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Monday, August 27, 2012

The Great EconoMechanics Debate

The latest installment is a Dallas Fed working paper by William R. White, who comes out of BIS (Bank of International Settlements). 

This paper discusses the awkward question of the limits of monetary policy. I assume that there are such limits - for example, ask yourself the mental question about what would happen if the Fed decided to buy up essentially all of the long term Treasuries outstanding?
Researchers at the Bank for International Settlements have suggested that a much broader spectrum of credit driven “imbalances10”, financial as well as real, could potentially lead to boom‐bust processes that might threaten both price stability and financial stability11. This BIS way of thinking about economic and financial crises, treating them as systemic breakdowns that could be triggered anywhere in an overstretched system, also has much in common with insights provided by interdisciplinary work on complex adaptive systems. This work indicates that such systems, built up as a result of cumulative processes, can have highly unpredictable dynamics and can demonstrate significant non linearities12. The insights of George Soros, reflecting decades of active market participation, are of a similar nature.

 As a testimony to this complexity, it has been suggested that the threat to price stability could also manifest itself in various ways. Leijonhufvud (2012) contends that the end results of such credit driven processes could be either hyperinflation or deflation14, with the outcome being essentially indeterminate prior to its realization. Indeed, Reinhart and Rogoff (2009) and Bernholz (2006) indicate that there are ample historical precedents for both possible outcomes.15
Of course deflation is not the intent, but a long shove in one direction tends to do odd things to financial systems. I guess I should disclose my own bias here. Among my basic precepts:

A) The same inputs into a modern economic system can have different results depending on the initial state and population effects. Demographics isn't Alles, but it's an awful lot!
B) Any "shove" away from equilibrium, continued for a long time frame, will eventually have destabilizing effects.
C) An imbalanced system will collapse, but the direction of the future collapse is not always predictable. What is predictable is that the imbalance in the system will make the system more prone to collapses as a result of external effects.
D) Any economics that ignores the workings of the banking system is BS economics, no matter how many Nobel prize winners believe in the BS.
E) Any economics that ignores the input of energy prices is BS economics, no matter how many Miseans believe in the BS. 

The questions the paper tries to answer are:
In current circumstances, two questions must be addressed. First, will ultra easy monetary conditions be effectively transmitted to the real economy? Second, assuming the answer to the first question is yes, will private sector spending respond in such a way as to stimulate the real economy and reduce unemployment? It is suggested in this paper that the answer to both questions is no.
Heresy! But is it true? I would suggest that it is at least partly true on two grounds. 

The first is that if you have aging populations, retirement security becomes a sought-after good. If you have aging populations who are being subjected to a prolonged discussion on the need to cut future retirement benefits, the population in question will necessarily respond by placing a higher importance on saving and a lower importance on current spending. Thus money spent now by governments, which logically does have a stimulating effect, will be seen as taking away from future consumption and will increase the desire to save.

The second ground is that there is in principle a lower bound to the credit stimulating effects of low interest rates, and that is because the risk of loss is an important component of actual interest rates - i.e. the time cost of money - and the risk of loss due to changes in rates over time is also an important component of actual interest rates. The lower current costs of money fall, the more the risk component becomes magnified in credit-granting decisions, which tends to suppress credit. The current tightened standards for mortgages are just an example of that process.

By creating government-backed pools of mortgages (Fannie, FHA) and selling bonds on the open market which compete with other government-guaranteed securities, one can somewhat offset the risk of loss due to rate risk. But there is no way to offset the relative growth of the risk of loss - the risk that the money won't be repaid. Because there is no way to offset it, either you ignore it and accrue more future government deficits, or you charge more to cover the risk of loss - which is why FHA premiums have gone up so much.

As soon as the relative importance of non-repayment of money rises, then the premium for risk rises, and the incentive for individual and corporate borrowers to save rises. So you create negative feedbacks, which is one reason why companies and individuals now want to save more

Both of these effects have predominated in Japan, which is how they managed to achieve two deflationary decades.  

Comments:
MOM,

So you create negative feedbacks, which is one reason why companies and individuals now want to save more.

I clicked on the link with much anticipation! I wanted to know who else was saving. The link took me to my own blog. Hahaha! Too funny (and tragic).
 

Yup, our demographics bias the system toward deflation and away from inflation. Whether that manifests itself as outright deflation or as hyperinflation depends on the details of fiscal policy and society's relationship with currency.

 
I agree with all of your precepts; and I agree that the outcome of the current monetary policy experiment is unpredictable.
 
Scott - but if it is unpredictable, then that unpredictability contradicts the goal of price stability and employment stability (the second goal being a mandate generally for the Fed and China, but not for most CBs).


 
Mark - I'm truly irritated by the corporations-sitting-on-cash meme.
 
MOM,

Mark - I'm truly irritated by the corporations-sitting-on-cash meme.

As you can probably guess, as a saver I am too.
 
MOM,

I would suggest that it is at least partly true on two grounds.

Mere words cannot adequately express how much I am personally living your first of two grounds.

The more the government tries to force me to spend (by lowering investment returns on "safer" bonds) the less spending and more saving I must do to compensate (lest my nest egg runs dry before I am dead and buried).

In my opinion, these unintended consequences are lurking in the shadows until the next recession hits. They are being masked by yet another wave of false prosperity. Long-term 8.5% pension fund return expectations? Good luck on that one!
 
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Mark - your personal dilemma is being replicated on a massive scale by pension funds. CALPERS returned 1% over the last 12 month period.

In order to prevent the effects of this being seen in the private sector, Congress passed a bill so that private pensions wouldn't have to up their contributions. Public pensions haven't been governed by the same laws, but then underfunding of public pensions is a major problem for many such funds.

Insurance companies providing casualty coverage are forced to raise rates, because such companies have to accumulate a pool of assets sufficient to cover future claims. So car insurance and property insurance rates rise.

This is playing out on a grand scale.

 
MOM,

So car insurance and property insurance rates rise.

I offer anecdotal evidence to support your claim.

My car is 16 years old. I just have the minimum insurance (no collision). I don't drive much and am therefore willing to self-insure most of it.

After years of no increases (or slight decreases), 2012 marks a new milestone.

They raised my monthly rates from $30.86 to $34.11. That's a 10.5% increase.
 
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