Category Archives: Economics

Is there a credit channel?

Posted on by

An important argument at the moment is whether or not the so-called credit channel exists. When central banks carry out quantitative easing, and even more so in the case of a “credit easing” policy like the one George Osborne announced recently, a major reason for it is that they are trying to reduce the price (i.e. the real-terms interest rate) and increase the supply of loans to businesses. This being their effective cost of capital, this should encourage them to invest, and thus to increase aggregate demand. This is the New Keynesian account; the monetarist one is that creating an expectation of future inflation creates a disincentive to hold onto cash.

But there is a criticism of the credit channel that works like this: as banks actually create credit, they are only loosely constrained by its supply. Instead, they supply just as much as their customers demand. If the customers are businesses, they are more likely to worry whether their new venture is a good one or not. If it’s a winner, whether it’s a winner with a carrying cost of 4% or 6% isn’t a primary consideration. If it’s a loser, it’s a loser no matter what the interest rate. The bank operates in one of two states – essentially, risk-loving or risk-averse. In the risk-loving state, it expands its balance sheet as fast as its customers demand credit. In the risk-averse state, it digs in and hoards cash. Therefore, there is no credit channel, and the transition between the two states is something like the Minsky model of financial crisis.

Now, I responded to Daniel Davies (who made exactly this argument on the blog he is still keeping private – surely it is time for an Occupy Dsquared movement) on the grounds that if a big, price-insensitive buyer like a central bank can cause a dramatic turnaround in the market for Swiss francs, it could by the same logic flip the bank from state 2 back to state 1 if it went in hard enough.

Here is a data point: the refusal rate for British SMB loans tripled from 2007 to 2010. This could be used in either sense – the credit channel side would argue that this shows that, yes, the supply of credit to the business sector has been choked off, the demand first side would argue that SMB lending is a terrible business to be in at the moment because there’s no demand for their products. The problem is, however, to what extent agency is with the sell- or the buy-side.

On the other hand, the UK business sector excluding finance and real estate was a net saver through the boom years; surely that’s got to be a problem.

That’s how it worked out for Sweden

Posted on by

At Crooked Timber, they’re discussing a Tobin tax. Andrew F. asks:

How well did this work out for Sweden?

In the ruins of the city once known as Stockholm, ragged survivors barter rotting fish for scraps of used toilet paper outside the scorched hulk of the former Riksbank, that was once the oldest central bank in the world. Many have hacked out their own eyes with shards of plastic rather than see the desolation and depravity they brought upon themselves. “Would we hadn’t done it! The Tax that Dare Not Speak Its Name has reduced us to things lower than beasts!”

Elsewhere, corpses litter what were the chic alleys of hipster Södermalm, marking out the last desperate and insane brawls over crispbread and Cheap Monday products, clearly fought to the knife or rather to anything that would take an edge, in that grim night without darkness.

In the darkened concrete bunkers of what used to be one of the world’s largest Internet exchange points, Netnod, we found the rotting bodies of sysadmins still surrounding a router that appeared to have exploded, as if some sort of wave of pure evil had exploded across the wires from the hearts of a million bloggers the moment the first transaction tax was assessed.

And they tell me it’s worse in Skane. That’s how it worked out for Sweden.

(Although, the Greek source quoted here seems to be thinking along the same lines:

“If we default, it’s not just the domino effect. It will make Argentina look like small game. This place will become worse off than Bangladesh. People will be killed for a sandwich as they cross the road. It will be that bad.”

)

Sunshine club members’ newsletter…

Posted on by

From William Keegan’s column in the sadly reduced business section of the Observer, a newspaper that used to be worth buying just for its business section, it looks like the sunshine club has got another member, ex-MPC man Christopher Smallwood of Lombard Street Research:

In Lombard Street Research’s Monthly Review for September, the economist Christopher Smallwood reminds us that “a currency system with Germany at its core necessarily displays a strong deflationary bias. For a monetary union to work well, it needs to be operated on the basis of ‘symmetrical obligations’ among the members. But if the strong surplus country is perpetually unwilling to take expansionary action, all necessary adjustments within the system have to be made by deficit countries taking deflationary action.”

Smallwood points out that Greece, Portugal, Spain and Italy have suffered a rise in costs relative to Germany and some of the northern economies of up to 30%….

Meanwhile, the BANKERS! remind us that something like 15% of German GDP is accounted for its intra-eurozone trade surplus. Also, note that Jürgen Trittin and the Greens are calling for a Northern European fiscal reflation, according to the transcript of the EFSF debate.

Speaking of the Observer and bankers, Heather Stewart quotes the IMF:

“The large number of ‘underwater’ mortgages poses a risk for a downward spiral of falling house prices and distress sales that further undermines consumption and labour mobility,” it warned, calling for courts to be allowed to write off a proportion of mortgages where borrowers have got themselves in trouble; for the taxpayer-backed mortgage guarantors Fannie Mae and Freddie Mac to encourage writedowns; and for an extension of state-level programmes to support troubled homeowners.”

The IMF is now arguing for unilateral cramdown by the GSEs.

Revisiting the Eurodebate

Posted on by

This post of P O’Neill’s made me think of something. That is, the British debate on joining the Euro, and on Europe more generally. I was strongly pro-Euro, something which now looks as bad a decision as joining the Liberal Democrats was. It’s hard to avoid the conclusion that had the UK had Eurozone interest rates in the 2000s, we would have had an even huger housing bubble and even more gigantic bank balance sheets, and we would have had to resolve them without being able to use the central bank as lender of last resort, and we would have been unable to devalue the currency as a stimulus mechanism.

Any counter-argument requires that the influence of the Bank of England in ECB policy would have been both powerful and right. The first is debatable, but we have to accept that the Bank didn’t restrain the housing bubble and also failed to respond to the crisis in the real economy in 2008, sitting on its hands and mumbling about inflation while the labour market cliff-dived and the bank regulators across the corridor frantically juggled with Halifax-Bank of Scotland, Lloyds, and Northern Rock. Also, the early 2000s situation of a bubbly periphery and a stagnant core would have been even worse with the London housing market in the Euro, and it’s hard to say how that would have panned out.

But what were we really debating in the 90s?

The arguments in favour, at least the economic ones, were that we might benefit from being fully integrated in a bigger trading bloc, that we would benefit from currency stability, that lower interest rates would be nice to have, and that the Eurozone restrictions would be a force that would require industry to be more competitive (or did they just mean lower wages?). The arguments against, at least the economic ones, were that the Stability & Growth Pact would be an anti-Keynesian force for deflation and that the option of devaluation would be removed.

Then there was a whole lot of other stuff. A lot of the “for” side thought it would make us more European and meant by this that it would make us more social-democratic (or Christian-Democratic, or even Free Democratic), although I don’t think any of them could have articulated a mechanism by which this would happen. I suspect that for a lot of us it was a bit like the Estonian MP who told Tim Garton Ash that “Europa ist…nicht Rußland!”, or in our case, Europe was not-America.

A lot of the “against” side seemed to agree with the idea that joining the Euro meant the triumph of social democracy, because they at least claimed to think that the European Union was an inherently socialist institution. Some of them still think this now, when it has imposed structural adjustment on three European countries in order to avoid the nightmare of fiscal expansion in Germany. Others took the Friedmanite line that currency adjustment was a form of free market competition and therefore desirable. This was at least defensible. And others thought that it was a scheme to redraw the UK’s internal borders or replace the flag or something.

The interesting contradiction here was that the same people who worried that we would be unable to devalue the currency were also fervent austerians who didn’t believe in demand management of any kind. It was as if they believed in hardcore new classicism up to the point where it affected their re-election. How could it happen?

Obviously, whether you felt the SAGP would be useful discipline or an anti-Keynesian straitjacket simply depended on whether you expected the economic problem of the 2000s to be inflation or deflation. But the economic argument that was very rarely discussed was the one that is now fascinating everybody – exactly how the Eurosystem, rather than the Euro, would function in a financial crisis. Apparently this was discussed in specialist circles, but it didn’t make even the best of the national press.

To sum up, I agree that the yes side was wrong about fixing the currency. To be honest, when asked, I always said I was in favour of joining if we could join at a significantly lower exchange rate. The benefits of which Jaguar-Land Rover just demonstrated. But this is a cop-out on my part. On the other hand, I think the Eurosceptics and some of the conservative Europhiles should accept that they were wrong about the SAGP – yes, Virginia, inflation was a phantom menace, and the ghosts of 1929 were not finished with us. And we can all agree that we were all wrong about the banking and financial aspects of the Eurosystem, in that we didn’t even bother to argue about them.

I promised to blame somebody in the last post. Here it comes: the key European politicians, especially the French and the Germans and the European Commission officials, who designed the Euro and the Eurosystem. They created a system that had a structural deflationary bias in an era of deflation, one that delivered rock-bottom interest rates to countries in the grip of land fever, and one that couldn’t cope with a banking crisis although it included the biggest banking system in the world. And then they kept putting up interest rates. What’s worse is that they now have the gall to give lectures about virtuous savers – even when they are the same individuals, like Wolfgang Schäuble, who were in power in the 1990s.

Yes, the banks are to blame

Posted on by

Daniel Davies’s effort to become the most popular man in Britain has, apparently, not developed to his advantage, to quote the Emperor Hirohito. It struck me that there are two opposed explanations for the unusual toxicity of the comments thread that ensued, and they tell us quite a lot about the Great Bubble and the Great Recession that followed.

The first would be Daniel’s explanation. Look at them! It took only six comments for someone to analogise him to a soldier whose commander pays him in whiskey and delta 8 vapes to cut the ears off prisoners, and sixty-five for someone to compare him to one of the anonymous organisers of the Holocaust. We got to Josef Stalin by comment 115 and to Megan McArdle by 108. Surely, this is evidence that there is an unreasoning and unproductive rage around at anything that smacks of banks, bankers, or banking.

The second would be mine. Fans of Daniel Davies’s work since the distant era of Adequacy.org will appreciate that he is a practised and expert troll, and distinguished among the guild of ancient Norwegian bridge-guardians by the fact he can turn it on and off as desired. Knowing that bankers are unpopular (were they ever popular?), and that Crooked Timber is a website full of left-wing people, he crafted a post that would cause them all to freak out amusingly.

You will of course notice that the basic distinction here is that one explanation is demand-driven and one supply-driven. The first assigns agency to the buyer, the second to the seller. The distinction is important in economics – one of the most standard assumptions is that consumer sovereignty holds and that firms are generally price-takers. Another key assumption is that industry fundamentally responds to demand. Electrical engineers would say that it is load-following, like a power plant whose output can be throttled up or down to respond to the needs of the grid.

In itself, this isn’t controversial. Industries produce what they can sell. There are lags in the supply-chain, and it’s possible to have temporary shortages or surpluses, but basically, the rate of production is both constrained and driven by demand. But the stronger form of this argument, and the one that is baked into essentially all economic models, is that not just the quantity of goods, but also their quality and kind, is demand driven. The distinction between drivers and constraints is important here. It is obvious, and trivial, to say that things nobody will buy won’t be produced for very long. But that is only half the argument.

How did we decide to try making fireguards out of chocolate, or self-certifying mortgages with negative-amortising interest rates, in the first place? Obviously, there are cases where new products do respond to an identifiable demand. At the level of the whole economy, though, this implies that every conceivable product or service already exists in latent form in the minds of customers, as if there was a statue in every block of stone waiting to get out. This is…somehow implausible and unsatisfying. Among other things, it has the curious consequence that being really true to the core assumptions of economics implies eliminating the role of the entrepreneur, at least as an inventor or product designer rather than as an operational manager.

If entrepreneurs are a thing, on the other hand, we have to accept the possibility that firms have agency in structuring the markets they sell into, that even if aggregate supply doesn’t create its own aggregate demand, it is possible for specific supply to create its own specific demand. It’s Milan fashion week, after all – an institution exquisitely dedicated to the proposition that producers can at least try to define what consumers will want.

Now, back to the mortgage market. Mortgage brokers are a fine example of a business that really is demand-driven. People come to them and say how much house they are trying to buy, and the broker tries to find someone who will lend them the money. As they were both in competition as firms, and usually rewarded on commission as individual workers, their structural incentives were to follow the housing market wherever it went. In that sense, property buyers had real agency and hence culpability. The broker/originator sector was also meant to evaluate their creditworthiness, but as it didn’t take the risk on the loans itself, it didn’t have any incentive to turn people down. It had agency, and therefore also blame.

But what about the banks? Just treating them as a normal business is illuminating. Businesses invent new products all the time – sometimes following demand, sometimes reaching ahead of it. Sometimes, what they invent is dangerous to the public and they have to be restrained. Nobody would argue, for example, that in inventing the RBMK nuclear reactor, the Soviet nuclear industry wasn’t berserkly irresponsible and directly to blame when one blew up.

And one product the banks surely did invent was outsourced mortgage-servicing. This practice may yet prove to be one of the most pernicious of the Great Bubble, not because it led to illegality as such (although there’s plenty of that), but because it is a major obstacle to recovery, and it is the more profitable the longer it stays that way. When lenders were responsible for collecting payments and dealing with borrowers themselves, they were much more likely to be reasonable with borrowers who struggled to keep up the payments. They had good economic reasons for this; typically, they would recover much more of their money in a negotiated settlement than in a foreclosure, an expensive process in itself that usually ends with the property going for auction at a fire-sale price.

But once the servicing function is outsourced, the incentives are actually reversed. Not only does the servicer, the party who has direct contact with the borrower, have no incentive to agree a modification of the original loan, they have every reason to insist on foreclosure. They get paid based on the tasks they carry out, and foreclosure generates a lot of lawyering and letters, all of them chargeable to the lender.

Now, there are three ways out of a balance-sheet recession. One is economic growth itself. As, I recall, Daniel Davies once said, if you are in debt as an individual, the best solution of all is to increase your income if it is at all possible. And the Kulmhof-Ranciere study argues that increasing real wages is the best way out of the crisis at the macro-level. Another is inflation. And the point has been made, by one Daniel Davies among others, that inflation is a rather simple mechanism to adjust all sorts of contracts that were set at nominal prices that have become unpayable, one which avoids all the complex machinery of courts and loan officers.

And a third is bankruptcy, in which we recognise by law the fact that both the lender and the borrower agreed on a contract that has become impossible to honour, and both of them share in the cost of cramming it down to a realistic level. Here is a case in which a major new product invented by the financial sector, in advance of demand, is directly blocking one of the three roads to economic recovery. To what extent the banks are responsible for the lack of progress on the other two is left as a topic for discussion.

In my next post, I’m going to look at some more people who are to blame. They are not Greek schoolteachers.

Why you shouldn’t trust the WSJ piece on BNP Paribas

Posted on by

The Wall Street Journal Europe has published this morning a market-moving opinion piece claiming to reveal serious funding troubles at French bank BNP Paribas. The article opens with an alleged quote from a BNP executive:

We can no longer borrow dollars. U.S. money-market funds are not lending to us anymore. Since we don’t have access to dollars anymore, we’re creating a market in euros. This is a first. . . . we hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore.

On the face of it, the quote didn’t seem that outlandish: the major French banks have a significant amount of the bad kind of European sovereign debt in their books, have not written off the potential losses quite as extensively as others have done and thus stand to suffer dearly in case of a Greek default. You could also argue that French banks haven’t always been 100% straightforward in their defense. And it’s not like hints of a dollar funding problem at a European bank haven’t surfaced in the past weeks.

Still, there are many reasons to be extremely skeptical of the article. Continue reading →

AF447 Economics

Posted on by

For Ed everything is always about demographics. For Kevin Drum and others everything is always about energy. Other people have decided that productivity is so high that unemployment is inevitable, or that all consumption is now welfare reducing. Still others that the Chinese are our rightful masters – submit! although poor old Europe runs a trade surplus. And of course these aren’t the only discoveries.

Other people still will tell you that millions of Americans who were gainfully employed up to 2008-2009 are suddenly of literally zero productivity – well, they surely are as long as they’re on the dole, but that’s not what they mean – or just that everyone went mysteriously lazy in a sort of spontaneous mass conversion event. Or that the United States has a serious deficiency of fast trains, which only became apparent all at once in 2008. It has been an era of enormous creativity in the analytical function of economics, which has been more than matched by the united consensus among practitioners in its policy-advising function.

Behold the power of Leszek Kolakowski’s Principle of the Infinite Cornucopia. This holds that there is an infinite cornucopia of arguments in favour of whatever course of action or inaction you happen to have decided on for whatever reason. All these fancy intellectual theories, and none of them consider the possibility that there’s a recession on. If that was accepted, of course, it would suggest that things really are this bad, Alan Greenspan really was this incompetent, maldistribution works like it did in the 20s, this is as bad as it looks, and simply taking your hands off the stick and leaving it to George was relatively the best policy, just because it wasn’t actively harmful.

Actually, the aviation analogy worries me; I keep thinking of the pilots of Air France 447, who flew an entirely airworthy aeroplane from 35,000 feet into the sea in a fully developed stall without seriously trying to recover because (as far as anyone knows) the immediate effects were counterintuitive.

I’m sympathetic to the energy explanation, but I do think the idea that there’s a recession on might still be worth a crack, and we might try pushing down the nose and increasing the air speed.

It’s the geography, stupid

Posted on by

Central and Eastern European economies aren’t doing well. German IFO business confidence tanks, on expectations of poor export orders. These two facts are related.

It’s been said before that the central core of economics failed to predict the great recession (or damn, can’t we call it a depression already? It’s been four years and it’s depressing enough) and that only a few key groups of people noticed anything unusual. Followers of Hyman Minsky and Charles Kindleberger saw the classic pattern of confidence, mania, panic, and crash unfolding. People who understood the economy as a system of accounts saw a number of huge imbalances in the flow of funds. Marxists considered that the source of the imbalances was the super-exploitation of Chinese workers and the maldistribution of the proceeds of growth in the West.

But I’m not sure if economic geography has been given enough credit. One economic geographer who predicted the crisis is of course Paul Krugman. From a geographical perspective, the CEE economies are part of a huge automotive engineering cluster rather like the US rustbelt or the West Midlands in the UK, reaching over from the Cologne area to Slovakia. (Actually, they always have been since the Industrial Revolution – here’s a beautiful 1938 Tatra and a much less beautiful 1914 Skoda 305mm mortar and caterpillar tractor.) From an industrial economics perspective, they are part of the German motor industry’s global supply chain, whether as upstream suppliers of parts and sub-assemblies or as downstream final assembly contractors. You can argue whether geography or functional specialisation determines this, but that’s not really relevant right now.

To put it another way, they aren’t exporters to “the German locomotive” but rather to the German economy’s customers, at one remove. The determining factor of their order books is how well the final products sell, and in the German economy’s historical default state as an industrial exporter, that depends on somebody somewhere buying more German goods than they sell goods to Germany.

A deflationary adjustment of the eurozone trade balances will be deflationary all the way along the supply chains. This is broadly what I was worrying about in May, 2010. The problem is not quite the same as it was for Keynes in the original Economic Consequences, a book which contains a lot of economic geography – back then, if the Germans were ever going to pay off their debts, Keynes pointed out, the rest of Europe had to let them export enough stuff. Now the boot is on the other foot. If the Greeks are ever going to get out of their debt crisis, the Germans have to let them export enough stuff. And if the Czechs and Hungarians and Baltics are not going to slide back into the mud, the Germans have to import enough stuff from them. Nobody imagines that the Greeks will be importing as many BMWs as they used to, so what can the answer be?

Life On PMI Cold Comfort Farm.

Posted on by

As the heat wave which has been hanging over Southern Europe for the last couple of weeks steadily eases off there is little sign that any of the warm air which is disippating is reaching the chilled motors of the European and Chinese economies. The results of this months flash PMI readings are at best more of the same, and at worst show continuing deterioration. While current conditions stabilised in some areas, new orders, and especially new export orders often hit new post-recovery lows. There is every likelihood that the final August global readings will be much more of the same. Continue reading →

On the value of “basic science” in economics and other disciplines

Posted on by

A few months ago, Larry Summers was reported to have made some comments regarding rules of thumb he used to distinguish between useful and not-so-useful economic papers when he was working in government:

He had a fairly clear categorisation for which ones were likely to be useful: read virtually all the ones that used the words leverage, liquidity, and deflation, he said, and virtually none that used the words optimising, choice-theoretic or neoclassical (presumably in the titles or abstracts).

However, while this sounds kind of harsh, he made sure to temper his criticism by saying that some seemingly useless things of apparently limited applicability might turn out to be useful in years to come (microfoundations for macroeconomics, perhaps?).

This last caveat is one I’ve frequently encountered in two contexts: From people who want to defend basic (natural) science, and from people who want to defend some discipline in economics that is just plain wacky. The argument is the same: It might turn out to be useful in the future.

Though true in the strict sense (I can’t rule out possible value coming from this research), the argument is frequently a “cheat”: I suspect that the person supporting basic science (or abstract economic theorizing) believes that this is nice and valuable intrinsically no matter what the usefulness of the results may turn out to be. But since this is a tough pitch to sell to the general public (especially for the economist), they try to say that “well, this could actually turn out to be valued highly by you even if you don’t care about the intrinsic value.” And yes, there are clear cases of (truly) useful things that came out of (seemingly) pointless and abstract theorizing. Here’s an example from the US Department of Energy:

The discovery that all matter comes in discrete bundles was at the core of forefront research on quantum mechanics in the 1920s. This knowledge did not originally appear to have much connection to the way things were built or used in daily life. In time, however, the understanding of quantum mechanics allowed us to build devices such as the transistor and the laser. Our present-day electronic world, with computers, communications networks, medical technology, and space-age materials would be utterly impossible without the quantum revolution in the understanding of matter that occurred seven decades ago. But the payoff took time, and no one envisioned the enormous economic and social outcome at the time of the original research.

However, it seems wrong (especially of an economist) to just transfer this argument from basic science (whether mathematics or theoretical physics or whatever) to economics. The reason is simple: Take two types of research. One (“applied research”?) is practical and will with high probability lead to valuable insights (in  terms of practical usefulness, economic value, material benefits to humanity or whatever). The other one (“basic research”?) is highly abstract and divorced from empirical applications and will with high probability fail to lead to such valuable insights. However, with both of them there is uncertainty, and we can imagine some probability distribution over “insight-value” that these could generate. It seems to me that unless we have reason to believe that the tail of the “basic science” distribution is fatter – i.e., unless the probability of making truly mind-blowing important progress  is higher for basic than for applied science – then we should always go for the applied in so far as the pragmatic value of the insights is what we want. The expected value would be higher, and the probability of an insight of any given value would be higher with the applied research. In other words, we need a “fat-tail” argument – an argument that the distributions will differ for observations lying far away from the mean. Since discussing differences in the tails of various distributions in another context was part of what made Summers resign as President of Harvard, this is a point I think he would get easily.

My point is just that I can see the possibility of this fat-tail argument in terms of certain types of basic science, but that does not mean it is present in economics. In physics there could be some argument such as “the higher the granularity and precision with which we can understand and manipulate the world around us, the more opportunities are open to us for manipulating it to our benefit,” and this can be supported by examples from experience. In mathematics there could be an argument that “the more analytical tools for a broader array of problems, the more mathematics will be able to power up other disciplines and improve their reach and value”. However, I am at a loss to see what more sophisticated representative agent-modelling in DSGE models or rational addiction models will give us. To me, such work seems more like Tolkienesque fantasy about alternate worlds. And if such fantasy about alternate probably-not-even-conceivably-realistic worlds can be useful – then the question is: Which ones are most likely to be useful, and how do we tell? Why representative agents deciding with optimal control theory? Why the (apparent) bias towards non-regulation and free markets?

Also – if such modeling divorced from evidence “could potentially” turn out to be useful – surely it could also “potentially” turn out to be harmful? For instance, if it misled (at times influential) economists into thinking that the world is simpler than it is and that it is imperative that we implement policies derived from such rational choice fan-fiction. An anecdote that may provide a possible example: Brooksley Born apparently, according to some, pushed hard for the regulation of a booming, wild-west-frontier derivatives market. In this she was stopped by President Clinton’s Working Group on Financial Markets. Alan Greenspan claimed that regulation could lead to financial turmoil, and at one point the very same Larry Summers we started with called her and said that

“You’re going to cause the worst financial crisis since the end of World War II.”… [Summers then said he had] 13 bankers in his office who informed him of this.