Friday, February 26, 2010

The indomitability of risk

Since my last post leads in to a point that I made in November 2008, I am recycling it here:

The 3 Laws of Risk

1. For every potential return created, we create an opposite potential risk. If banks wish to earn investment income, they need to engage in a financial transaction. The more transactions they enter, the greater the potential income and risk.

2. Risk, once created, cannot be destroyed or absolutely decreased (unless potential return is also decreased or given up). It can only be transferred, shared, or dispersed.

3. In a system where risk has been shared and dispersed among interconnected institutions, any random adverse change in risk in any locality will adversely change the risk in other localities of the system. This is true of all kinds of risk, whether credit default risk, market risk, volatility risk, interest risk, currency risk, sovereign risk, or capitulation risk. They are all inter-connected.

These three laws then lead us into extrapolating five major implications of risk on a financial system.

5 implications of risk on a financial system

1. Any firm trying to earn additional return by taking on the risk of another party, either by entering into a swap, selling an option, guarantee, or insurance to the other party, incurs a potential risk of loss that runs up to a maximum of the loss of the counterparty. AIG and Citibank, more than any others, have learned this the hard way.

2. Any firm that tries to hedge its risk by entering into a swap with another party only succeeds in transferring the original risk to another party. That’s what Goldman was successful in doing to AIG.

3. Worse, if each party in the chain that offers to be a counterparty in this risk management process tries to earn a minimal return on the transaction, it creates additional counterparty risk that was not there before. Hence the more firms involved in a chain of counterparty swaps and derivatives transactions, the greater the resulting risk created in the system. Any and all returns earned from entering into these types of transactions should not paid out to employees or shareholders of the firms, but kept as capital buffer in the event of such systemic meltdown.

4. The more interconnected a system, and the more of these types of transactions it has, the greater the likelihood of a systemic meltdown. Due to the need to bailout insolvent but crucial entities (to the continued functioning of the system) in the event of a meltdown, these firms should not be allowed to enter into derivative transactions.

5. There is no such thing as a benign or risk-free environment. You can never create an environment where risk has been controlled or made benign. It only means risk has been put at rest. But the more risk is put at rest, the greater its potential blowup energy. You may only succeed in causing it to implode more fiercely, and in unexpected ways. This makes the case for having a centralized clearing house that more important. With a clearing house, we can better track where in the system risk is building up, and we can correspondingly require greater collateral protection before something unexpected blows up.

Investment bankers, swaps......and Ulcer!

So the Greek government has been revealed to be using swaps to disguise its debt. What else is new? It seems that there is no limit to the convolutions and disguises that can be made possible by using swaps.

Want to borrow more but don’t want to show on your books just how much you might be liable for in the future? Why not raise an amount with a swap arrangement, such that the liability you record on your books does not correspond to the actual servicing you have to pay? Want to improve your profitability ‘optics’? Why not do a swap where you can record upfront gains while hiding any future premiums that may have been created. Want to get into an investment not legally allowed for your institution? Why not buy the legally allowed one, and swap the returns (and the risks) with what you had wanted all along? The list of uses goes on.

When investment bankers talk about the benefits of derivatives, they talk about its function in managing risks for companies and investors. They talk about its ability to shift risk from those who don’t, or can’t take risk, to those willing and able to bear it. What they don’t talk about is just what types of companies, investors and entities, in real life, are the best clients for such products.

No, it’s not investors trying to manage risks. The best way to manage risk is to avoid positions whose possible risks can kill the organization. No, the best clients for derivatives are those who want to use it hide their existing risks, to convolute their end investors. The best client s are those who want to take on MORE risk, without seeming like they are doing so. They are those who want to seem like they are going by the book, when in fact they are betting the farm.

Swaps seem to be the most versatile product of them all for people with this kind of need. And investment banks have been hawking swaps to willing (and knowing ) clients all these years. For swaps enable client issuers to push issues with what I would call ULCER – Undisclosed Liabilities Contingent on Expected Risk – onto other investors.

Contingent risks are a normal staple of any investing. You cannot get into any business, or buy into any investment product with reasonable return, without avoiding a corresponding risk. When an investor enters into a transaction, there are contingent risks, and there any number of scenarios where they can expect to realize the risk.

The problem here is the undisclosed liabilities part. The swap enables issuers to sell instruments that hide the risk. Because the risk is coming from an asset or liability that is not recorded on the issuer’s balance sheet, no disclosure is made of this contingent risk (unless it is audited by a conscientious auditor who insists on mentioning it in the footnotes) The liability risk only gets disclosed if the time comes when subsequent events make the risk to become more evident, and expected.

It is difficult to swallow that companies (and governments) would unknowingly get into these kinds of swap arrangements without fully understanding the risks. For one, they know that they are getting the twisted benefits. In Greece’s case, they were able to raise more debt than they recorded. Because of the swap, the end buyers of that debt, and any subsequent debts, never knew that they were being fed an issue with ULCER.

When a company reports healthy profits in the current period, which mainly come from one-time mark-to-market gains on a swap where future streams may end up being contingent liabilities of the company, you can say that the company’s shareholders are being fed an issue with ULCER.

And when an insurance firm’s investment manager, aided by a swap, buys a fluctuating rate instrument denominated in a speculative currency not allowed buy its investment guidelines, its subscribers and investors and being fed ULCER.

But what can you expect of investment bankers who continue to hawk deal after deal of this sort? After all, most of their biggest clients now have numerous alternatives for raising capital, or can directly fund their projects themselves using internally-generated funds. The only way they stay relevant is by allowing themselves to be the intermediary which allows their clients to hide risk from potential and existing investors. So they pimp more swaps to more clients. And these swaps are now the main reason there is so much ULCER in the financial system, and everyone is getting sick digesting all its toxic acid.

Sunday, February 21, 2010

But what about depositors?

Nick Rowe has stirred up a real hornet’s nest with his last two posts, here and here. He’s basically saying that banks’ lending decisions are affected by reserves, rather than just by capital, as what the Chartalists (or MMT or PK, as they also seem to be known by) have been saying.

Economists from all directions of the monetary and economic profession have weighed in. There have been arguments in the comments, either saying that banks are reserve-constrained, and then either saying that all the reserves the Fed has recently created will be lent out soon, sparking inflation, or are being constrained by the Fed’s interest on reserves. Then there were arguments that banks are not reserve-constrained (and that they do not matter at all,) and are instead capital-constrained. There has been mention about Canada’s banking system having been zero reserve for some time now.

There have been arguments saying that additional reserves create loans, or that additional deposits create loans. There have been arguments that banks lend only when there are creditworthy clients, but there are also those who say banks have to lend when deposit levels rise, and there are those who say that banks have to decide to both raise loans and deposits simultaneously. There have even been assertions that small banks care more about reserves while big banks care more about deposits when deciding to lend out. There has been confusion as to excess reserves is vs. excess desired reserves. There was some discussion of reserves as merely a bank settlement mechanism, and also what might happen if banks ever settle without base money. And there have been discussions on how a bank’s making more loans actually increases money supply, i.e., if there is a multiplier.

Those 2 posts of Nick have been a veritable 'clash of the titans', and the most creative economic bloggers in banking and monetary theory seem to have chimed in. Interesting ideas, all, so I put forth a question to all, thinking there should be something in current thinking that addresses it:

But what about the depositors? I have yet to hear ideas on what happens to depositors when the banks are awash with reserves. Do they still continue keeping their money with the banks, knowing that it nets them no differently from putting their money under the mattress? What of their other alternatives? What if it's causing them to pour more money instead in objects with 'perceived' scarcity? Could this lead to an actual reduction in the multiplier?

Ok, I added the multiplier statement because it was after all a post about multipliers. At this point, I’m not sure anymore that loans and deposits could have a directly observable multiplier effect. But since depositors seemed, to me, a crucial component of the concept being discussed, why was all the discussion merely centered on how the flooding of reserves may or may not affect bank lending? How was it affecting bank deposits? Depositors are, after all, you and I, and people we know.

I’m still waiting for someone to take up my query, and it has now been buried underneath further discussions on whether banks indeed lend reserves. I can only surmise that while everybody remains engrossed on why banks haven’t been lending out all those new reserves that the central bank has pushed onto their balance sheets, we would soon be shocked by the final outcome of what Roubini has warned us as being the mother of all carry trades. Flooding commercial banks with reserves without regard to its effect on depositors' rates is a boon for Wall Street investment firms looking to capitalize on the resulting depositor disenchantment. Even if they get only those disenchanted enough at the margin, that could still be enough to explain for the return of risk among investment funds. So in the meantime, Wall Street hustlers will probably make hay while the sun is out. I have the perfect pitch for them:

"Give me your funds, your surplus,
Your crowded out deposits yearning for yield,
The wretched refuse of the banks swimming in reserves.
Send these, the yieldless, liquidity-tossed to me,
I lift my investment rates beside the golden carry trade!"

Tom Hickey makes a valid point in comments: Reserves are of no concern to depositors. Reserves are solely for interbank settlement and do not have any direct impact on the depositors until they write checks on their deposit accounts. Then there is never a worry because the Fed always provides the reserves necessary for the system to settle transactions among commercial banks. Where's the problem?

Reserves affect borrowers in the commercial banking system because the Fed sets the FFR and the discount rate on borrowed reserves in the interbank overnight market that influences spreads by affecting the banks' cost of making a loan. Depositors with funds in excess of FCID limits need to be concerned about bank solvency (capital), not liquidity (reserves).

So I clarify my thoughts: You could say that since most commercial banks now have excess reserves, this is lowering the price for them to source funds for settlement, so they do not have to pay as much to attract depositors as a stable source of funding. Although thinking about it more, it may not really be the flooding of reserves in the commercial banks that may have caused the lower rates per se, if they are, as winterspeak/JKH said in Nick’s post, just the after-effects of Fed buying out bank toxic assets. But could it be more correct to say that the low FFR (rather than reserves) is causing the deposit rates to be low?

Nonetheless, what I’m pointing out here is the after-effect: that depositors at the margin who are dissatisfied with their current rates putting money in the bank may be easily convinced to put more money in funds/shadow banks that are 1) outside the scope of normal regulation, 2) are usually invested in securities that are higher risk, and 3) generally introduce inter-connectedness risk into the system, if these shadow banks invest/hedge with/lend to one another.

Friday, February 19, 2010

Unfettered opportunity

This is more a philosophical post than it is economic. I want to explore what the real cost of “unfettered opportunity” is.

Most humans want to be free – free to do what they like, within the bounds of law, to do things how they so wish, and to enjoy the rewards of whatever outcome their effort leads to. This is a basic human desire. I also believe that everything worth the effort has to provide a clear upside to those who do, compared to where they are now.

Every culture and every group of people has its own standards of what unfettered opportunity should be. Some groups would allow individuals the endless chance to work harder, to take more risks, to do what others would rather not do, and allow that enterprising individual to reap whatever benefits his work allows him to. Some groups would lean more towards a more harmonious teamwork, where everybody shares in the pain more equally, but also shares in the gains equally as well. Most groups would lean somewhere in between.

In the US, the culture leans more towards individual initiative and individual enterprise. This has been their hallmark, and they have continually trumpeted it as a leading cause of the high success of capitalism there. For capitalism is a system that best functions when people are allowed to have an individualized stake in the outcome, and therefore allows for greater competition to get the spoils.

But at the end of the day, not everyone will emerge the big winner, and along the way, many people who worked, to share in the spoils, may fall along the wayside, casualties of the gritty battle, not for limited spoils, but to corner the largest amount of it.

If you ask a regular guy brought up in the culture that is America, they would say that they would rather have a government that steps out of the way, does not overly tax its citizens, and allows them to keep more of their ‘fair share’. They will not stand for a government that seeks to redistribute income, such that everybody gets to have a more equal share of the common pie. For I believe that it is also true that in that redistributative scenario, many may be tempted to slack off and live off of the burdens of those who work.

However, what are the bounds of unfettered opportunity? Should there be any? Should it also mean that individuals are able to define wholly what their work is, and how it should be done? I ask this because, in a system where everybody is in a rush to get more of the common pie, to get their ‘fair share’ of the spoils, people could often overstep the boundaries of fair play. Moreover, if this rush to get as much as you can becomes an overarching determinant of the work ethic of an entire people, then people are led, incrementally but most assuredly, further and further beyond the boundaries.

Over time, what started off as a simple system that allowed people to work for their own benefit, without the hanging sword of an ever present government looking to take away their gains, becomes a system where only the most ruthless and most clever by half gain everything. This leads to an outcome where the winner eventually takes all.

And yet, despite the obvious disadvantages of such unfettered opportunity, many American have historically seemed to want it that way, in the belief that they will at least have the chance to be the one that gets to take it all. This mentality is no different from the high stakes gambler who seeks to put in every last penny he has in a common pot where only person will end up getting the whole jackpot.

Why does this mentality exist? And why is it so prevalent, or can become prevalent in a culture such as the US? What is it about getting more that makes people want to have the chance to have it all, even if the chances of one’s being the one to get it are slim?

Or maybe nobody actually believes that there are people ruthless enough to take as much as they can, even though their effort ends up causing a loss to someone else? And by this, I’m not thinking in terms of a zero sum game. I’m thinking in terms of people who would compromise the safety and integrity of an entire system in their quest to win. I’m thinking of the crazed hostage taker willing to blow up an entire building, including himself, unless he gets what he wants. I’m thinking of the cattle farmer who games the buyer, by making cattle drink more water before weighing them (the etymology of the term ‘watering stock’).

Anyway, I’m already jumping topics – the paying of taxes, greed, the commission of fraud. But they all have a common starting point, which is the allowance of unfettered opportunity. I believe that people who work more or risk more should be entitled to greater share of spoils. They should not be taxed for earning more. But I don’t believe that people who, out of greed - will lie, cheat, steal, or commit outright fraud - should be given free pass. Those who end up introducing risk to others or to the system, or causing hardship to others, or putting costs where there was none before - these are the products of a culture where rampant opportunism has run amok.

I think equal opportunity is something that any country should strive to provide its citizens. But in the interest of the common good, there should be boundaries, and there should be harsh consequences to those who decide to cross these boundaries. And I think that something could also be said about taxing the acquisition of wealth beyond what one individual can productively put to use within a realistic lifetime.

Tuesday, February 16, 2010

US banks are not capital-constrained

So Scott Fulwiller and the rest of the Chartalist gang have been saying that bank lending is capital-constrained. Banks will not lend if they do not have the requisite capital.

Well, that just goes to show you how American banks are really a cut above all the rest. You see, American banks are NOT limited by capital constraints. Here are 6 reasons why:

1. Securitization Why do you need to extend loans to everyone asking for one when you can just originate them and pass them along to other holders? Why tie up your capital for 20 to 30 years when you can just be the intermediary crunching the loans and securitizing them to hungry investors? Here’s the thing. …extending loans and keeping them on the balance sheet—capital-eating. Originating and distributing an endless pipeline of loans and keeping the fees --capital accreting. You do the math.

And if one day, these originating banks will want to originate loans to bolster their own asset base, they can always provide a second mortgage to this existing base of clients. And should circumstances ever warrant that haircuts one day be necessary on haphazardly underwritten loans, having the second mortgage doesn’t necessarily mean they are subordinate. The originating banks can always bully their first lien holders (who bought the securitized loans) to take up some of the haircut, because after all, they can always say no. Take that first lien and shove it up you ass, moronic investors. Thank you yield-hungry investors.

2. SIVs Why do you need to put up capital when nobody knows you have such loans? So set up as many off balance sheet entities as you can, and make their inter-relationships obtuse and incomprehensible. Set them up offshore as much as possible. Thank you offshore corporate lawyers.

3. AAA-rated asset-backed securities Hey, if you happen to be one of the 2B2F banks, why even bother with the headaches of underwriting and monitoring hundreds of individual credit risks at all? Why not just get sliced and diced tranches of these securitized assets from the originators, and just buy up all the AAA-rated ones. How much of a capital risk weight will that be when all you’ve got are lots of AAA? Thank you S&P.

4. Mark-to-market accounting And hey, as long as you’ve got lots of securities on your balance sheet, look out for the capital appreciation made possible by your own investing activities. You’re 2B2F, when you go to market, you lift the market. Invest, mark-to-market, repeat. Then watch that capital grow. Thank you FASB.

5. Mark-to-model accounting And if you happen to be investing instead in illiquid securities, you can still mark them to your advantage. In fact, precisely since these securities are bespoke and not easily priced in the market, they have the best prospects of capital appreciation via mark to make believe. Thank you financial engineers.

6. Uncle Sam Well, if all these risk-taking activities end up biting you in the butt, and your capital is in danger of popping away like a bubble, why not double down? For all you know, the market will like the fact that you are supporting the market for your investments. And at the worst possible case, you know who really is the market maker of last resort, right? If you’re a member of the financial community of the world’s largest economy, the one that possesses the global default currency that can print as much money as it takes to prop you up, then who needs to really have all that capital just languishing your balance sheet? So thank you US taxpayers.

So while all the rest of the world’s banks have been busying themselves with endless rounds of equity capital raising, in the good ol’ US of A, there hasn’t really been any need. Bank capital raising is for chumps. In the US, they DIVIDEND capital out. Take that, lesser mortals.

While it may be true that lending is capital-constrained for the rest of the world, over there, it is demand-constrained. Chuck Norris kick to you, Basel II. For as long as there is demand for loans, everybody come and get them. And in an economy that builds up capital due to the very act of lending and investing made possible by the banks, demand for loans will increase. You can say that there is a self-reinforcing mechanism at work here. In this environment, demand for loans can reach up to infinity.

Update: This is not a send-up of Scott's point, but a satire of certain bankers' mentality, as I explain in the comments.

update 2: US banks don't need borrowers in order to 'lend'

Monday, February 15, 2010

Why I blog

A while back, I had a group at work with whom I’d have regular coffee breaks with. During these coffee conversations, which normally occurred during lunch hour, topics of interest, generally involving work, but oftentimes involving the economy in general, would be discussed. These discussions often yielded important ideas for our work, or for special projects, so the discussions were an integral part of widening our group’s aggregate knowledge base, and in increasing our respective productivities.

I have since moved on and I no longer get to have these conversations with the old group. But oftentimes, I would still have these conversation in my head, and I would yearn for the good old give and take with a group similarly engrossed with the same areas of interest. This is how I have come to get into blogging, because it essentially replicates the exchange of ideas and information that my old coffee group had. In fact, it was one of my old group mates who introduced me to the idea of blogging.

So now I put thoughts and topics on this blog that I would have otherwise discussed over cups of hot beverage with the old group. The act of writing my thoughts forces me to articulate and synthesize a starting position about a topic, much like when I was trying to get the group to my way of thinking, or when asking them for inputs in areas where my own levels of expertise was still lacking. Only this time, with a blog posted on the internet, the entire world wide web are the possible listeners and exchangers of ideas.

I blog pseudonymously because I want the freedom to express whatever positions I have, without regard to possible repercussions to my working life. I still work in private industry, and hence, anything I write publicly, using my own name, will come up in google searches, along with my own name. Hence, any and all positions I have in the blog, now or ever in the past, whether I still favour that position, have revised it a bit, or completely abandoned, can and will be used against me or the organization that I work with. That isn't a very wise choice, especially when some of the ideas and positions I adhere to could be detrimental to current or future clients, funders, partners, or workmates. So to avoid possible breaches of this personally imposed confidentiality, I don’t talk about having the blog, even to my family and closest friends . (I'm aware that Google, the owner of this blogging platform, could one day be a source of breach).

I chose economics as my specific area of conversation because of its relevance to current world problems. And ever since I read Joseph Stiglitz’ Globalization and its Discontents, I have come to realize that what we sometimes know to be correct prescriptions to economic problems could actually be, if you think about it, making problems worse. His book convinced me that we really don’t know enough about economics for anyone to be a fool-proof prescriptive policy adviser. Each case is different, and requires a specific inquiry into its own circumstances.

I have ever since been an omnivorous reader of economic ideas, to cull the best ideas, from both unconventional sources and what Stiglitz terms conventional wisdom. I’ve since come to notice that you can take conventional approaches in your search for answers, but if you think outside the box, still arrive at unconventional conclusions.

I’d like to believe that my small contributions, whether in this blog, or in discussions somewhere else, help and in framing the discussions better, in arriving at better approaches, and in getting closer to a correct answer, one blog discussion at a time. Hopefully, these discussions will yield useful ideas, widen our over-all aggregate knowledge base, and increase our chances of arriving at solutions that, while they solve the current problems at hand, minimize the possibility of causing the next problems.

Wednesday, February 10, 2010

I seem, in Greenspan’s words, to have found a flaw in my previous beliefs

I cannot be certain about it right now, but well, let me show you via posts by two prolific economic bloggers.

1. Do low rates in and of itself cause a bubble?

I have been of the belief that loose central bank policy has been responsible for stimulating the bubble investor mentality of the last decade. Low interest rates cause people to speculate, therefore, the central bank should avoid doing so in the future. But here is a post from Nick Rowe, in which he describes his thoughts on bubbles, that introduces some doubts on my certainty about central bank complicity:

And, for what it's worth, I believe in bubbles because I believe humans tend to follow faddish beliefs in lots of things, and I don't see why their beliefs in asset values should be any different….The expectations about the fundamental component are expectations about something that has an objective existence apart from beliefs about it. The expectations about the bubble component are expectations about expectations. Like Tinkerbell the fairy, they only exist if we believe in them; otherwise they die. That's what should make bubbles unstable. If others stop believing in them, there is no reason for us to believe in them.

See the implication? When humans want to believe something, they can make it so. If they believe that something will go up in value, then it will go up in value, low rates or not.

Real bubbles are unstable; they burst when you prick them. They don't spontaneously revert to their original size…..How do you know if something was a bubble? If you prick it and it bursts, it probably was a bubble. If you prick it and it goes back to the original size, it probably wasn't.

See the implication here? Once an asset bubble has been burst, confidence in the asset should not easily come back. Nick here is talking about the Canadian real estate.

Now some might argue that the Bank of Canada's low interest rates have re-inflated the bubble. But if the metaphor "bubble" means anything, it means you can't just re-inflate it after it's burst. It's supposed to be unstable."

This can be taken to absolve the Bank of Canada, Fed, in causing bubbles. Implication here is that their policy actions cannot create a ‘bubble’ because it is primarily caused by people who believe in an asset’s continued price appreciation. If an asset has shown that its price can suddenly burst, why would anyone go back in that asset market? What kind of mechanical investor goes and piles back in an asset that has been already proven to be ‘burstable’?

Maybe you could argue that there was a bubble in Canadian house prices; that bubble has now popped; but the fall in long term interest rates has raised the fundamental value by enough to compensate for the popped bubble; so the net effect on prices is about zero. But higher unemployment, and lower expected growth in real incomes, should have reduced the fundamental value of houses, and may well have offset any effect from lower interest rates.

Implication here is that lowered rates are a central bank’s policy to offset lower incomes, and an offset to owners for the lowered nominal prices. There is inevitability to the lowered rates, because short of the government handing out money to offset everyone’s lowered income, lowered rates seemed to be the only way to get everyone on the same cost level they were in before. No central bank blowing bubbles? Now if the lower rates also happened to raise asset values by enough to compensate for the popped bubble, does this mean it was stoking a bubble in the first place?

Here’s Nick’s reply: Since we don't really have much in the way of a theory about when bubble start and stop, it is hard to say whether monetary policy (or, more strictly, the need for interest rates to be low) was or was not responsible. There is some possibility that low interest rates make bubbles more likely to form, because very small changes in fundamentals (like expected growth rates) will then have bigger effects on fundamental values, so it becomes harder to tell what the fundamental value of an asset is. And *falling* (as opposed to low) interest rates, by causing rising fundamental values and prices, may sow the seeds of a bubble. But this is so speculative.

If low interest rates cannot be convincingly linked to the rise in asset prices, perhaps quantitative easing could be making the difference. Well, first off, here’ s Scott Fullwiller in reply to my query: Banks don't lend reserves. They create a loan, which simultaneously creates a deposit. Quantitative easing does absolutely nothing for banks' operational abilities to create loans. Banks are capital constrained, not reserve or deposit constrained.

And in a post by him…. the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank's ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding. In other words, there is no loan officer at any bank that checks with the bank's liquidity officer to see if the bank has reserves before it makes a loan.

What constrains a bank in the creation of new loans and deposits, then? First, there is the fact that there must be a willing borrower . . . one whom the bank deems to be creditworthy. Second, the loan must be perceived as profitable . . . in this case, the bank's ability to raise deposits does matter, since it probably expects the borrower to withdraw the deposit it will create, and finding new deposits is much cheaper for the bank than borrowing from other banks or from the Fed. Third, the loan must be on the regulator's approved list of assets, and if the loan results in an expansion of the bank's balance sheet, the bank must be aware of the impact on its capital requirements and other financial ratios with which the regulator is concerned.

Okay, in short, the central bank in adding reserves does not necessarily lead to more lending. Now I’ve been of the view that since QE changes the yield curve on treasury debt, transferring income from savers to borrowers, then QE can increase the supply of money in circulation, or at the very least, the amounts banks could be willing to lend. This is the only way to reverse the trend of transferring income from savers to borrowers.

But it can’t be denied that no additional lending is encouraged if no profitable accounts can be found. The banks have to therefore ‘believe’ that there are creditworthy and profitable accounts before they will undertake in more lending.

2. How much of the bubble is really controllable by the central bank?

Now neither can banks use excess reserves to speculate directly, as the regulatory capital cost of using them is more expensive than the reserve itself. But there is arguably a ‘bubble’ in a lot of asset classes: treasury bonds, emerging market debt, commodities. There must then be some other source of funds for the speculators who are, as Roubini terms it, doing the mother of all carry trades. If the commercial banks haven’t been funding the recent speculation in a big way, then these other sources, in and of themselves, can cause the bubble. They could be the mutual and money market funds, hedge funds, etc. Now none of these are within the central bank’s purview, but they all have scores of liquidity that are no longer funnelling towards the commercial banks, and they respond to low rates by reaching for yield in riskier asset classes.

So I have two questions:
If central banks cannot cause bubbles, they cannot also do anything to burst them. If rate setting and quantitative easing do not affect the market , once they already have their own beliefs about assets and potential accounts, then what is the central bank’s economic use, beyond regulation, that cannot be done by Treasury? (Though I think we're seeing a lot of indications that it really needs to be a stronger regulator, if we want borrrowers to be protected.)

And if the case is indeed that low rates can and does influence the creation of bubbles, and the effect is transmitted in the market via financial entities that are beyond central bank purview, should it then be regulating everybody else?

update: no more doubts about Fed ability to create bubbles

Saturday, February 6, 2010

How to think of what is happening with the Euro

Now let’s continue the thought experiment from my previous post to another kind of currency, the regional currency union (‘cough’, Euro! ‘cough, cough’).

In this instance, let’s think of Country AX and BX, who both use the common currency X. Neither of them issues their own currency. Currency is issued by a master headquarters comprised of bureaucrats from both AX and BX.

Now AX is a more productive economy than BX. As a result, it experiences a string of surpluses, while BX does not. In fact, just to catch up to AX, BX incurs debt (in X, of course) to finance its growth programs.

AX continues its string of surpluses. BX does not have the same results. The main reason is that AX’s string of surpluses is making X, which is a floating currency, more valuable. This makes BX’s exports more expensive for other countries, so it cannot hope to replicate AX’s results.

So to finance its deficits, and to finance its debt services, BX incurs more and more debt in X.

Now everything would be fine if AX would just give all its excess earning of X to BX. But that was not the point of incurring surplus in the first place. AX has an ageing population, and it has social programs to finance. So BX goes on its merry way of borrowing.

Master headquarters won’t help too, as it won’t ‘print’ more of X just to help BX, because doing so would be detrimental to AX. (There are also other countries, CX, DX, EX, who will also be adversely affected) So BX is in a bind.

How long before BX goes down and drags the entire X currency with it? But then if X goes down, that solves BX's unaffordability problem.

P.S. I just thought of this. When AX incurs its surpluses, doesn't master headquarters print more X, so other countries will have the currency to buy AX's goods? Implication is that for as long as BX is part of currency union X, and AX continues its surpluses, then BX will never run out X to borrow. But if master headquarters is actually a central bank and not a sovereign country, then it 'prints money' by actually printing money, not via government spending. So no jobs are actually created by its printing. Jobs are only created at AX because of AX's productivity, and the printing is merely a result of that. It's not printing in the same vein as that by country A in the previous post. Have I missed something else?

Friday, February 5, 2010

On currencies, global trade imbalances, money creation, and the GDR

Thinking about currency and money creation in the past few days has lately caused me to make some thought experiments on world trade, and in particular, the recently proposed idea of a global currency. Now I don’t normally go about making these thought experiments, so please let me know if I am missing something, or making some lapse in causation. If anything, I think I’m beginning to get the arguments of Marshall Auerback.

Now, a majority of economic thinkers in the world, now or in recent past, come from the United States. This causes some, if not altogether unintended, thinking of all trades purely in terms of US dollars. And why not? The US dollar is, after all, the current global currency medium. All trades the world over are priced, quoted, cleared, and settled in US dollar, the default global currency.

So let’s start our thought experiment. Let’s state that the country with the default global currency (which we know to actually be the US) is country A. It trades with another generic world country, which we shall call country B. To simplify matters, for now let’s only look at countries A and B. But know that there are a multitude of other countries that also trade with them and each other, also using A’s currency.

Now when A imports more than it exports, it incurs a deficit vis-à-vis country B. Because the trade was settled in A’s currency, B acquires foreign reserves (The reserves will be of course be in A’s currency). A, meanwhile, being the issuer of default currency, doesn’t have to do anything more than ‘print’ more currency.

Now what happens when it’s the other way, and B is the one that incurs the deficit? Because its currency is not the default, B has to buy A’s currency to settle the trade. It therefore borrows in A’s currency. The more deficits it incurs, the more borrowings it has to make in a foreign currency.

Now over the longer term, the net borrowings of B should depreciate its currency vis-à-vis A’s, which should make its exports cheaper in terms of A’s currency. Therefore, in the longer term, the balance should tilt back into B exporting more to A than A exporting more to it.

Again, when B is the surplus country, and it ends up holding more of A’s currency as reserves, its currency should go up vis-à-vis A’s currency. Therefore, longer term, A’s exports should become cheaper when converted to B’s currency. Longer term, A’s imports from B should go down and its exports to B should go up.


Now suppose B wanted to peg its currency to A, because doing so makes its exports to A, as well as to the other countries, cheaper. Its continuous surpluses enables it to accumulate more reserves of A’s currency. But to keep its currency from rising, it will lend its reserves back to A. A then gets more money to finance even more deficits. B does not lend to A because A needs the money (Why would it need more of what it can just print?). B lends to A because the act of lending enables B to maintain its peg to A. It is therefore not in B’s interest to stop lending, even when A’s constant deficits results in A’s currency depreciating. For one, B needs to keep lending if it wants to keep the peg. Two, precisely because of the peg, B's currency also goes down vis-à-vis other countries’ currencies.


Now, let’s suppose a country C, which has had a history of deficits, and therefore, has a sizeable borrowing in A’s currency. C, therefore, cannot afford a significant depreciation of its currency in terms of A's, because that would make its debt servicing more expensive. Then again, a depreciation in C's currency makes its exports cheaper in terms of A’s currency, and therefore enables C to export more, and to acquire more of A’s currency to pay down its debt. The best risk mitigating strategy for C is therefore to accumulate more and more reserves of A. Thus, to make sure it has the ability to control for potential fluctuations in its currency, and to pay down its debts, C will want to accumulate ever rising reserves of A. Thus, C provides even more opportunities for A to finance even more deficits.

Now, A, even if it eventually acquires significant borrowings from B and C, again need not worry much. As far as it’s concerned, either of two things can occur: 1) B and C stop financing more debts, in which case, A will just stop incurring deficits, but A’s currency will correspondingly fall, which will enable it to export more, and things balance out again, or 2) B and C will stick to their original objectives, to continue the peg or to accumulate more A’s reserves, which means A will be able to continue financing deficits. Also, whether scenario 1 or 2 happens, A will always be able to meet its objectives just by printing more money.

A never has to borrow (or can even manage to borrow) in anyone else’s currency because 1) other countries’ currencies are never in sufficient supply, and 2) there is not much use for anybody else’s currency when all trades are priced and settled in A’s currency.


Now, how would a move to a global currency change things? Let’s go back to the thought experiment.

When A incurs a deficit with B, it has to buy the GDR to finance the deficit. B has to sell currency to get paid the net surplus in its own currency. Over time, A’s currency goes down in terms of the GDR, while B’s goes up. Longer term, this should balance things as B ends up importing more from A than A from B.

Because all trades are already in GDR, there is no longer an incentive for B to peg its currency to A. Even more so, B cannot peg its currency to the GDR because it’s actually a basket of everybody’s currencies. Pegging to GDR causes B to have an endless loop with its own currency. So no more successful pegs.

Because all trades are already in GDR, country C, which has significant borrowing A’s currency, will still have an interest in exporting more, so that it has the reserves necessary to keep its currency from depreciating. However, because A will also need to buy the GDR to settles its trades, A will now no longer have an incentive to continue incurring deficits. This means less opportunities for C to accumulate reserves. So when the GDR comes, if C already had a sizable reserve to begin with, then maybe it will be safe. But if C had accumulated a very sizable borrowing in A’s currency, then the prevalent use of the GDR will probably ensure that C will perennially have trouble in keeping up with its debt servicing. The only way that C can pay is to continue incurring surplus with A. Thus, maybe A and C will continue settling in A’s currency, and C will continue to finance A’s deficits, until it feels it has enough reserves to maintain a stable currency.

So net, the GDR will constrain A’s ability to, in Tom Hickey’s words, “maintain order and foster the development of emerging nations, by making capital and technology available where it is needed”. It will also stop A's population from continuing to enjoy spending more than they produce, out of everybody else's need to acquire its currency. It will also entail a (probably temporary) difficulty for countries that have sizable foreign debts.

But over-all, it will probably result in less global imbalances. Does this conclusion seem complete to you?

Wednesday, February 3, 2010

Responses to my questions about Chartalism

In the comments, I get responses to my questions about Chartalism from Tom Hickey, Winterspeak and JKH, and I respond to their answers. I am posting them here to provide continuity from my previous post.

Tom Hickey said: Hi Rogue, good questions.
1. A sovereign government that is the monopoly provider of a non-convertible floating fx currency is not financially constrained but there are real constraints on currency issuance or either inflation or deflation will result. As the monopoly provider of the currency of issue, which enters the economy through government disbursements and creates net financial assets, the government has the corresponding responsibility to provide the proper amount of currency to balance nominal aggregate demand with real output capacity at full employment, neither providing too much, which would be inflationary, nor too little, which would be deflationary. Primary signals in judging nominal AD relative to real output capacity are the output gap and the employment rate.

2. Good question. This is why MMT favors fiscal means, since both disbursements and taxation can be tightly targeted to encourage more efficient and effective distribution when inefficiencies and deficiencies arise.

3. Floating fx rates generally handle international currency balance with respect to trade and other such issues. In addition, as the issuer of the world's reserve currency, the US is in a special position and relationship with other nations and their currencies. Therefore, the US must balance national and international needs. Similarly, the developed nations have recognized their responsibility to the global economy by maintaining order and fostering the development of emerging nations. This involves making capital and technology available where it is needed, for example, as well as forging international cooperation, e.g., WTO, G20, IMF, World Bank, SDR's, etc. Of course, there is still a long way to go.

4. The commercial banking system creates bank money or credit money by lending -loans create deposits. Therefore, all credit money in the economy nets to zero. Only the currency issuer can increase net financial assets (by disbursing) and reduce them (by taxing). The central bank affects the commercial banking system chiefly through its control of the overnight rate on reserves, which influence the cost of lending, hence, borrowing.

5. No absolute limit. This is a political choice. The Chinese make different choices in this regard than the US, for example.

6. The US government has a responsibility under the Constitution "to provide for the general welfare" (Preamble). MMT takes this to apply monetarily particularly to employment. MMT scholars have published a great deal on full employment and price stability.

7. MMT scholars have proposed a job guarantee that would set a stable floor price for labor.

There are two excellent intros to MMT principles:
Warren Mosler's 7 Deadly Innocent Frauds
L. Randall Wray, Understanding Modern Money: The Key to Full Employment and Price Stability

winterspeak said...
No disagreement with Tom, but another perspective:

1. Upper constraint to Govt issuing currency is an intolerable amount of inflation.

2. The best way to ensure Govt currency goes to everyone in today's high-tax world is to lower taxes (take less money away from people). Regressive taxes like payroll tax work best here. Or, it can be disbursed on per capita basis.

3. Chartalists like imports. It means an economy can issue tokens for real stuff. Real stuff is worth something, money is just a token, so yes, run higher deficits (lower taxes, higher spending) and fund foreign savings demand.

4. Banks are a public private partnership with the Govt. They cannot create net financial assets. Capital requirements limit how much credit they can extend. The hope is that banks will focus on making good loans (loans that will be paid back) because private capital is in first loss position for when those loans go bad. This is not how it has worked in practise for quite some time due to terrible regulation, and predatory banks are a product of their environment.

5. How much the Govt can or should direct private investigation is an issue outside of chartalism. Chartalism is mostly just accounting, it isn't really a "theory".

6. Generally, the Govt should keep its people employed. So yes, if businesses experience aggregate demand shortfall, and employment falls, the Govt should step in.

7. The system embraces market competition by having private capital in first loss position, and adjusting fiscal demand broadly. Although this is a funny question as in practise, we are in a chartalist world, and what happens in practise is the Govt largess goes to those who are politically connected (GM unions, Goldman Sachs)

JKH said...
Agree with Tom and winterspeak. I’ll add that Chartalism might be viewed as a two stage process of understanding and belief. Understanding is the result of a correct interpretation of the facts of accounting, and how the monetary system actually works. This is a significant hurdle. Not nearly enough economists understand basic monetary operations – for example, why the textbook “multiplier” theory of deposits leads to outer darkness, or what excess reserves actually represent on today’s Federal Reserve balance sheet. Belief is what individual Chartalists do with the result of their understanding, and how they steer it into preferred ideology and policy. Belief is an option. Understanding how the monetary system is a requirement. Most Chartalists will emphasize that understanding allows debate about policy that otherwise can’t take place on a level playing field insofar as facts on the ground are concerned. The problem is that not nearly enough economists are yet able to pass that threshold of understanding because of existing educational indoctrination.

I respond:
Tom, Winterspeak, JKH, thanks for providing answers to my questions.

1. Tom, I see the logic of using the output gap and employment rate as the signals to look for. For as long as fiscal actions are going towards productive activities that create actual employment instead of non-productive speculative activities, then the net benefit should outweigh any incremental inflation.

2. WS, agreed that lowering tax may enable some businesses marginally responsive to hiring when lowered tax rates frees up some cash flow for this purpose, but perhaps at this point in our current economic predicament, more hiring and spending by government will do more of the trick, since what businesses need more than anything is a boost in sales.

3. WS, I guess if it all boils down to nothing more than trade balances (and the deficit nation does not actually incur debts that have interest and maturity obligations as a normal loan would) then you’re right, it shouldn’t matter how much money actually goes towards imports. Come to think of it, surplus countries do not acquire the deficit nation’s bonds when they finance deficits, they acquire foreign reserves. So it’s just cash that they can use to fund future deficits vis-a-vis the former deficit country (US).

4. My actual concern with the banks acting as fiat boosters is that not all bank loans could actually go towards consumption or towards financing productive activities. Sometimes they are used towards financial speculation. This results in an income boost for the recipient, who does not merely deposit it in the bank or use it fund consumption, but uses it to fund even more speculation in the same (or other) assets. In other words, banks can have a closed loop effect on the growth of asset bubbles. I’m sure this is something outside the scope of the original intent of government fiat, but I was wondering if Chartalist framework had any additional ideas on how to contain this loop from happening. Otherwise, yes, WS, banks are the product of their environment, and probably the only way to contain it is with strong regulation.

5. Tom, I thought as much. For as long as it contributes to productive employment and increases national output, then why should government be limited from it (Well, it shouldn’t be immoral or promote public vice, though that hasn’t stopped government from being the monopoly gambling business operator in some countries.) WS, if it’s not a theory, just accounting, that probably explains why I didn’t find it hard to reconcile these ideas with my own conceptions of the economy.

6. Flowing from Tom’s answer in # 1, ok.

7. My concern in question 7 was that having a definite safety net could also have the unintended consequence of having people not try harder to innovate anymore. Who cares if we don’t innovate, when if we lose our jobs as a result, the government is always there to give us our new gig? So perhaps there should be a clear distinction that government will only provide a safety net when there is a general demand decline in the economy, not to any casualty of a previously giant corporation that loses market share.

UPDATE: There are more clarifications about Chartalism from Scott Fullwiler in the comment thread.

Tuesday, February 2, 2010

Questions about Chartalism

I first got acquainted with Chartalism because two regular commenters of Nick Rowe’s posts, Winterspeak , Scott Fullwiler, and JKH, constantly to pertain to this (to me) seemingly coherent and consistent system of thought in their reasoning on certain discussions. I encountered it again in this discussion thread at Interfluidity.

I’ve been doing a bit of research on it in the last few days and I’ve discovered that Neo-Chartalists’ central ideas seem to converge around the contributions of L. Randall Wray, Warren Mosler, and Bill Mitchell. The system they advocate has a different starting point as the conventionally held beliefs in economics, or what they call ‘Neo-liberal’ ideology. To illustrate briefly what Chartalism is, let me explain what Neo-liberal is to them. The main difference in systems seems to be in how money is created, or how its use comes about in an economy.

Neo-liberals believe that money is created by economic trades by private sector participants in the market. Money arises because it is a more efficient to use a commonly accepted currency rather than engaging in barter for all of one’s basic needs. This money is then what the private sector uses to pay its debts, taxes and other obligations. When there is an economic dislocation, such as what recently happened, because private participants find themselves highly indebted, they engage in less trades, and this leads to a general decrease in aggregate demand. In this instance, the government should step in and stimulate the economy, by filling in the deficient demand.

Chartalists believe that money is created, so that government can induce its citizens to work and pay their taxes. Government, as the issuing authority, makes use of money as a way to get its citizens to defend its borders, police its citizens, teach its children, and the various other duties that need to be done in running a state. Because money is what the government, in turn, will accept as payment for taxes, people will willingly work for money. And because everybody is subjected to taxes, money then becomes a useful medium of currency among the citizens when they trade with one another, because the recipient can also use it to pay his own taxes. In short, the starting point of Chartalism is the issuance of fiat money by government. This fiat can be anything, and need not be backed by any real commodity. The mere fact that it is backed by government, and will be accepted by government, is enough.

In this view of the economy, when an economic dislocation happens, Chartalists also believe that government should step in. in fact, for Chartalists, whenever there is a dislocation, the ultimate cause can always be traced back to government. Because money is created by government issuing money and using it to spend for government’s needs, when the government decides to scale back money in circulation, either by spending less or taxing more, less money circulating leads to less money to fund for everybody’s work. Companies that used to get more from the government now scale back their operations. This leads to less income for its workers who then decrease their demand for goods and services in the private sector. Hence, even more so for Chartalists than it is for what they call the Neo-Liberals, the solution for our current economic problem is more government spending.

This line of thought is not that hard to accept for me. Whether money in fact arises from private sector trades or because government wants to give its citizens the means to pay their taxes, they’re both believable for me. And the Chartalist implications, that government needs to step in and help whenever there is deficient private sector demand, is something that I have also advocated here several times.

However, before I am willing to revise my ‘Neo-liberal’ framework for the Chartalist one, I’d like to ask a few questions. If given acceptable answers, I will embrace Chartalism with all its ramifications. These are my questions:
1. If currently circulating government fiat is the lower constraint to generating demand, then the inevitable conclusion is that all the government needs to do is to spend more, up to infinity, to pick up any slack. How do Chartalists determine what is the upper constraint to issuing more currency?

2. How does government ensure that fiat issued to generate demand goes to every person that needs to spend more, rather than this amount just being hijacked by rentseekers? (i.e,m monopolists, certain types of bankers, asset speculators)?

3. How does Chartalism account for leakages in an economy? i.e., fiat going towards spending abroad, or towards imports, or buying assets abroad? Will the government just issue more and spend more to compensate? When does it stop? When all citizens of the world are employed?

4. In the Chartalist view, banks are used by the government as sort of monetary boosters. When they loan out funds, they merely debit their accounts with the central bank, which can, for intents and purposes, ‘print the money’ by crediting their reserve. How do you control so that banks (fiat boosters) don’t create more fiat than what is needed? (This assumes that there is indeed an upper constraint to money issued/what can be spent by government) After all, if we take the ultimate implication of Chartalist view (I could be mistaken) more loans leads to more demand. This way, banks did what the government could have otherwise done itself, by spending more in the real economy.

5. What is the absolute scale of what the government is allowed to do/spend on to stimulate the economy? i.e., Can it start up manufacturing firms, to make up for all those lost to offshoring? Or start banks, start daycare centers, dogwalking companies, for as long as it creates employment?

6. What is the limit (if any) to the government backstopping any declines in aggregate demand? i.e., If businesses in aggregate experience a levelling off of sales, do we expect government to step in to maintain previous levels of aggregate employment?

7. How does this system incorporate market competition if everyone is backstopped? Ex. You have 99% employment, 90% of whom are employed by Microsoft, while 9% is employed by an upstart Google. If Google starts growing, it’s going to destroy jobs at Microsoft. Will the government step in and hire those laid off at Microsoft?

If I get answers to this, I’m will shed off my ‘Neo-liberal’ framework right this minute in favour of Chartalism. (I have a feeling that reality is actually a hybrid of both systems) All the same, government needs to help pick up the slack.

UPDATE: This today from Marshall Auerback is a good summary of the Chartalism view.