Schäuble Calls on Italy to Pursue Structural Reform

By Andrea Thomas

July 16 (WSJ) — German Finance Minister Wolfgang Schäuble called on Italy to pursue its ambitious structural reform efforts if it wants to boost its economic-growth prospects. “Especially since growth forecasts for Italy have been reduced recently, it’s important to reform and cut the debt level convincingly,” he said. Italian Prime Minister Matteo Renzi has presented ambitious and broad-based reforms, he added. “The Stability and Growth Pact is the foundation for politico-economic cohesion in Europe,” said Mr. Schäuble. “The Stability and Growth Pact provides sufficient flexibility. It’s doesn’t stand in the way of structural reforms; quite the opposite, it promotes them.”

This is a direct response to Prime Minister Renzi who asked for what can be described as a minuscule amount flexibility with the deficit rules. (Note that Schauble didn’t even say said reforms would boost growth, only ‘growth prospects’, whatever that means.)

The problem is that for any given level of govt spending (a political decision) tax liabilities are too high to allow ‘savings desires’ to be accommodated. And ‘the debt level’ is best thought of as the ‘money supply’ (deposits at the CB) that’s the euro ‘savings’/net financial assets of the non govt sectors.

Said another way, the currency itself is the EU’s public monopoly, and the mass unemployment is necessarily the evidence that the monopolist is restricting the ‘supply’ of net financial assets demanded by the economy.

Said another way, for all practical purposes said reforms don’t increase aggregate demand. At best they address what I call distributional issues.

My proposal is for Italy to deliver an ultimatum to the EU giving them 30 days to relax the 3% deficit limit and eliminate the 60% debt/GDP limit.

If the EU refuses, Italy has two choices:

1. Do nothing as the destruction of their civilization continues,

2. Begin taxing and spending in ‘new lira’ with fiscal policy that promotes output and employment.

And note that if they do go to ‘new lira’ and retain their now constitutionally mandated balanced budget requirement, it will all get even worse.

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 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.’

The BoEs sharp shock to monetary illusions

The Old Lady (of Threadneedle Street) fails to get an A

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

:(

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.

As previously discussed, the ‘missing piece’ from the standard export model is buying the currency of your target market, as Germany used to do, and as the EU can’t do for ideological reasons- they don’t want to give the appearance that dollar reserves back the euro, and they want the euro to be the reserve currency. And they want to net export… whatever!

Spanish Central Bank Joins Chorus of Concern Over Euro’s Strength

By Paul Hannon

March 12 (WSJ) — In a news conference Thursday after the ECB’s decision to leave its policy unchanged, the bank’s president Mario Draghi said the euro’s 9% appreciation against the U.S. dollar since mid-2012 had been “a factor that is affecting in a significant way” the inflation rate, likely responsible for lowering it by almost half a percentage point. SpeakingMonday, Bank of France Governor Christian Noyer—who also sits on the ECB’s governing council—said that a strong euro lowers the inflation rate. “We are clearly not very happy at the moment,” he said.On Wednesday, Bank of Spain Governor Luis Maria Linde joined the chorus, making an explicit connection between the currency’s gains and possible future action by the ECB. “A stronger euro may lead to an easier policy, or a drop in inflation,” said Mr. Linde said. “We would like to have a little bit more inflation in the euro zone.”

The threshold may be high but there is one somewhere up there:

Fed should be ‘very patient’ in cutting stimulus: Rosengren (Reuters) The high number of part-time workers who would rather work full-time, the still-high unemployment rate, and very low inflation suggest significant “slack” in labor markets and “call for a very patient approach to removing monetary policy accommodation, particularly given the softness in recent economic data,” Boston Federal Reserve Bank President Eric Rosengren said. Rosengren said that it has been difficult for economists to determine whether weak employment reports for the past two months have been influenced bad weather or if they reflect an economic slowdown, and predicted that harsh winter weather will make the February jobs report similarly difficult to interpret. “In my view, this uncertainty provides an additional strong rationale for taking a patient approach to removing the monetary policy accommodation that the Federal Reserve has been deploying.”

These are closings from contracts signed months earlier:

New home sales hit five-and-a-half year high in January (Reuters) Sales of new U.S. single-family homes jumped 9.6 percent to a seasonally adjusted annual rate of 468,000 units. December’s sales were revised up to a 427,000-unit pace from the previously reported 414,000-unit rate. Sales in the Northeast soared 73.7 percent to a seven-month high, while the South recorded a 10.4 percent rise in transactions to a more than five-year high. Sales tumbled 17.2 percent in the Midwest last month, while rising 11 percent in the West. New home sales rose 2.2 percent compared with January 2013. For all of 2013. Last month, the supply of new houses on the market was unchanged at 184,000 units. The median price of a new home last month rose 3.4 percent to $260,100 from January 2013. At January’s sales pace it would take 4.7 months to clear the supply of houses on the market.

I still suspect some of the q4 activity was ahead of expiring tax credits:

Hope on Horizon for Home-Supply Crunch: Builder Borrowing Picks Up (WSJ) Data released Wednesday by the Federal Deposit Insurance Corp. show that the outstanding balance on loans for land acquisition, development and construction rose in the fourth quarter to $209.9 billion, compared with $206 billion in the third quarter. Last year, the average price of a new U.S. home was $322,100, up 10.2% from 2012. The latest increase in construction lending “is an encouraging signal,” said David Crowe, chief economist for the National Association of Home Builders. But lending remains far from peak, as outstanding land and construction loans topped out at $631.8 billion in the first quarter of 2008. According to the FDIC, outstanding loans solely for construction of homesexcluding development, land acquisition and commercial projectsincreased to $43.7 billion in the fourth quarter, up from a recent low of $40.7 billion in last year’s first quarter.

This helps support prices but doesn’t directly add much to GDP apart from commissions etc. unless it’s new construction:

Foreign appetite for US properties remains strong (FT) Last year the US maintained its position as the top destination for direct commercial property investment by foreigners with $38.7bn pouring into the country, according to a report from brokerage Jones Lang LaSalle. The total was up 44 per cent on 2012. Canadian, Chinese and Australian investors led the charge, with investors targeting top-tier areas such as Manhattan, Los Angeles and Chicago as well as secondary markets including Houston, Dallas and Seattle. Almost half all investments were in office buildings, 16 per cent in apartment blocks, 15 per cent in retail, while hotels, industrial properties and land development made up the rest. Foreign money comprises about 10 per cent of all capital for commercial property investment in the US, which JLL has said could accelerate if international investors expand beyond core assets to riskier deals that deliver higher returns.

The lack of domestic credit expansion and only very modest export growth leaves only govt. to spend more than its income and they keep pressing the wrong way on that as well:

Euro zone lending contraction compounds ECB headache (Reuters) Loans to the private sector fell by 2.2 percent in January from the same month a year earlier, ECB data released on Thursday showed. That compared to a contraction of 2.3 percent in December. Euro zone M3 money supply grew at an annual pace of 1.2 percent, picking up slightly from 1.0 percent in December. The ECB has set out two scenarios that could trigger fresh policy action: a deterioration in the medium-term inflation outlook and an “unwarranted” tightening of short-term money markets. Before the ECB gets to quantitative easing a cut in interest rates is one option for dealing with low euro zone inflation, or tight money markets. Another option the ECB has discussed is to suspend operations to soak up the money it spent buying sovereign bonds under its now-terminated Securities Markets Programme (SMP) during the euro zone’s debt crisis.

6.8% unemployment considered a successful economy?
whatever…

Lowest number of Germans out of work in Feb since Sept 2012 (Reuters) The number of people out of work in Europe’s largest economy decreased by 14,000 to 2.914 million, data from the Labour Office showed. That meant there were fewer unemployed people in Germany than at any time since September 2012. It was the third consecutive monthly drop in joblessness. Separate data from the Federal Statistics Office on Thursday showed employment climbing to a record high of almost 42 million. Berlin expects private consumption, which boosted growth in 2013, to increase by 1.4 percent as workers benefit from an increase in employment to an expected record of 42.1 million this year and a nominal 2.7 percent jump in earnings. The jobless rate held steady at 6.8 percent, its lowest level since German reunification more than two decades ago.

Germany’s wealth distribution most unequal in euro zone (Reuters) Private wealth is more unevenly distributed in Germany than in any other euro zone state. While the richest one percent of people in Germany have personal wealth of at least 800,000 euros ($1.09 million), over a quarter of adults have either no wealth or negative wealth because of debt, the study by Germany’s DIW think tank showed. According to the study, Germany’s Gini coefficient, a measure of income inequality, was 0.78 in 2012. That compared with 0.68 in France, 0.61 in Italy and 0.45 in Slovakia. A score of 0 indicates minimal inequality and 1.0 maximal inequality. Germans have total net assets worth 6.3 trillion euros, with land and real estate accounting for 5.1 trillion euros, and the average German adult has net assets worth around 83,000 euros, according to DIW. In the study, private wealth includes owned real estate, financial assets, valuables and debt.

French jobless total rises to record in January (Reuters) The number of people out of work in France rose by 8,900 in January to reach a record, as President Francois Hollande’s goal of taming unemployment eluded him yet again. Labour Ministry data showed on Wednesday that the number of people registered as out of work reached 3,316,200 in mainland France, up 0.3 percent over a month and 4.4 percent over a year. Hollande’s popularity has plummeted to record lows. He struggled and ultimately failed to live up to a pledge to get unemployment falling by the end of last year. With that promise in tatters despite at least 2 billion euros ($2.73 billion) spent on subsidized jobs, Labour Minister Michel Sapin said earlier on Wednesday that the jobless total should fall this year. Hollande offered last month to phase out 30 billion euros in payroll charges that companies have to pay, in exchange for committing to targets to create jobs.

Spanish Economic Growth Slower Than Expected (WSJ) Gross domestic product grew by 0.2% in the fourth quarter compared with the third, the country’s national statistics institute INE said Thursday. The figure was lower than the INE’s and the government’s preliminary reading, which had pegged quarterly growth at 0.3%. Public spending fell 3.9% compared with the third quarter. Household consumption was up 0.5% in the same period. Strong export growth helped Spain’s economy emerge from a nine-quarter recession in the second half of 2013, but the recovery has so far been anemic, because households remain highly indebted, unemployment still stands around 26% and the government can’t raise public spending because it is struggling to lower its budget deficit. According to the INE, economic output shrunk by 0.2% in the fourth quarter of 2013 compared with the fourth quarter of a year earlier.

Private rental surge hits benefits bill (FT) Englands housing market is seeing a seismic shift towards private rented property and away from home ownership. Figures from the official English housing survey published on Wednesday show the number of households living in the private rented sector overtook those in social housing for the first time last year. Almost 4m households now live in privately rented homes, and a quarter of the tenants are now subsidised by housing benefit, according to the annual survey. Private renting is now the second-largest tenure in England, behind home ownership. Under two-thirds of households now own their own home down from 71 per cent a decade ago. The number of households in the private rented sector receiving the benefit has risen by two-thirds in the past five years, with 390,000 more households in this category beginning to claim, the English housing survey found.

Does China want their currency to adjust to the yen the way other EM currencies have done?

China dismisses concern over sudden renminbi fall (FT) The recent movement of the renminbi exchange rate is the result of market players adjusting their near-term renminbi trading strategies, the State Administration of Foreign Exchange, an agency under the central bank, said. It added that the currencys movement was nothing unusual: The degree of exchange rate volatility is normal by the standards of developed and emerging markets. There is no need to over-interpret it. China faced immense capital inflows at the start of this year, according to data published on Tuesday by the central bank. Banks bought a net $73bn of foreign currency in the onshore market from their clients who wanted renminbi in January, the biggest monthly amount on record. Inflows have been accelerating since the middle of last year when Chinas mountain of foreign exchange reserves grew $500bn to $3.8tn.

China’s Central Bank Engineered Yuan’s Decline (WSJ) China’s central bank engineered the recent decline in the country’s currency to shake out speculators as it prepares to allow a wider trading range for the tightly tethered yuan, according to people familiar with the central bank’s thinking. In the past week, the People’s Bank of China has been guiding the yuan lower against the dollar. It has done so by setting a weaker benchmark against which the yuan can trade. It has also intervened in the currency market by directing state-owned Chinese banks to buy dollars, according to traders. China’s central bank and commercial banks purchased nearly $45 billion worth of foreign exchange in December, the fifth consecutive month of net purchases. The PBOC decided to tamp down expectations for one-way appreciation in the yuan and curb speculative trading during two-day currency-policy meeting that ended on Feb. 18, the people said.

Seems no one is pointing out how this is all looking a lot like ‘catch up’ vs last year’s yen move?

As previously discussed, the proactive yen move from under 80 to over 100 vs the dollar- a 30% or so pay cut for domestic workers in terms of prices of imports- was an internationally deflationary impulse.

It’s called ‘currency wars’ with the exporters pushing hard on their govts to do whatever it takes to keep them ‘competitive’. And all, at least to me, shamelessly thinly disguised as anything but. And, in fact, it’s not ‘wrong’ to call it ‘dollar appreciation’ rather than EM currency depreciation given the deflationary bias of US (and EU) fiscal and monetary (rate cuts/QE reduce interest income for the economy) policy.

This is a highly deflationary force for the US (and EU) via import prices and lost export pricing power, also hurting earnings translations and, in general weakening US domestic demand, as increased domestic oil output doesn’t reduce net imports as much as would otherwise be the case.

And while I’m not saying energy independence is a ‘bad thing’ note that the UK has been largely ‘energy independent’ for quite a while, so there’s obviously more to it.

The optimal policy move for the US is fiscal relaxation- like my proposed FICA suspension- to get us back to full employment and optimize our real terms of trade. (and not to forget the federally funded transition job for anyone willing and able to work to facilitate the transition from unemployment to private sector employment as the economy booms).

But unfortunately Congress is going the other way and making it all that much worse.

Emerging market currencies take a battering

By Katrina Bishop

January 24 (CNBC) — Emerging market currencies continued to take a beating on Friday — with Turkey’s lira hitting a new record low against the dollar yet again — amid growing concerns about the U.S. Federal Reserve’s monetary guidance.

On Friday, the dollar strengthened to 2.3084 against Turkey’s currency. Investors also piled out of the South African rand and Argentina’s peso, and both the Indian rupee and the Indonesian rupiah fell to two-week lows against the dollar. Meanwhile, the Australian dollar fell to $0.8681 – its lowest level in three-and-a-half years.

“The market is in panic mode. We have huge psychological fear that is going to emerging markets, despite a global environment that hasn’t changed that much,” Benoit Anne, head of global emerging market strategy at Societe Generale, told CNBC.

“My bias at this stage — although it’s a bold one — is that this is all about the credibility of the Fed with respect to its forward guidance. This fear that the Fed is going to tighten quicker than expected is translating into emerging markets.”

The U.S. central bank has promised that it will not raise interest rates until unemployment hits 6.5 percent – but some analysts are concerned that rate hikes could come sooner than expected.

U.S. monetary policy has always had a significant on emerging markets, and the Fed’s bond-buying program boosted risk sentiment, causing investors to turn their back on so-called “safe havens” and pile into assets seen as riskier – such as emerging market currencies.

Speculation of Fed tapering in 2013 hit emerging markets hard, with currencies including India, Turkey, Russia and Brazil coming under intense pressure in 2013.
But Anne added these recent moves were likely to be more temporary.

“It’s a matter of weeks rather than the whole year 2014 as a total write off for emerging markets,” he said. “Although it will take the Fed re-establishing its credibility towards forward guidance before we see respite in emerging markets.”

Link:

Chianciano Presentation

Says its backed by taxes and men with guns…
;)

PAUL KRUGMAN: Bitcoin’s Value Is Driven By The Fact That It Sounds Impressive

Do you think they know austerity causes loans to go bad?

Troubled loans at Europe’s banks double in value (FT) European banks’ non-performing loans have doubled in just four years to reach close to €1.2tn and are expected to keep rising. A report by PwC found that non-performing loans (NPLs) rose from €514bn in 2008 to €1.187tn in 2012, with rises in the most recent year driven by deteriorating conditions in Spain, Ireland, Italy and Greece. It predicted further rises in the years ahead because of the “uncertain economic climate”. Richard Thompson, a partner at PwC, said the “reshaping” of European bank balance sheets had several more years to run as lenders shed troubled and unwanted loans and attempted to strengthen their balance sheets. He estimates European banks are sitting on €2.4tn of non-core loans that they plan to wind down or sell off. The first eight months of 2013 have seen €46bn of European loan portfolio transactions, equal to the entire amount recorded in 2012.

Do you think they know higher rates support higher inflation and weaken the currency?

India’s Central Bank Expects Inflation to Remain Stubborn (WSJ) The Reserve Bank of India Monday sounded concern about inflation, which it said would remain outside its comfort zone this fiscal year. In its half-yearly review of macroeconomic and monetary developments, released a day before its monetary-policy meeting, the RBI also highlighted the need to boost economic growth. But its stress was more on inflation. Inflation at the wholesale level—the main measure of prices in India—notched a seven-month high of 6.46% in September. It has remained above the central bank’s comfort level of 5% for four consecutive months through September. The RBI said it expects both consumer and wholesale inflation to remain around their current levels. “This indicates persistence of inflation at levels distinctly above what was indicated by the Reserve Bank earlier in the year,” it said.

The last thing they want is the euro to get strong and eat into their fledgling trade surplus and, in general, do its deflationary thing.

But what can they do? Discourage Japan and the rest from buying their member nation’s debt? Not.

Buy $, yen, etc? No- ideologically impossible. Gives the appearance that fx reserves are backing the euro, etc.

That leaves ‘monetary easing’ of some sort that doesn’t directly work, but hopes to scare investors out of euro.

BOJ Survey Shows Consumer Sentiment Worsen As Energy Prices Rise

October 2 (Dow Jones) — A Bank of Japan survey showed Wednesday that consumer sentiment worsened for the first time in three quarters as a rise in energy prices amid a lack of major wage increases negatively affected their views on the economy. The central bank’s survey of the general public showed that the diffusion index measuring the current state of the economy fell to minus 8.3 from minus 4.8. Of the poll of 2,252 consumers, 83% of respondents said they expect the prices of goods and services to rise over the coming year. That’s higher than 80.2% in the previous June survey. The survey also showed that 16.2% of the respondents see the economy improving in coming year, down from the previous 24.3%.

Here’s my take on the Volcker article

My comments in below:

The Fed & Big Banking at the Crossroads

By Paul Volcker

I have been struck by parallels between the challenges facing the Federal Reserve today and those when I first entered the Federal Reserve System as a neophyte economist in 1949.

Most striking then, as now, was the commitment of the Federal Reserve, which was and is a formally independent body, to maintaining a pattern of very low interest rates, ranging from near zero to 2.5 percent or less for Treasury bonds. If you feel a bit impatient about the prevailing rates, quite understandably so, recall that the earlier episode lasted fifteen years.

The initial steps taken in the midst of the depression of the 1930s to support the economy by keeping interest rates low were made at the Fed’s initiative. The pattern was held through World War II in explicit agreement with the Treasury. Then it persisted right in the face of double-digit inflation after the war, increasingly under Treasury and presidential pressure to keep rates low.

Yes, and this was done after conversion to gold was suspended which made it possible. And they fixed long rates as well/

The growing restiveness of the Federal Reserve was reflected in testimony by Marriner Eccles in 1948:

Under the circumstances that now exist the Federal Reserve System is the greatest potential agent of inflation that man could possibly contrive.
This was pretty strong language by a sitting Fed governor and a long-serving board chairman. But it was then a fact that there were many doubts about whether the formality of the independent legal status of the central bank—guaranteed since it was created in 1913—could or should be sustained against Treasury and presidential importuning. At the time, the influential Hoover Commission on government reorganization itself expressed strong doubts about the Fed’s independence. In these years calls for freeing the market and letting the Fed’s interest rates rise met strong resistance from the government.

Not freeing the ‘market’ but letting the Fed chair have his way. Rates would be set ‘politically’ either way. Just a matter of who.

Treasury debt had enormously increased during World War II, exceeding 100 percent of the GDP, so there was concern about an intolerable impact on the budget if interest rates rose strongly. Moreover, if the Fed permitted higher interest rates this might lead to panicky and speculative reactions. Declines in bond prices, which would fall as interest rates rose, would drain bank capital. Main-line economists, and the Fed itself, worried that a sudden rise in interest rates could put the economy back in recession.

All of those concerns are in play today, some sixty years later, even if few now take the extreme view of the first report of the then new Council of Economic Advisers in 1948: “low interest rates at all times and under all conditions, even during inflation,” it said, would be desirable to promote investment and economic progress. Not exactly a robust defense of the Federal Reserve and independent monetary policy.

But in my humble opinion a true statement!

Eventually, the Federal Reserve did get restless, and finally in 1951 it rejected overt presidential pressure to maintain a ceiling on long-term Treasury rates. In the event, the ending of that ceiling, called the “peg,” was not dramatic. Interest rates did rise over time, but with markets habituated for years to a low interest rate, the price of long-term bonds remained at moderate levels. Monetary policy, free to act against incipient inflationary tendencies, contributed to fifteen years of stability in prices, accompanied by strong economic growth and high employment. The recessions were short and mild.

I agreed with John Kenneth Galbraith in that inflation was not a function of rates, at least not in the direction they believed, due to interest income channels. However, the rate caps on bank deposits, etc. Did mean that rate hikes had the potential to disrupt those financial institutions and cut into lending, until those caps were removed.

In general, however, the ‘business cycle’ issues are better traced to fiscal balance.

No doubt, the challenge today of orderly withdrawal from the Fed’s broader regime of “quantitative easing”—a regime aimed at stimulating the economy by large-scale buying of government and other securities on the market—is far more complicated. The still-growing size and composition of the Fed’s balance sheet imply the need for, at the least, an extended period of “disengagement,” i.e., less active purchasing of bonds so as to keep interest rates artificially low.

Artificially? vs what ‘market signals’? Rates are ‘naturally’ market determined with fixed fx policies, not today’s floating fx.

In fact, without govt ‘interference’ such as interest on reserves and tsy secs, the ‘natural’ rate is 0 as long as there are net reserve balances from deficit spending.

Nor is there any technical or operational reason for unwinding QE. Functionally, the Fed buying securities is identical to the tsy not issuing them and instead letting its net spending remain as reserve balances. Either way deficit spending results in balances in reserve accounts rather than balances in securities accounts. And in any case both are just dollar balances in Fed accounts.

Moreover, the extraordinary commitment of Federal Reserve resources,

‘Resources’? What does that mean? Crediting an account on its own books is somehow ‘using up a resource’? It’s just accounting information!

alongside other instruments of government intervention, is now dominating the largest sector of our capital markets, that for residential mortgages. Indeed, it is not an exaggeration to note that the Federal Reserve, with assets of $3.5 trillion and growing, is, in effect, acting as the world’s largest financial intermediator. It is acquiring long-term obligations in the form of bonds and financing those purchases by short-term deposits. It is aided and abetted in doing so by its unique privilege to create its own liabilities.

The Fed creates govt liabilities, aka making payments. That’s its function. And, for example, the treasury securities are the initial intervention. They are paid for by the Fed debiting reserve accounts and crediting securities accounts. All QE does is reverse that as the Fed debits the securities accounts and ‘recredits’ the reserve accounts. So it can be said that all QE does is neutralize prior govt intervention.

The beneficial effects of the actual and potential monetizing of public and private debt, which is the essence of the quantitative easing program, appear limited and diminishing over time. The old “pushing on a string” analogy is relevant. The risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention.

Right, with the primary fundamental effect being the removal of interest income from the economy. The Fed turned over some $100billion to the tsy that the economy would have otherwise earned. QE is a tax on the economy.

All of this has given rise to debate within the Federal Reserve itself. In that debate, I trust that sight is not lost of the merits—economic and political—of an ultimate return to a more orthodox central banking approach. Concerning possible changes in Fed policy, it is worth quoting from Fed Chairman Ben Bernanke’s remarks on June 19:

Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters as the near-term restraint from fiscal policy and other headwinds diminishes. We also see inflation moving back toward our 2 percent objective over time.

If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of [asset] purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.

In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.

I would like to emphasize once more the point that our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook as well as on the cumulative progress toward our objectives. If conditions improve faster than expected, the pace of asset purchases could be reduced somewhat more quickly. If the outlook becomes less favorable, on the other hand, or if financial conditions are judged to be inconsistent with further progress in the labor markets, reductions in the pace of purchases could be delayed.

Indeed, should it be needed, the Committee would be prepared to employ all of its tools, including an increase in the pace of purchases for a time, to promote a return to maximum employment in a context of price stability.

Implying QE works to do that.

I do not doubt the ability and understanding of Chairman Bernanke and his colleagues. They have a considerable range of instruments available to them to manage the transition, including the novel approach of paying interest on banks’ excess reserves, potentially sterilizing their monetary impact.

Reserves can be thought of as ‘one day treasury securities’ and the idea that paying interest sterilizing anything is a throwback to fixed fx policy, not applicable to floating fx.

What is at issue—what is always at issue—is a matter of good judgment, leadership, and institutional backbone. A willingness to act with conviction in the face of predictable political opposition and substantive debate is, as always, a requisite part of a central bank’s DNA.

A good working knowledge of monetary operations would be a refreshing change as well!

Those are not qualities that can be learned from textbooks. Abstract economic modeling and the endless regression analyses of econometricians will be of little help. The new approach of “behavioral” economics itself is recognition of the limitations of mathematical approaches, but that new “science” is in its infancy.

Monetary operations can be learned from money and banking texts.

A reading of history may be more relevant. Here and elsewhere, the temptation has been strong to wait and see before acting to remove stimulus and then moving toward restraint. Too often, the result is to be too late, to fail to appreciate growing imbalances and inflationary pressures before they are well ingrained.

Those who know monetary operations read history very differently from those who have it wrong.

There is something else that is at stake beyond the necessary mechanics and timely action. The credibility of the Federal Reserve, its commitment to maintaining price stability, and its ability to stand up against partisan political pressures are critical. Independence can’t just be a slogan. Nor does the language of the Federal Reserve Act itself assure protection, as was demonstrated in the period after World War II. Then, the law and its protections seemed clear, but it was the Treasury that for a long time called the tune.

And didn’t do a worse job.

In the last analysis, independence rests on perceptions of high competence, of unquestioned integrity, of broad experience, of nonconflicted judgment and the will to act. Clear lines of accountability to Congress and the public will need to be honored.

And a good working knowledge of monetary operations.

Moreover, maintenance of independence in a democratic society ultimately depends on something beyond those institutional qualities. The Federal Reserve—any central bank—should not be asked to do too much, to undertake responsibilities that it cannot reasonably meet with the appropriately limited powers provided.

I know that it is fashionable to talk about a “dual mandate”—the claim that the Fed’s policy should be directed toward the two objectives of price stability and full employment. Fashionable or not, I find that mandate both operationally confusing and ultimately illusory. It is operationally confusing in breeding incessant debate in the Fed and the markets about which way policy should lean month-to-month or quarter-to-quarter with minute inspection of every passing statistic. It is illusory in the sense that it implies a trade-off between economic growth and price stability, a concept that I thought had long ago been refuted not just by Nobel Prize winners but by experience.

The Federal Reserve, after all, has only one basic instrument so far as economic management is concerned—managing the supply of money and liquidity.

Completely wrong. With floating fx, it can only set rates. It’s always about price, not quantity.

Asked to do too much—for example, to accommodate misguided fiscal policies, to deal with structural imbalances, or to square continuously the hypothetical circles of stability, growth, and full employment—it will inevitably fall short. If in the process of trying it loses sight of its basic responsibility for price stability, a matter that is within its range of influence, then those other goals will be beyond reach.

Back in the 1950s, after the Federal Reserve finally regained its operational independence, it also decided to confine its open market operations almost entirely to the short-term money markets—the so-called “Bills Only Doctrine.” A period of remarkable economic success ensued, with fiscal and monetary policies reasonably in sync, contributing to a combination of relatively low interest rates, strong growth, and price stability.

Yes, and the price of oil was fixed by the Texas railroad commission at about $3 where it remained until the excess capacity in the US was gone and the Saudis took over that price setting role in the early 70′s.

That success faded as the Vietnam War intensified, and as monetary and fiscal restraints were imposed too late and too little. The absence of enough monetary discipline in the face of the overt inflationary pressures of the war left us with a distasteful combination of both price and economic instability right through the 1970s—a combination not inconsequentially complicated further by recurrent weakness in the dollar.

No mention of a foreign ‘monopolist’ hiking crude prices from 3 to 40?

Or of Carter’s deregulation of nat gas in 78 causing OPEC to drown in excess capacity in the early 80′s?

Or the non sensical targeting of borrowed reserves that worked only to shift rate control from the FOMC to the NY fed desk, and prolonged the inflation even as oil prices collapsed?

We cannot “go home again,” not to the simpler days of the 1950s and 1960s. Markets and institutions are much larger, far more complex. They have also proved to be more fragile, potentially subject to large destabilizing swings in behavior. There is the rise of “shadow banking”—the nonbank intermediaries such as investment banks, hedge funds, and other institutions overlapping commercial banking activities.

Not to mention restaurants letting people eat before they pay for their meals. This completely misses the mark.

Partly as a result, there is the relative decline of regulated commercial banks, and the rapid innovation of new instruments such as derivatives. All these have challenged both central banks and other regulatory authorities around the developed world. But the simple logic remains; and it is, in fact, reinforced by these developments. The basic responsibility of a central bank is to maintain reasonable price stability—and by extension to concern itself with the stability of financial markets generally.

In my judgment, those functions are complementary and should be doable.

They are, but it all requires an understanding of the underlying monetary operations.

I happen to believe it is neither necessary nor desirable to try to pin down the objective of price stability by setting out a single highly specific target or target zone for a particular measure of prices. After all, some fluctuations in prices, even as reflected in broad indices, are part of a well-functioning market economy. The point is that no single index can fully capture reality, and the natural process of recurrent growth and slowdowns in the economy will usually be reflected in price movements.

With or without a numerical target, broad responsibility for price stability over time does not imply an inability to conduct ordinary countercyclical policies. Indeed, in my judgment, confidence in the ability and commitment of the Federal Reserve (or any central bank) to maintain price stability over time is precisely what makes it possible to act aggressively in supplying liquidity in recessions or when the economy is in a prolonged period of growth but well below its potential.

With floating fx bank liquidity is always infinite. That’s what deposit insurance is all about.
Again, this makes central banking about price and not quantity.

–

Feel free to distribute.

Smart not to intervene and use reserves.

And even the 19% isn’t as much as Japan’s recent approx. 25% drop, so they all remain stronger vs the yen. So the US now loses ‘competitiveness’ vs a whole mob of exporters cutting ‘real’ wages vs US, Canada, UK, and the Eurozone etc. As the ongoing global race to the bottom for real wages continues…

And maybe some day they’ll figure out that cutting rates supports a currency as it cuts interest paid by govt, making the currency ‘harder to get’.

And that exports are real costs and imports real benefits.

And that real standards of living are optimized by sustaining domestic full employment with fiscal adjustments.

Emerging Nations Save $2.9 Trillion Reserves in Rout

By Jeanette Rodrigues, Ye Xie and Robert Brand

September 4 (Bloomberg) — Developing nations from Brazil to India are preserving a record $2.9 trillion of foreign reserves and opting instead to raise interest rates and restrict imports to stem the worst rout in their currencies in five years.

Foreign reserves of the 12 biggest emerging markets, excluding China and countries with pegged currencies, fell 1.6 percent this year compared with an 11 percent slump after the collapse of Lehman Brothers Holdings Inc. in 2008, data compiled by Bloomberg show. The 20 most-traded emerging-market currencies have weakened 8 percent in 2013 as the Federal Reserve’s potential paring of stimulus lures away capital.

After quadrupling reserves over the past decade, developing nations are protecting their stockpiles as trade and budget deficits heighten their vulnerability to credit-rating cuts. Brazil and Indonesia boosted key interest rates last month to buoy the real and rupiah, while India is increasing money-market rates to try to support the rupee as growth slows. Central banks should draw on stockpiles only once currencies have depreciated enough to adjust for the trade and budget gaps, according to Canadian Imperial Bank of Commerce.

“If fundamentals are going against you, it’s not credible to defend a currency level — investors would rush for the exit when they see the reserves depleting,” said Claire Dissaux, managing director of global economics and strategy at Millennium Global Investment in London. “The central banks are taking the right measures, allowing the currencies to adjust.”

‘Fragile Five’
The South African rand, real, rupee, rupiah and lira, dubbed the “fragile five” by Morgan Stanley strategists last month because of their reliance on foreign capital for financing needs, fell the most among peers this year, losing as much as 19 percent.

Foreign reserves in the 12 developing nations including Russia, Taiwan, South Korea, Brazil and India, declined to $2.9 trillion as of Aug. 28, from $2.95 trillion on Dec. 31 and an all-time high of $2.97 trillion in May, data compiled by Bloomberg show. The holdings increased from $722 billion in 2002.

The figures don’t reflect the valuation change of the securities held in the reserves. China, which holds $3.5 trillion as the world’s largest reserve holder, is excluded to limit its outsized impact.

In the three months starting September 2008, reserves dropped 11 percent as Lehman’s collapse sent the real down 29 percent and the rupee 12 percent. India’s stockpile declined 16 percent during the period, while Brazil spent more than $14 billion in reserves in six months starting October, central bank data show.

‘Contagion Potential’
“Often, on the day of the intervention or its announcement, a currency will get a small bounce upward,” Bluford Putnam, chief economist at CME Group Inc., wrote in an Aug. 28 research report. “For the longer-term, however, market participants often return to a focus on the basic issues of rising risks and contagion potential.”

Putnam said “aggressive” short-term interest rate increases that “dramatically” raise the costs of going short a currency can work to stem an exchange-rate slide.

The Turkish and Indian central banks have developed tools to fend off market volatility while keeping their benchmark rates unchanged. Turkey adjusts rates daily and Governor Erdem Basci promised more “surprise” tools to defend the lira while vowing to keep rates unchanged this year. Since July, India has curbed currency-derivatives trading, restricted cash supply, limited outflows from locals and asked foreign investors to prove they aren’t speculating on the rupee.

Records Lows
India’s steps failed to prevent its currency from touching a record low of 68.845 per dollar on Aug. 28. The lira tumbled to an unprecedented 2.0730 the same day.

The rupee plummeted 8.1 percent in August, the biggest loss since 1992 and the steepest among 78 global currencies, according to data compiled by Bloomberg. The lira plunged 5.1 percent, the rand dropped 4.1 percent, the real fell 4.6 percent and the rupiah sank 5.9 percent, the data show.

The Indian currency rose 1.1 percent 67.0025 per dollar as of 1:46 p.m. in Mumbai today, while its Indonesian counterpart gained 0.3 percent to 11,409 versus the greenback. South Africa’s rand appreciated 0.8 percent to 10.2549 per dollar, while the Turkish lira strengthened 0.4 percent to 2.0505.

Interest-rate swaps show investors expect South Africa and India’s benchmark rate will increase by at least 0.25 percentage point, or 25 basis points, by year-end, according to data compiled by HSBC Holdings Plc. In Brazil, policy makers are forecast to raise the key rate by 100 basis points to 10 percent, and Turkey will lift the benchmark one-week repurchase rate by 200 basis points to 6.5 percent, the data show.

Turkey’s Babacan Warns Of Financial Turmoil

By Yasemin Congar

August 27 (Al Monitor) — Emerging markets will soon find themselves operating in a new world order. Few people are as painfully aware of this as Turkey’s Deputy Premier Ali Babacan.

A soft-spoken politician whose key positions in three successive Justice and Development Party (AKP) governments included a two-year stint as foreign minister, Babacan is currently the highest-ranking cabinet member responsible for the economy.

Needless to say, he was all ears when US Federal Reserve Chairman Ben Bernanke suggested on May 22 before the US Congress that it could begin to downsize its $85 billion-per-month bond-buying program.

Babacan had seen that coming. He warned Turkey repeatedly against overspending in 2012 — even at the risk of displeasing Prime Minister Recep Tayyip Erdogan — because he knew cheap loans would soon grow scarce.

Loans in lira are at whatever the CB wants them to be.

Indeed, the United States is getting ready to curtail the stimulus that has injected cash into emerging markets for the last four years.

QE isn’t about cash going anywhere, including not going to EM.

What they got was portfolio shifting that caused indifference rates to change.

Stocks plummeted at the news and national currencies fell against the dollar, with India, Brazil and Turkey all registering substantial losses.

Again, portfolio shifts reversing causing indifference levels to reverse.

Still, answering questions on live television on May 23, Babacan was as cool-headed as ever. First, he reminded the viewers that the European Central Bank and Bank of Japan would follow suit, thus making the impact of the Fed’s exit even stronger on Turkey. Then he said, “If they carry out these operations in an orderly and coordinated fashion, we will ride it out.”

Hope so. They need to focus on domestic full employment.

As Babacan would surely have known, that is a big if. Despite a recent call for coordination by the International Monetary Fund’s managing director, Christine Lagarde, sell-offs in emerging markets do not seem to be a major concern for the architects of the taper plan.

“We only have a mandate to concern ourselves with the interest of the United States,” Dennis Lockhart, president of the Atlanta Fed, told Bloomberg TV. “Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

In fact, adjustment is not a question of choice here. Emerging economies will have to find a way to continue funding growth and paying off debt without the liquidity infusion. It won’t be easy.

Can’t be easier. Lira liquidity for their banking system is always infinite.

It’s just a matter of the CB pricing it. I’d suggest a Japan like 0% policy and a fiscal deficit large enough to allow for full employment.

The looming exodus of cash and higher borrowing costs have already caused permanent damage in Turkey. The lira weakened dramatically on Aug. 23, with the dollar surpassing two liras for the first time in history.

That was not what caused the decline.

The decline was from portfolio managers changing their indifference levels between the lira and the dollar or euro, for example.

Turkey’s Central Bank dipped into its reserves, but a $350 million sale of foreign exchange reserves failed to calm the market.

A mistake. No reason to buy their own currency with $ reserves, which should only be used for ‘emergency imports’, such as during wartime. All the intervention did was support monied interests shifting portfolios.

Babacan, for his part, has been referring to Bernanke’s May 22 speech as a turning point. The global economic crisis has entered a new phase since that day, he said. “We’ll all see the spillover effects and new faces of the crisis in the coming months.”

What they will mostly see is the effects of their policy responses if they keep doing what they’ve been doing.

He did not stop there. In his signature straight-shooting manner, he also signaled a downward revision. “It should not be surprising for Turkey to revise its growth rate below 4%. … We set our annual exports target at $158 million, but it looks difficult to reach this target as well.”

Which opens the door for a tax cut/spending increase/fiscal adjustment to sustain output and employment.

A politician who seldom walks and talks like a politician, Babacan has been a maverick of sorts in the government. He entered politics in 2001 when he joined Erdogan and others to found the AKP. At the time, he was a 34-year-old with a degree from the Kellogg School of Management and work experience as a financial consultant in Chicago. In 2002, he was appointed the state minister for economy and became the youngest member of the cabinet.

Today, Babacan still has the boyish looks that earned him the nickname “baby face,” and he still exhibits a distaste for populism.

Guess he doesn’t support high levels of employment. In that case they are doing the right thing.

The most significant feature of Turkey’s recent economic success is fiscal discipline, and no one in the government has been a stronger supporter of that than Babacan.

Yikes! Kellogg school turns out flakes… :(

Around this time last year, when a fellow cabinet member, Economy Minister Zafer Caglayan — equally hardworking, yet keener on instant gratification — criticized the Central Bank’s tight monetary policy, Babacan slammed him.

“We do not have the luxury of pressing the brakes,” Caglayan had said. Babacan’s response: “In foggy weather, the driver should not listen to those telling him to press the gas pedal.”

The weather is clear, the driver is blind.

In what came to be known as the “gas-break dispute,” Erdogan threw his weight behind Caglayan and criticized the statutorily independent Central Bank for keeping interest rates too high.

Agreed!

Last week, the Central Bank hiked its overnight lending rate for the second month in a row by 50 basis points to 7.75%. Erdogan and Caglayan watched quietly this time, hoping the raise would help prevent the lira from sliding further. It did not.

Of course not. It makes it weaker via the govt spewing out more in lira interest payments to the economy.

As Babacan’s proverbial fog is slowly lifting to reveal a slippery slope, I can’t help but wonder if he feels vindicated by the turn of events. Probably not, since the risk that awaits Turkey now is worse than a taper tantrum, and Babacan must know just how bad it can get.

The Fed’s decision exposed Turkey’s vulnerability.

Yes, ignorance.

Described by economist Erinc Yeldan as “a gradually deflating balloon, subject to erratic and irregular whims of the markets,” Turkey’s speculative growth over the last four years has been financed by running a large current account deficit, which in turn was funded with hot money that is no longer readily available.

Nonsensical doubletalk.

As Standard Bank analyst Timothy Ash pointed out last week, “It is a bit hard to recommend [buying the lira or entering] bond positions while inflation remains elevated, and the current account is still supersized at $55-60 billion, with that huge external financing requirement.”

Or, it’s hard selling the dollar or euro with their intense deflationary/contractionary policies…

Estimated at $205 billion, or a quarter of Turkey’s gross domestic product (GDP), the external financing requirement is huge, indeed.

There is no such thing.

“A more extreme measure of vulnerability would add the $140 billion of foreign-held bonds and shares,” Hugo Dixon wrote in his Reuters blog. “If this tries to flee, the lira could plunge.”

Huh???

Babacan admits that “Turkey might feel the negative effects of the Fed’s policy shift a bit higher than others … due to our already higher current account deficit.”

Turkey’s reliance on hot money to turn over its short-term external debt, which has been increasing more rapidly than the national income, is only the tip of the iceberg. What makes Turkey’s robust growth rates of 9% in 2010 and 8.5% in 2011 unrepeatable might be the disappearance of cheap loans. However, the real reason behind the unsustainability of such growth is structural.

Growth can be readily sustained with lira budget deficits and a 0 rate policy would help with price stability as well.

From insufficient capital accumulation and a low savings ratio to poor labor efficiency, the Turkish economy suffers chronic ills that can only be cured through radical reforms, including a major overhaul of the education system.

Education is good, but unemployment is the evidence the deficit is too small.

Again, Babacan knows it. Earlier this year, he commented on the government’s plan to increase the GDP per capita to $25,000 in 2023 by pointing out an anomaly:

“No other country in the world with an average education of only 6.5 years has a per capita income of $10,500. And no country with such an education level ever had an average income of $25,000. Without solving our education problem, our 2023 targets will remain a dream.”

Some say ignorance is bliss. Listening to Babacan makes me think they may be right. After 11 years, being part of a government that failed to do what you know should have been done cannot be much fun.