Comments on crude pricing, the economy, and the banking system

Crude pricing

The Saudis are the ‘supplier of last resort’/swing producer. Every day the world buys all the crude the other producers sell to the highest bidder and then go to the Saudis for the last 9-10 million barrels that are getting consumed. They either pay the Saudis price or shut the lights off, rendering the Saudis price setter/swing producer.

Specifically, the Saudis don’t sell at spot price in the market place, but instead simply post prices for their customers/refiners and let them buy all they want at those prices.

And most recently the prices they have posted have been fixed spreads from various benchmarks, like Brent.

Saudi spread pricing works like this:
Assume, for purposes of illustration, Saudi crude would sell at a discount of $1 vs Brent (due to higher refining costs etc.) if they let ‘the market’ decide the spread by selling a specific quantity at ‘market prices’/to the highest bidder. Instead, however, they announce they will sell at a $2 discount to Brent and let the refiners buy all they want.

So what happens?
The answer first- this sets a downward price spiral in motion. Refiners see the lower price available from the Saudis and lower the price they are willing to pay everyone else. And everyone else is a ‘price taker’ selling to the highest bidder, which is now $1 lower than ‘indifference levels’. When the other suppliers sell $1 lower than before the Saudi price cut/larger discount of $1, the Brent price drops by $1. Saudi crude is then available for $1 less than before, as the $2 discount remains in place. Etc. etc. with no end until either:
1) The Saudis change the discount/raise their price
2) Physical demand goes up beyond the Saudis capacity to increase production

And setting the spread north of ‘neutral’ causes prices to rise, etc.

Bottom line is the Saudis set price, and have engineered the latest decline. There was no shift in net global supply/demand as evidenced by Saudi output remaining relatively stable throughout.

The Global Economy

If all the crude had simply been sold to the highest bidder/market prices, in a non monetary relative value world the amount consumed would have been ‘supply limited’ based on the real marginal cost, etc. And if prices were falling do to an increased supply offered for sale, the relative price of crude would be falling as the supply purchased and consumed rose. This would represent an increase in real output and real consumption/real GDP(yes, real emissions, etc.)

However, that’s not the case with the Saudis as price setter. The world was not operating on a ‘quantity constrained’ basis as the Saudis were continuously willing to sell more than the world wanted to purchase from them at their price. If there was any increase in non Saudi supply, total crude sales/consumption remained as before, but with the Saudis selling that much less.

Therefore, with the drop in prices, at least in the near term, output/consumption/GDP doesn’t per se go up.

Nor, in theory, in a market economy/flexible prices, does the relative value of crude change. Instead, all other prices simply adjust downward in line with the drop in crude prices.

Let me elaborate.
In a market economy (not to say that we actually have one) only one price need be set and with all others gravitating towards ‘indifference levels’. In fact, one price must be set or it’s all a ‘non starter’. So which price is set today? Mainstream economists ponder over this, and, as they’ve overlooked the fact that the currency is a public monopoly, have concluded that the price level exists today for whatever ‘historic’ reasons, and the important question is not how it got here, but what might make it change from today’s level. That is, what might cause ‘inflation’. That’s where inflation expectations theory comes in. For lack of a better reason, the ‘residual’ is that it’s inflation expectations that cause changes in the price level. And not anything else, which are relative value stories. And they operate through two channels- workers demanding higher wages and people accelerating purchases. Hence the fixation on wages as the cause of inflation, and using ‘monetary policy’ to accelerate purchases, etc.

Regardless of the ‘internal merits’ of this conclusion, it’s all obviated by the fact that the currency itself is a simple public monopoly, rendering govt price setter. Note the introduction of monetary taxation, the basis of the currency, is coercive, and obviously not a ‘market expense’ for the taxpayer, and therefore the idea of ‘neutrality’ of the currency in entirely inapplicable. In fact, since the $ to pay taxes and buy govt secs, assuming no counterfeiting, ultimately come only from the govt of issue, (as they say in the Fed, you can’t have a reserve drain without a prior reserve add), the price level is entirely a function of prices paid by the govt when it spends and/or collateral demanded when it lends. Said another way, since we need the govt’s $ to pay taxes, the govt is, whether it knows it or not, setting ‘terms of exchange’ when it buys our goods and service.

Note too that monopolists set two prices, the value of their product/price level as just described above, and what’s called the ‘own rate’/how it exchanges for itself, which for the currency is the interest rate, which is set by a vote at the CB.

The govt/mainstream, of course, has no concept of all this, as inflation expectations theory remains ‘well anchored.’ ;)

In fact, when confronted, argues aggressively that I’m wrong (story of my life- remember, they laughed at the Yugo…)

What they have done is set up a reasonably deflationary purchasing program, of buying from the lowest bidder in competition, and managed to keep federal wages/compensation a bit ‘behind the curve’ as well, partially indexed to their consumer price index, etc.

And consequently, govt has defacto advocated pricing power to the active monopolist, the Saudis, which explains why changes in crude prices and ‘inflation’ track as closely as they do.

Therefore, the way I see it is the latest Saudi price cuts are revaluing the dollar (along with other currencies with similar policies, which is most all of them) higher. A dollar now buys more oil and, to the extend we have a market economy that reflects relative value, more of most everything else. That is, it’s a powerful ‘deflationary bias’ (consequently rewarding ‘savers’ at the expense of ‘borrowers’) without necessarily increasing real output.

In fact, real output could go lower due to an induced credit contraction, next up.

Banking

Deflation is highly problematic for banks. Here’s what happened at my bank to illustrate the principle:

We had a $6.5 million loan on the books with $11 million of collateral backing it. Then, in 2009 the properties were appraised at only $8 million. This caused the regulators to ‘classify’ the loan and give it only $4 million in value for purposes of calculating our assets and capital. So our stated capital was reduced by $2.5 million, even though the borrower was still paying and there was more than enough market value left to cover us.

So the point is, even with conservative loan to value ratios of the collateral, a drop in collateral values nonetheless reduces a banks reported capital. In theory, that means if the banking system needs an 8% capital ratio, and is comfortably ahead at 10%, with conservative loan to value ratios, a 10% across the board drop in assets prices introduces the next ‘financial crisis’. It’s only a crisis because the regulators make it one, of course, but that’s today’s reality.

Additionally, making new loans in a deflationary environment is highly problematic in general for similar reasons. And the reduction in ‘borrowing to spend’ on energy and related capital goods and services is also a strong contractionary bias.

UPDATE: Saudi Arabia cuts all oil prices to U.S., Asia – Bloomberg (OIL)

Dec 4 — Saudi Arabia cuts all oil prices to U.S. and Asia, according to Bloomberg headlines.

UPDATE: Reports have the message issued by Saudi Aramco — the state-owned oil and gas giant — now recalled.

EU Commission- more of same

:(

Latvia’s Dombrovskis Brings Fiscal Hawk Record to EU Commission

By Mathew Dalton

Oct 5 (WSJ) — The budget hawk who steered Latvia out of economic collapse with a bruising austerity program is poised to get one of the EU’s top economic-policy jobs as Europe is heading toward a clash over austerity.

Former Prime Minister Valdis Dombrovskis is nominated to join the European Commission, the European Union’s executive arm, as one of its top economic policy makers. When he appears before the European Parliament for his confirmation hearing on Monday, one of the main questions will likely be whether he plans to bring the tough policies he used in Latvia to a much bigger stage.

A host of Europe’s deep-seated economic problems await him. They include anemic growth, high unemployment and the threat of deflation, all of which may haunt the region for years to come.

The 43-year-old Mr. Dombrovskis, whose portfolio will include oversight of national budgets, will be at the center of the debate now raging in Europe about whether tight budgets will exacerbate those problems and fuel the rise of extremist, anti-EU political parties.

His most immediate problem will be how to bring the finances of the French and Italian governments back in line with the EU’s budget rules. Paris and Rome argue the dismal shape of their economies means they should be granted more time to hit EU budget targets.

Wielding degrees in economics and physics, Mr. Dombrovskis brings formidable technical skills to the debates that lie ahead, say people who have worked with him, along with a free-market—some would say right-wing—economic philosophy and a direct personal style. “He’s very focused on fiscal rigor,” said Olli Rehn, a member of the European Parliament and the EU’s previous economics commissioner, who worked with Mr. Dombrovskis on an international bailout for Latvia in 2009. “He’s quite blunt and quite straightforward. I don’t know if that is being right-wing or not.”

Under Mr. Dombrovskis’s leadership, Latvia adopted sharp spending cuts to win emergency loans from the EU and the International Monetary Fund. His government kept the Latvian currency pegged to the euro, a measure that many economists say deepened the country’s pain.

The economy ultimately shrank by 25%. Poverty soared, as did emigration. The IMF sometimes chided Mr. Dombrovskis’s government for not doing enough to shield poorer Latvians from the hardship of the crisis.

Mr. Dombrovskis said that Latvia had no other choice but to cut deeply and that he wouldn’t necessarily recommend the Latvian solution for other countries. “I don’t think we can say that something is mechanically applicable from one situation to another,” he said.But he does argue that cutting the budget deficit quickly, as Latvia did in 2009 and 2010, is the best way to stabilize government finances. That puts him at odds with some economists and European officials, who have argued that sharp cuts can actually widen the deficit by throwing the economy into a deep recession. Mr. Dombrovskis also sought to temper his image as a hard-core budget hawk: “I see my task as balancing the economic and financial side, with the social side,” he said.

Einars Repše, Mr. Dombrovskis’s finance minister, said that Mr. Dombrovskis often mediated between competing forces in the government on budget questions.

“I recollect him being more on the cautious side than myself,” Mr. Repše said. “I was much more a supporter of radical and immediate consolidation.”

Starting in 2011, Latvia posted some of the highest growth rates in the EU. Its bailout program has been hailed a success by officials in Brussels and Washington, burnishing Mr. Dombrovskis’s international profile. Yet the unemployment rate is still 11% and many of the country’s younger and better-educated workers have emigrated, facts that often go unmentioned by Latvia’s boosters.

“There is still much more to do in Latvia,” Mr. Dombrovskis acknowledges.

In the next commission, with Jean-Claude Juncker as president, Mr. Dombrovskis is expected to be the hawkish foil to Pierre Moscovici, the dovish former French finance minister with whom he will share decision-making powers over national budgets. Mr. Rehn said the turmoil of the Latvian bailout, when his government occasionally came to the brink of collapse, should serve him well as he navigates the commission’s internal debates.

“He has cool nerves and strong composure,” Mr. Rehn said, “and he can intellectually handle difficult situations under pressure.”

Mexico cuts rates

Little do they know that lowering rates removes interest income from the economy and on the supply side lowers costs and lowers forward prices, thereby reducing inflationary forces…

Mexico central bank unexpectedly cuts rate to spur weak economy

By Michael O’Boyle and Alexandra Alper

June 6 (Reuters) — Mexico’s central bank unexpectedly slashed interest rates to a record low on Friday, saying a sluggish economy gave it room for a one-off cut to spur growth without fanning inflation pressures.

The Banco de Mexico cut its benchmark interest rate by 50 basis points to 3.00 percent, surprising 21 analysts who had unanimously forecast in a Reuters poll that rates would stay on hold.

Latin America’s No. 2 economy barely grew in the first quarter as a harsh winter dragged on growth in the United States, Mexico’s top trading partner, while Mexican tax hikes hit domestic demand.

“Given the greater margin of slack in the economy, the efficient convergence of inflation towards 3 percent is feasible with a lower reference interest rate,” the central bank said in a statement.

Policymakers said they did not expect to further cut rates, suggesting even lower borrowing costs would not be prudent since the United States is expected to begin a tightening cycle and growth in Mexico is forecast to pick up.

The bank’s move stunned markets. Traders reported chaos on trading floors. Mexican bond yields tumbled and the stock market rose to its highest level this year, while the peso currency briefly hit a session low.

Prices for the county’s benchmark 10-year peso bond jumped, pushing down its yield by 33 basis points in the biggest one-day drop since last September. “Banks were really caught off guard,” said one Mexico-based bond broker. The cut was surprising given the bank’s conservative reputation. Analysts speculated the decision was split, reasoning that Gov. Agustin Carstens likely pushed for a bold cut, overriding concerns of other board members about inflation.

In its decision, the central bank said inflation risks have lessened. Annual inflation has been falling since it spiked above the central bank’s 4 percent limit in January, largely due to new taxes on soft drinks and fast food.

But policymakers said there were still risks that economic growth could slow after a weaker-than-expected start to the year. Last month the government cut its estimate for annual growth in 2014 from 3.9 percent to 2.7 percent.

The central bank said despite stronger exports, it was still worried about weakness in domestic spending.

The country’s central bank had not been expected to lower its main rate so far below the current inflation rate, which was 3.44 percent in the 12-month period though mid-May.

In previous years, sharp drops in the peso currency have made Mexican interest rate cuts risky since lower borrowing costs could push yield-hungry investors to dump Mexican fixed income assets and further hurt the currency.

A weak currency can spur inflation through higher import prices. Analysts said the central bank was taking advantage of renewed calm in financial markets and the recent dip in inflation to shore up economic growth.

“They seized the moment,” said Delia Paredes, an economist at Banorte bank in Mexico City. “It was quite a surprise.”

Professor Andrea Terzi quoted on CNBC

Well done!!!!

You’d think he’d turn to Brits like Charles Goodhart who wrote volumes on it for the last 50 years!
;)

How QE may be doing more harm than good

By Paul Gambles

May 7 (CNBC) — I’ve spent the last few weeks talking almost entirely about the Bank of England’s (BoE) latest research findings – and that we’re headed toward what could be the most almighty economic and market meltdown ever seen unless we embark on drastic changes in economic policy.

The default reaction to this has tended to be a mixture of incredulity and confusion, with most people wondering “What’s Gambles going on about now?” This piece is an attempt at proclaiming a pivotal moment in economic understanding at a key time for the global economy.

The findings in question are contained in the BoE’s Quarterly Bulletin. The paper’s introduction states that a “common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach.”

This “misconception” is obviously shared by the world’s policymakers, including the U.S. Federal Reserve, the Bank of Japan and the People’s Bank of China, not to mention the Bank of England itself, who have persisted with a policy of quantitative easing (QE).

QE is seen by its adherents, such as former U.S. Federal Reserve Chairman Ben Bernanke, as both the panacea to heal the post-global financial crisis world and also the factor whose absence was the main cause of the Great Depression. This is in line with their view that central banks create currency for commercial banks to then lend on to borrowers and that this stimulates both asset values and also consumption, which then underpin and fuel the various stages of the expected recovery, encouraging banks to create even more money by lending to both businesses and individuals as a virtuous cycle of expansion unfolds.

The theory sounds great.

However it has one tiny flaw. It’s nonsense.

Back in June 2011, when CNBC’s Karen Tso asked me why I was so critical of Ben Bernanke, an acknowledged academic expert on The Great Depression, I explained that I couldn’t justify the leap of blind faith demanded by Bernanke’s neo-classical monetarist theories.

Professor Hyman Minsky was one of the first to recognize the flaw in those theories. He realized that in practise, in a credit-driven economy, the process is the other way round. The credit which underpins economic activity isn’t created by a supply of large deposits which then enables banks to lend; instead it is the demand for credit by borrowers that creates loans from banks which are then paid to recipients who then deposit them into banks. Loans create deposits, not the other way round.

In the BoE’s latest quarterly bulletin, they conceded this point, recognizing that QE is indeed tantamount to pushing on a piece of string. The article tries to salvage some central banker dignity by claiming somewhat hopefully that the artificially lower interest rates caused by QE might have stimulated some loan demand.

However the elasticity or price sensitivity of demand for credit has long been understood to vary at different points in the economic cycle or, as Minsky recognized, people and businesses are not inclined to borrow money during a downturn purely because it is made cheaper to do so. Consumers also need a feeling of job security and confidence in the economy before taking on additional borrowing commitments.

It may even be that QE has actually had a negative effect on employment, recovery and economic activity.

This is because the only notable effect QE is having is to raise asset prices. If the so-called wealth effect — of higher stock indices and property markets combined with lower interest rates — has failed to generate a sustained rebound in demand for private borrowing, then the higher asset values can start to depress economic activity. Just think of a property market where unclear job or income prospects make consumers nervous about borrowing but house prices keep going up. The higher prices may act as either a deterrent or a bar to market entry, such as when first time buyers are unable to afford to step onto the property ladder.

Dr Andrea Terzi, Professor of Economics at Franklin University, also suggests that many in the banking and finance industry, who often have trouble with the way academics teach and discuss monetary policy, will find the new view much closer to their operational experience. “The few economists who have long rejected the ‘state-of-the-art’ in their models, and refused to teach it in their classrooms, will feel vindicated,” he adds.

Foremost among those economists is Prof Steve Keen: a long-time proponent of the alternative view, endogenous money. Having co-presented with Prof. Keen, I’ve been taken with the way that his endogenous money beliefs stand up to ‘the common sense test.’ The proverbial ‘man on the Clapham omnibus’ knows that borrowing your way out of debt while your returns are dwindling makes no sense. Friedman and Bernanke couldn’t see that.

Ben Bernanke positioned himself as a student of history who had learned from the mistakes of the past. Dr. Terzi questions this, “This view that interest rates trigger an effective ‘transmission mechanism’ is one of the Great Faults in monetary management committed during the Great Recession.”

“The reality is that the level of interest rates affects the economy mildly and in an ambiguous way. To state that monetary policy is powerful is an unsubstantiated claim.”

For a central bank to recognize that its economic understanding is flawed is a major admission. However, unless it takes the opportunity to correct its policy in line with this new understanding then it will repeat the same old mistakes.

The world’s central banks are steering a course unwittingly directly towards a repeat of the 1930s but on a far greater scale. It’s not yet clear that there is any commitment to change this course or indeed whether there is still time to do so. Either way, it will be very interesting to see what future economic historians make of Ben Bernanke’s contribution to economic policy.

Comments on Martin Wolf’s banking article

Strip private banks of their power to create money

By: Martin Wolf
The giant hole at the heart of our market economies needs to be plugged

Printing counterfeit banknotes is illegal, but creating private money is not. The interdependence between the state and the businesses that can do this is the source of much of the instability of our economies. It could – and should – be terminated.

It is perfectly legal to create private liabilities. He has not yet defined ‘money’ for purposes of this analysis

I explained how this works two weeks ago. Banks create deposits as a byproduct of their lending.

Yes, the loan is the bank’s asset and the deposit the bank’s liability.

In the UK, such deposits make up about 97 per cent of the money supply.

Yes, with ‘money supply’ specifically defined largely as said bank deposits.

Some people object that deposits are not money but only transferable private debts.

Why does it matter how they are labeled? They remain bank deposits in any case.

Yet the public views the banks’ imitation money as electronic cash: a safe source of purchasing power.

OK, so?

Banking is therefore not a normal market activity, because it provides two linked public goods: money and the payments network.

This is highly confused. ‘Public goods’ in any case aren’t ‘normal market activity’. Nor is a ‘payments network’ per se ‘normal market activity’ unless it’s a matter of competing payments networks, etc. And all assets can and do ‘provide’ liabilities.

On one side of banks’ balance sheets lie risky assets; on the other lie liabilities the public thinks safe.

Largely because of federal deposit insurance in the case of the us, for example. Uninsured liabilities of all types carry ‘risk premiums’.

This is why central banks act as lenders of last resort and governments provide deposit insurance and equity injections.

All that matters for public safety of deposits is the deposit insurance. ‘Equity injections’ are for regulatory compliance, and ‘lender of last resort’ is an accounting matter.

It is also why banking is heavily regulated.

With deposit insurance the liability side of banking is not a source of ‘market discipline’ which compels regulation and supervision as a simple point of logic.

Yet credit cycles are still hugely destabilising.

Hugely destabilizing to the real economy only when the govt fails to adjust fiscal policy to sustain aggregate demand.

What is to be done?

How about aggressive fiscal adjustments to sustain aggregate demand as needed?

A minimum response would leave this industry largely as it is but both tighten regulation and insist that a bigger proportion of the balance sheet be financed with equity or credibly loss-absorbing debt. I discussed this approach last week. Higher capital is the recommendation made by Anat Admati of Stanford and Martin Hellwig of the Max Planck Institute in The Bankers’ New Clothes.

Yes, a 100% capital requirement, for example, would effectively limit lending. But, given the rest of today’s institutional structure, that would also dramatically reduce aggregate demand -spending/sales/output/employment, etc.- which is already far too low to sustain anywhere near full employment levels of output.

A maximum response would be to give the state a monopoly on money creation.

Again, ‘money’ as defined by implication above, I’ll presume. The state is already the single supplier/monopolist of that which it demands for payment of taxes.

One of the most important such proposals was in the Chicago Plan, advanced in the 1930s by, among others, a great economist, Irving Fisher.

Yes, a fixed fx/gold standard proposal.

Its core was the requirement for 100 per cent reserves against deposits.

Reserves back then were ‘real’ gold certificates.

The floating fx equiv would be 100% capital requirement.

Fisher argued that this would greatly reduce business cycles,

And greatly reduce aggregate demand with the idea of driving net exports to increase gold/fx reserves, or, alternatively, run larger fiscal deficit which, on the gold standard, put the nation’s gold supply at risk

end bank runs

Yes, banks would only be lending their equity, so there is nothing to ‘run’

and drastically reduce public debt.

If you wanted a vicious deflationary spiral to lower ‘real wages’ and drive net exports

A 2012 study by International Monetary Fund staff suggests this plan could work well.

No comment…

Similar ideas have come from Laurence Kotlikoff of Boston University in Jimmy Stewart is Dead, and Andrew Jackson and Ben Dyson in Modernising Money.

None of which have any kind of grasp on actual monetary operations.

Here is the outline of the latter system.

First, the state, not banks, would create all transactions money, just as it creates cash today.

Today, state spending is a matter of the CB crediting a member bank reserve account, generally for further credit to the person getting the corresponding bank deposit. The member bank has an asset, the funds credited by the CB in its reserve account, and a liability, the deposit of the person who ultimately got the funds.

If the bank depositor wants cash, his bank gets the cash from the CB, and the CB debits the bank’s reserve account. So the person who got paid holds the cash and his bank has no deposit at the CB and the person has no bank deposit.

So in this case the entire ‘money supply’ would consist of dollars spent by the govt. But not yet taxed. That’s called the deficit/national debt. That is, the govt’s deficit would = the (net) ‘money supply’ of the economy, which is exactly the way it is today.

Customers would own the money in transaction accounts,

They already do

and would pay the banks a fee for managing them.

:(

Second, banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers.

So anyone who got paid by govt (directly or indirectly) could invest in an account so those same funds could be lent to someone else. Again, by design, this is to limit lending. And with ‘loanable funds’ limited in this way, the interest rate would reflect supply and demand for borrowing those funds, much like and fixed exchange rate regime.

So imagine a car company with a dip in sales and a bit of extra unsold inventory, that has to borrow to finance that inventory. It has to compete with the rest of the economy to borrow a limited amount of available funds (limited by the ‘national debt’). In a general slowdown it means rates will skyrocket to the point where companies are indifferent between paying the going interest rate and/or immediately liquidating inventory. This is called a fixed fx deflationary collapse.

They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.

As above.

Third, the central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.

What does ‘create new money’ mean in this context? If they spend it, that’s fiscal. If they lend it, how would that work? In a deflationary collapse there are no ‘credit worthy borrowers’ as they system is in technical default due to ‘unspent income’ issues. Would they somehow simply lend to support a target rate of interest? Which brings us back to what we have today, apart from deciding who to lend to at that rate, the way today’s banks decide who to lend to? And it becomes a matter of ‘public bank’ vs ‘private bank’, but otherwise the same?

Finally, the new money would be injected into the economy in four possible ways: to finance government spending,

That’s deficit spending, as above, and no distinction regards to current policy

in place of taxes or borrowing;

Same as above. For all practical purposes, all govt spending is via crediting a member bank account.

to make direct payments to citizens;

Same thing- net fiscal expenditure

to redeem outstanding debts, public or private;

Same

or to make new loans through banks or other intermediaries.

As above, that’s just a shift from private banking to public banking, and nothing more.

All such mechanisms could (and should) be made as transparent as one might wish.

The transition to a system in which money creation is separated from financial intermediation would be feasible, albeit complex.

No, it’s quite simple actually, as above.

But it would bring huge advantages. It would be possible to increase the money supply without encouraging people to borrow to the hilt.

Deficit spending does that.

It would end “too big to fail” in banking.

That’s just a matter of shareholders losing when things go bad which is already the case.

It would also transfer seignorage – the benefits from creating money – to the public.

That’s just a bunch of inapplicable empty rhetoric with today’s floating fx regimes.

In 2013, for example, sterling M1 (transactions money) was 80 per cent of gross domestic product. If the central bank decided this could grow at 5 per cent a year, the government could run a fiscal deficit of 4 per cent of GDP without borrowing or taxing.

In any case spending in excess of taxing adds to bank reserve accounts, and if govt doesn’t pay interest on those accounts or offer interest bearing alternatives, generally called securities accounts, the consequence is a 0% rate policy. So seems this is a proposal for a permanent zero rate policy, which I support!!! But that doesn’t require any of the above institutional change, just an announcement by the cb that zero rates are permanent.

The right might decide to cut taxes, the left to raise spending. The choice would be political, as it should be.

And exactly as it is today in any case

Opponents will argue that the economy would die for lack of credit.

Not if the deficit spending is allowed to ‘shift’ from private to public.

I was once sympathetic to that argument. But only about 10 per cent of UK bank lending has financed business investment in sectors other than commercial property. We could find other ways of funding this.

Govt deficit spending or net exports are the only two alternatives.

Our financial system is so unstable because the state first allowed it to create almost all the money in the economy

The process is already strictly limited by regulation and supervision

and was then forced to insure it when performing that function.

The liability side of banking isn’t the place for market discipline, hence deposit insurance.

This is a giant hole at the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector.

The funds to pay taxes already come only from the state.

The problem is that leadership doesn’t understand monetary operations.

This will not happen now. But remember the possibility. When the next crisis comes – and it surely will – we need to be ready.

Agreed!!!!!

Draghi on the euro

Draghi says a stronger euro would trigger looser ECB policy (Reuters)

Except by my calculations he has it backwards, as lower rates make a currency like the euro stronger, not weaker, via the interest income channels, etc.

ECB President Mario Draghi said that euro appreciation over the last year was an important factor in bringing euro zone inflation down to its current low levels, accounting for 0.4-0.5 percentage point of decline in the annual rate, which stood at 0.5 percent year-on-year in March. “I have always said that the exchange rate is not a policy target, but it is important for price stability and growth. And now, what has happened over the last few months is that is has become more and more important for price stability,” Draghi said at a news conference. “So the strengthening of the exchange rate would require further monetary policy accommodation.

As above.

If you want policy to remain accommodative as now, a further strengthening of the exchange rate would require further stimulus,” he said.

I agree, except I’d propose leaving rates at 0 fiscal relaxation to the point of domestic full employment, etc.

Furthermore, their policy of depressing domestic demand to drive exports/competitiveness has successfully resulted in growing net exports. However, unless combined with buying fx reserves of the targeted market areas, the euro appreciates until the net exports reverse, regardless of ‘monetary policy.’

Comments on Stanlely Fisher’s ‘Lessons from Crises, 1985-2014’

Lessons from Crises, 1985-2014

Stanley Fischer[1]


It is both an honor and a pleasure to receive this years SIEPR Prize. Let me list the reasons. First, the prize, awarded for lifetime contributions to economic policy, was started by George Shultz. I got my start in serious policy work in 1984-85, as a member of the advisory group on the Israeli economy to George Shultz, then Secretary of State. I learned a great deal from that experience, particularly from Secretary Shultz and from Herb Stein, the senior member of the two-person advisory group (I was the other member). Second, it is an honor to have been selected for this prize by a selection committee consisting of George Shultz, Ken Arrow, Gary Becker, Jim Poterba and John Shoven. Third, it is an honor to receive this prize after the first two prizes, for 2010 and for 2012 respectively, were awarded to Paul Volcker and Marty Feldstein. And fourth, it is a pleasure to receive the award itself.

When John Shoven first spoke to me about the prize, he must have expected that I would speak on the economic issues of the day and I would have been delighted to oblige. However, since then I have been nominated by President Obama but not so far confirmed by the Senate for the position of Vice-Chair of the Federal Reserve Board. Accordingly I shall not speak on current events, but rather on lessons from economic crises I have seen up close during the last three decades and about which I have written in the past starting with the Israeli stabilization of 1985, continuing with the financial crises of the 1990s, during which I was the number two at the IMF, and culminating (I hope) in the Great Recession, which I observed and with which I had to deal as Governor of the Bank of Israel between 2005 and 2013.

This is scheduled to be an after-dinner speech at the end of a fine dinner and after an intensive conference that started at 8 a.m. and ran through 6 p.m. Under the circumstances I shall try to be brief. I shall start with a list of ten lessons from the last twenty years, including the crises of Mexico in 1994-95, Asia in 1997-98, Russia in 1998, Brazil in 1999-2000, Argentina in 2000-2001, and the Great Recession. I will conclude with one or two-sentence pieces of advice I have received over the years from people with whom I had the honor of working on economic policy. The last piece of advice is contained in a story from 1985, from a conversation with George Shultz.


I. Ten lessons from the last two decades.[2]


Lesson 1: Fiscal policy also matters macroeconomically. It has always been accepted that fiscal policy, in the sense of the structure of the tax system and the composition of government spending, matters for the behavior of the economy. At times in the past there has been less agreement about whether the macroeconomic aspects of fiscal policy, frequently summarized by the full employment budget deficit, have a significant impact on the level of GDP. As a result of the experience of the last two decades, it is once again accepted that cutting government spending and raising taxes in a recession to reduce the budget deficit is generally recessionary. This was clear from experience in Asia in the 1990s.[3] The same conclusion has been reached following the Great Recession.

Who would have thought?…

At the same time, it needs to be emphasized that there are circumstances in which a fiscal contraction can be expansionary particularly for a country running an unsustainable budget deficit.

Unsustainable?
He doesn’t distinguish between floating and fixed fx policy. At best this applies to fixed fx policy, where fx reserves would be exhausted supporting the peg/conversion. And as a point of logic, with floating fx this can only mean an unsustainable inflation, whatever that means.

More important, small budget deficits and smaller rather than larger national debts are preferable in normal times in part to ensure that it will be possible to run an expansionary fiscal policy should that be needed in a recession.

Again, this applies only to fixed fx regimes where a nation might need fx reserves to support conversion at the peg. With floating fx nominal spending is in no case revenue constrained.

Lesson 2: Reaching the zero interest lower bound is not the end of expansionary monetary policy. The macroeconomics I learned a long time ago, and even the macroeconomics taught in the textbooks of the 1980s and early 1990s, proclaimed that more expansionary monetary policy becomes either impossible or ineffective when the central bank interest rate reaches zero, and the economy finds itself in a liquidity trap. In that situation, it was said, fiscal policy is the only available expansionary tool of macroeconomic policy.

Now the textbooks should say that even with a zero central bank interest rate, there are at least two other available monetary policy tools. The first consists of quantitative easing operations up and down the yield curve, in particular central bank market purchases of longer term assets, with the intention of reducing the longer term interest rates that are more relevant than the shortest term interest rate to investment decisions.

Both are about altering the term structure of rates. How about the lesson that the data seems to indicate the interest income channels matter to the point where the effect is the reverse of what the mainstream believes?

That is, with the govt a net payer of interest, lower rates lower the deficit, reducing income and net financial assets credited to the economy. For example, QE resulted in some $90 billion of annual Fed profits returned to the tsy that otherwise would have been credited to the economy. That, with a positive yield curve, QE functions first as a tax.

The second consists of central bank interventions in particular markets whose operation has become significantly impaired by the crisis. Here one thinks for instance of the Feds intervening in the commercial paper market early in the crisis, through its Commercial Paper Funding Facility, to restore the functioning of that market, an important source of finance to the business sector. In these operations, the central bank operates as market maker of last resort when the operation of a particular market is severely impaired.

The most questionable and subsequently overlooked ‘bailout’- the Fed buying, for example, GE commercial paper when it couldn’t fund itself otherwise, with no ‘terms and conditions’ as were applied to select liquidity provisioning to member banks, AIG, etc. And perhaps worse, it was the failure of the Fed to provide liquidity (not equity, which is another story/lesson) to its banking system on a timely basis (it took months to get it right) that was the immediate cause of the related liquidity issues.

However, and perhaps the most bizarre of what’s called unconventional monetary policy, the Fed did provide unlimited $US liquidity to foreign banking systems with its ‘swap lines’ where were, functionally, unsecured loans to foreign central banks for the further purpose of bringing down Libor settings by lowering the marginal cost of funds to foreign banks that otherwise paid higher rates.

Lesson 3: The critical importance of having a strong and robust financial system. This is a lesson that we all thought we understood especially since the financial crises of the 1990s but whose central importance has been driven home, closer to home, by the Great Recession. The Great Recession was far worse in many of the advanced countries than it was in the leading emerging market countries. This was not what happened in the crises of the 1990s, and it was not a situation that I thought would ever happen. Reinhart and Rogoff in their important book, This Time is Different,[4] document the fact that recessions accompanied by a financial crisis tend to be deeper and longer than those in which the financial system remains operative. The reason is simple: the mechanisms that typically end a recession, among them monetary and fiscal policies, are less effective if households and corporations cannot obtain financing on terms appropriate to the state of the economy.

The lesson should have been that the private sector is necessarily pro cyclical, and that a collapse in aggregate demand that reduces the collateral value of bank assets and reduces the income required to support the credit structure triggers a downward spiral that can only be reversed with counter cyclical fiscal policy.

In the last few years, a great deal of work and effort has been devoted to understanding what went wrong and what needs to be done to maintain a strong and robust financial system. Some of the answers are to be found in the recommendations made by the Basel Committee on Bank Supervision and the Financial Stability Board (FSB). In particular, the recommendations relate to tougher and higher capital requirements for banks, a binding liquidity ratio, the use of countercyclical capital buffers, better risk management, more appropriate remuneration schemes, more effective corporate governance, and improved and usable resolution mechanisms of which more shortly. They also include recommendations for dealing with the clearing of derivative transactions, and with the shadow banking system. In the United States, many of these recommendations are included or enabled in the Dodd-Frank Act, and progress has been made on many of them.

Everything except the recognition of the need for immediate and aggressive counter cyclical fiscal policy, assuming you don’t want to wait for the automatic fiscal stabilizers to eventually turn things around.

Instead, what they’ve done with all of the above is mute the credit expansion mechanism, but without muting the ‘demand leakages’/’savings desires’ that cause income to go unspent, and output to go unsold, leaving, for all practical purposes (the export channel isn’t a practical option for the heaving lifting), only increased deficit spending to sustain high levels of output and employment.

Lesson 4: The strategy of going fast on bank restructuring and corporate debt restructuring is much better than regulatory forbearance. Some governments faced with the problem of failed financial institutions in a recession appear to believe that regulatory forbearance giving institutions time to try to restore solvency by rebuilding capital will heal their ills. Because recovery of the economy depends on having a healthy financial system, and recovery of the financial system depends on having a healthy economy, this strategy rarely works.

The ‘problem’ is bank lending to offset the demand leakages when the will to use fiscal policy isn’t there.

And today, it’s hard to make the case that us lending is being constrained by lack of bank capital, with the better case being a lack of credit worthy, qualifying borrowers, and regulatory restrictions- called ‘regulatory overreach’ on some types of lending as well. But again, this largely comes back to the understanding that the private sector is necessarily pro cyclical, with the lesson being an immediate and aggressive tax cut and/or spending increase is the way go.

This lesson was evident during the emerging market crises of the 1990s. The lesson was reinforced during the Great Recession, by the contrast between the response of the U.S. economy and that of the Eurozone economy to the low interest rate policies each implemented. One important reason that the U.S. economy recovered more rapidly than the Eurozone is that the U.S. moved very quickly, using stress tests for diagnosis and the TARP for financing, to restore bank capital levels, whereas banks in the Eurozone are still awaiting the rigorous examination of the value of their assets that needs to be the first step on the road to restoring the health of the banking system.

The lesson remaining unlearned is that with a weaker banking structure the euro zone can implement larger fiscal adjustments- larger tax cuts and/or larger increases in public goods and services.

Lesson 5: It is critical to develop now the tools needed to deal with potential future crises without injecting public funds.

Yes, it seems the value of immediate and aggressive fiscal adjustments remains unlearned.

This problem arose during both the crises of the 1990s and the Great Recession but in different forms. In the international financial crises of the 1990s, as the size of IMF packages grew, the pressure to bail in private sector lenders to countries in trouble mounted both because that would reduce the need for official financing, and because of moral hazard issues. In the 1980s and to a somewhat lesser extent in the 1990s, the bulk of international lending was by the large globally active banks. My successor as First Deputy Managing Director of the IMF, Anne Krueger, who took office in 2001, mounted a major effort to persuade the IMF that is to say, the governments of member countries of the IMF to develop and implement an SDRM (Sovereign Debt Restructuring Mechanism). The SDRM would have set out conditions under which a government could legally restructure its foreign debts, without the restructuring being regarded as a default.

The lesson is that foreign currency debt is to be avoided, and that legal recourse in the case of default should be limited.

Recent efforts to end too big to fail in the aftermath of the Great Recession are driven by similar concerns by the view that we should never again be in a situation in which the public sector has to inject public money into failing financial institutions in order to mitigate a financial crisis. In most cases in which banks have failed, shareholders lost their claims on the banks, but bond holders frequently did not. Based in part on aspects of the Dodd-Frank Act, real progress has been made in putting in place measures to deal with the too big to fail problem. Among them are: the significant increase in capital requirements, especially for SIFIs (Systemically Important Financial Institutions) and the introduction of counter-cyclical capital buffers for banks; the requirement that banks hold a cushion of bail-in-able bonds; and the sophisticated use of stress tests.

The lesson is that the entire capital structure should be explicitly at full risk and priced accordingly.

Just one more observation: whenever the IMF finds something good to say about a countrys economy, it balances the praise with the warning Complacency must be avoided. That is always true about economic policy and about life. In the case of financial sector reforms, there are two main concerns that the statement about significant progress raises: first, in designing a system to deal with crises, one can never know for sure how well the system will work when a crisis situation occurs which means that we will have to keep on subjecting the financial system to tough stress tests and to frequent re-examination of its resiliency; and second, there is the problem of generals who prepare for the last war the financial system and the economy keep evolving, and we need always to be asking ourselves not only about whether we could have done better last time, but whether we will do better next time and one thing is for sure, next time will be different.

And in any case an immediate and aggressive fiscal adjustment can always sustain output and employment. There is no public purpose in letting a financial crisis spill over to the real economy.

Lesson 6: The need for macroprudential supervision. Supervisors in different countries are well aware of the need for macroprudential supervision, where the term involves two elements: first, that the supervision relates to the financial system as a whole, and not just to the soundness of each individual institution; and second, that it involves systemic interactions. The Lehman failure touched off a massive global financial crisis, a reflection of the interconnectedness of the financial system, and a classic example of systemic interactions. Thus we are talking about regulation at a very broad level, and also the need for cooperation among regulators of different aspects of the financial system.

The lesson are that whoever insures the deposits should do the regulation, and that independent fiscal adjustments can be immediately and aggressively employed to sustain output and employment in any economy.

In practice, macroprudential policy has come to mean the deployment of non-monetary and non-traditional instruments of policy to deal with potential problems in financial institutions or a part of the financial system. For instance, in Israel, as in other countries whose financial system survived the Great Recession without serious damage, the low interest rate environment led to uncomfortably rapid rates of increase of housing prices. Rather than raise the interest rate, which would have affected the broader economy, the Bank of Israel in which bank supervision is located undertook measures whose effect was to make mortgages more expensive. These measures are called macroprudential, although their effect is mainly on the housing sector, and not directly on interactions within the financial system. But they nonetheless deserve being called macroprudential, because the real estate sector is often the source of financial crises, and deploying these measures should reduce the probability of a real estate bubble and its subsequent bursting, which would likely have macroeconomic effects.

And real effects- there would have been more houses built. The political decision is the desire for real housing construction.

The need for surveillance of the financial system as a whole has in some countries led to the establishment of a coordinating committee of regulators. In the United States, that group is the FSOC (Financial Stability Oversight Council), which is chaired by the Secretary of the Treasury. In the United Kingdom, a Financial Policy Committee, charged with the responsibility for oversight of the financial system, has been set up and placed in the Bank of England. It operates under the chairmanship of the Governor of the Bank of England, with a structure similar but not identical to the Bank of Englands Monetary Policy Committee.

Lesson 7: The best time to deal with moral hazard is in designing the system, not in the midst of a crisis.

Agreed!
Moral hazard is about the future course of events.

At the start of the Korean crisis at the end of 1997, critics including friends of mine told the IMF that it would be a mistake to enter a program with Korea, since this would increase moral hazard. I was not convinced by their argument, which at its simplest could be expressed as You should force Korea into a greater economic crisis than is necessary, in order to teach them a lesson. The issue is Who is them? It was probably not the 46 million people living in South Korea at the time. It probably was the policy-makers in Korea, and it certainly was the bankers and others who had invested in South Korea. The calculus of adding to the woes of a country already going through a traumatic experience, in order to teach policymakers, bankers and investors a lesson, did not convince the IMF, rightly so to my mind.

Agreed!
Nor did they need an IMF program!

But the question then arises: Can you ever deal with moral hazard? The answer is yes, by building a system that will as far as possible enable policymakers to deal with crises in a way that does not create moral hazard in future crisis situations. That is the goal of financial sector reforms now underway to create mechanisms and institutions that will put an end to too big to fail.

There was no too big to fail moral hazard issue. The US banks did fail when shareholders lost their capital. Failure means the owners lose and are financially punished, and new owners with new capital have a go at it.

Lesson 8: Dont overestimate the benefits of waiting for the situation to clarify.


Early in my term as Governor of the Bank of Israel, when the interest rate decision was made by the Governor alone, I faced a very difficult decision on the interest rate. I told the advisory group with whom I was sitting that my decision was to keep the interest rate unchanged and wait for the next monthly decision, when the situation would have clarified. The then Deputy Governor, Dr. Meir Sokoler, commented: It is never clear next time; it is just unclear in a different way. I cannot help but think of this as the Tolstoy rule, from the first sentence of Anna Karenina, every unhappy family is unhappy in its own way.

It is not literally true that all interest rate decisions are equally difficult, but it is true that we tend to underestimate the lags in receiving information and the lags with which policy decisions affect the economy. Those lags led me to try to make decisions as early as possible, even if that meant that there was more uncertainty about the correctness of the decision than would have been appropriate had the lags been absent.

The lesson is to be aggressive with fiscal adjustments when unemployment/the output gap starts to rise as the costs of waiting- massive quantities of lost output and negative externalities, particularly with regard to the lives of those punished by the government allowing aggregate demand to decline- are far higher than, worst case, a period of ‘excess demand’ that can also readily be addressed with fiscal policy.

Lesson 9: Never forget the eternal verities lessons from the IMF. A country that manages itself well in normal times is likely to be better equipped to deal with the consequences of a crisis, and likely to emerge from it at lower cost.

Thus, we should continue to believe in the good housekeeping rules that the IMF has tirelessly promoted. In normal times countries should maintain fiscal discipline and monetary and financial stability. At all times they should take into account the need to follow sustainable growth-promoting macro- and structural policies. And they need to have a decent regard for the welfare of all segments of society.

Yes, at all times they should sustain full employment policy as the real losses from anything less far exceed any other possible benefits.

The list is easy to make. It is more difficult to fill in the details, to decide what policies to
follow in practice. And it may be very difficult to implement such measures, particularly when times are good and when populist pressures are likely to be strong. But a country that does not do so is likely to pay a very high price.

Lesson 10.

In a crisis, central bankers will often find themselves deciding to implement policy actions they never thought they would have to undertake and these are frequently policy actions that they would have preferred not to have to undertake. Hence, a few final words of advice to central bankers (and to others):

Lesson for all bankers:
Proposals for the Banking System, Treasury, Fed, and FDIC

Never say never


II. The Wisdom of My Teachers

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Feel free to distribute, thanks.

Over the years, I have found myself remembering and repeating words of advice that I first heard from my teachers, both academics and policymakers. Herewith a selection:


1. Paul Samuelson on econometric models: I would rather have Bob Solow than an econometric model, but Id rather have Bob Solow with an econometric model than Bob Solow without one.

2. Herb Stein: (a) After listening to my long description of what was happening in the Israeli economy in 1985: Yes, but what do we want them to do?”

(b) The difference between a growth rate of 2% and a growth rate of 3% is 50%.

(c) If something cannot go on forever, it will stop.
3. Michel Camdessus (former head of the IMF):

(a) At 7 a.m., in his office, on the morning that the U.S. government turned to the IMF to raise $20 billion by 9:30 a.m: Gentlemen, this is a crisis, and in a crisis you do not panic

(b) When the IMF was under attack from politicians or the media, in response to my asking Michel, what should we do?, his inevitable answer was We must do our job.

(c) His response when I told him (his official title was Managing Director of the IMF) that life would be much easier for all of us if he would only get himself a cell phone: Cell phones are for deputy managing directors.

(d) On delegation: In August, when he was in France and I was acting head of the IMF in Washington, and had called him to explain a particularly knotty problem and ask him for a decision, You have more information than me, you decide.

4. George Shultz: This event happened in May 1985, just before Herb Stein and I were due to leave for Israel to negotiate an economic program which the United States would support with a grant of $1.5 billion. I was a professor at MIT, and living in the Boston area. Herb and I spoke on the phone about the fact that we had no authorization to impose any conditions on the receipt of the money. Herb, who lived in Washington, volunteered to talk to the Secretary of State to ask him for authorization to impose conditions. He called me after his meeting and said that the Secretary of State was not willing to impose any conditions on the aid.

We agreed this was a problem and he said to me, Why dont you try. A meeting was hastily arranged and next morning I arrived at the Secretary of States office, all ready to deliver a convincing speech to him about the necessity of conditionality. He didnt give me a chance to say a word. You want me to impose conditions on Israel? I said yes. He said I wont. I asked why not. He said Because the Congress will give them the money even if they dont carry out the program and I do not make threats that I cannot carry out.

This was convincing, and an extraordinarily important lesson. But it left the negotiating team with a problem. So I said, That is very awkward. Were going to say To stabilize the economy you need to do the following list of things. And they will be asking themselves, and if we dont? Is there anything we can say to them?

The Secretary of State thought for a while and said: You can tell them that if they do not carry out the program, I will be very disappointed.

We used that line repeatedly. The program was carried out and the program succeeded.

Thank you all very much.

[1] Council on Foreign Relations. These remarks were prepared for presentation on receipt of the SIEPR (Stanford Institute for Economic Policy Research) Prize at Stanford University on March 14, 2014. The Prize is awarded for lifetime contributions to economic policy. I am grateful to Dinah Walker of the Council on Foreign Relations for her assistance.

[2] I draw here on two papers I wrote based on my experience in the IMF: Ten Tentative Conclusions from the Past Three Years, presented at the annual meeting of the Trilateral Commission in 1999, in Washington, DC; and the Robbins Lectures, The International Financial System: Crises and Reform Several other policy-related papers from that period appear in my book: IMF Essays from a Time of Crisis (MIT Press, Cambridge, MA, 2004). For the period of the Great Recession, I draw on Central bank lessons from the global crisis, which I presented at a conference on Lessons of the Global Crisis at the Bank of Israel in 2011.

[3] This point was made in my 1999 statement Ten Tentative Conclusions referred to above, and has of course received a great deal of focus in analyses of the Great Recession.

[4] Carmen Reinhart and Kenneth Rogoff, This Time is Different, Princeton University Press, Princeton, NJ, 2009.

Turkey’s Prime Minister on rates and inflation

Turkey’s central bank prepared to tighten policy further

“Mr Erdogans own resistance to interest rate rises goes deep: on the flight, the prime minister insisted that, contrary to economic theory, increases in interest rates cause inflation. I believe that inflation and interest rates are not inversely proportional but in direct proportion, he told reporters. In other words, the relationship between inflation and interest is cause and effect: the interest rate is the cause, inflation is the result. If you increase the rate, inflation increases. If you reduce it, both drop together. When you think they are inversely proportional you always get much more negative results.