (amv)

Excellent statement by Stephen Smale, in: Dynamics in General Equilibrium Theory, The American Economic Review, Vol. 66, No. 2, Papers and Proceedings of the Eightyeighth Annual Meeting of the American Economic Association (May, 1976), pp. 288-294:

A criticism commonly made of economic theory is its failure to make predictions of crises in the country or to anticipate correctly unemployment or inflation. One must be cautious in the social sciences about looking toward physics for answers. However, some comparisons with the physical sciences seem profitable in connection with the above criticism. In those sciences, where theory itself is in a far more advanced state, limitations can be seen in a similar way. For example a given individual human body functions according to physical principles; however no physical scientist would predict a heart attack. The physical theory gives understanding of aspects of what goes on in the human body only under very idealized conditions. The physical theories eventually play some role in the education of medical doctors, who can then say some things, some times about a patient's susceptibility to a heart attack, preventive measures, and cures.

The economy of the world or even a nation is a very complex phenomenon, like a human body, involving a number of factors, both economic and political. It is no more reasonable to expect economic theorists to predict a nation's economic future than for a theoretical scientist to predict the future health of an individual.