Tuesday, April 14, 2015

Blanchard on Countours of Policy

Olivier Blanchard, (IMF research director) has a thoughtful blog post, Contours of Macroeconomic Policy in the Future. In part it's background for the IMF's upcoming conference with the charming title Rethinking Macro Policy III: Progress or Confusion?” (You can guess my choice.)

Olivier cleanly poses some questions which in his view are likely to be the focus of policy-world debate for the next few years.  Looking for policy-oriented thesis topics? It's a one-stop shop.

Whether these should be the questions is another matter. (Mostly no, in my view.)

As a blogger, I can't resist a few pithy answers. But please note, I'm mostly having fun, and the questions and essay are much more serious.

Financial regulation
... Where do we stand? Are some dimensions of systemic risk easier to measure (e.g., leverage in the banking sector vs. interconnectedness of banks and non-banks or risks outside the banking sector)? How should we assess the experience with stress-tests?  And have we made enough progress in reducing systemic risk since the crisis, e.g., with Dodd-Frank, the Vickers commission, the Financial Stability Board, etc?

Answer: "Systemic risk" is barely defined. The idea that regulators will, this time, really really, understand risks taken by the big banks, see trouble ahead, and stop the banks from failing, is a triumph of hope over repeated experience.
The only progress -- and it's big -- is the slow realization that banks can and should issue lots more equity.
Macro Prudential Policies
... Do we have or can we develop tools to deal with the different types of risk, from high housing prices, to insufficient capital in some financial institutions, to sudden drops in liquidity in some financial markets?
Using these tools ...raises political economy issues.  In a housing boom, increasing the loan to value ratio may be politically difficult.  Questions:  Given these issues, when should we use macro prudential tools, or should we use tougher, non contingent financial regulation? To be concrete, should we aim for variable capital ratios and decide when to adjust them, or just give up on the variable part, and aim for high but constant capital ratios?

Answer: The hubris that the Davos set will be able to figure out just the right amount of capital, and then fine-tune that month-to-month and bank-to-bank is astounding. "Political economy concerns" is putting it mildly. The IMF's "bubble" or "imbalance" is the local Congressman's boom, and he or she will be hopping mad if the Fed restricts credit to his district or pet industry in favor of another

The fact that our regulators are still talking about liquidity betrays a fundamental confusion of individual vs. systemic risks. Liquidity is the plan, "if we lose money we'll sell assets." To who? Regulators demanding liquidity to plan for a financial crisis is like the FAA making sure everyone on the plane has enough money to buy a parachute in case of engine failure.  
Finally, it is clear that both financial regulation and macro prudential tools are likely to lead financial actors to adjust and explore ways of getting around them. Questions:  In this game of cat and mouse, can the macro prudential regulators hope to win?  Or will regulation and tools become increasingly complex and possibly counterproductive?

That's easy. No and Yes. Actually I'm being too pessimistic. Regulatory capture works both ways. An easy forecast: Stress-testers at the Fed will be getting lucrative salary offers to move to the private sector and help pass stress tests. Which they will increasingly do. 
Monetary Policy 
...  Questions:  Under the highly realistic assumption that financial regulation and macroprudential tools do not fully take care of financial stability, [Highly realistic indeed! You just answered the first set of questions as I did!] should monetary policy take financial stability into account?  And if so, how?  Can the interest rate or other monetary policy tools reduce financial risk?   How should macro prudential tools and monetary policy be coordinated?  Should they both be under the responsibility of the central bank?
 Let's remember that the crash of 1929 was, at least in the standard history, sparked by the Fed trying to restrain what they saw as the bubble in the stock market.

If this is the case, and central banks have tools which can have effects on very specific sectors of the economy, can they retain full independence?

No. In a democracy, independence comes with limited authority. The financial central planner cannot and will not long stay independent.   
The zero ... lower bound on the  interest rate set by central banks was thought to be a theoretical curiosum, unlikely to happen, and, in any case, easy to combat if reached.   If reached, central banks could, through announcements of future monetary policy, increase expected inflation and achieve large negative interest rates.  We have learned that this was simply wishful thinking.  The zero lower bound could be reached, inflation expectations are not easy to manipulate, and it may take a very long time to exit.

Three cheers. Wow, Olivier, who wrote one of the most influential calls for announcements of higher inflation targets, looks at the data and calls it "wishful thinking." Bravo. 

.. Quantitative Easing,... Questions:  ...should central banks eventually return to the traditional mode of intervening at the short end of the market, or should they continue to buy and sell longer maturity sovereign or corporate bonds?   Should the balance sheets of central banks return to their pre-crisis size, or remain permanently larger?  If the central bank intervenes along the yield curve, how should monetary policy and debt management by the Treasury be combined?
Large balance sheet, interest-paying reserves, open to everyone. Some crisis interventions reveal very desirable permanent states of affairs. Stop fooling around with direct intervention in long-term debt, mortgage-backed security markets, and don't follow other central banks to buying and selling stocks, foreign exchange, etc.

Fiscal Policy
... Questions: What is a dangerous level of debt? That which markets doubt you can repay. Seriously, if you're growing fast with a good long run plan for containing expenditures and raising revenue without ruinous taxation, a lot. If not, a lot less. ... What do we know about confidence effects?  You mean statements by officials that "engender confidence?" Go back to the Romans, burn incense at the Temple of Jupiter. More seriously, we've learned that speaking loudly with no stick doesn't work. ...Should the old idea of the fiscal golden rule, the separation of a current and of a capital account, be resurrected? Separating two sides of an accounting identity sounds like an interesting golden rule. I think it would be golden to separate the current account and capital account I run down at the apple store -- they give me stuff, I don't have to give them money. Olivier surely has something more sophisticated in mind, and I'm revealing I'm a rube at this policy-speak coded language. 
Most observers agree that the fiscal stimulus early in the crisis was instrumental in limiting the decrease in output.   I'm glad he said "most" not "all"....
Capital inflows, exchange rate management and capital controls
The crisis has reinforced the notion that international capital flows can be very volatile, with emerging markets being particularly vulnerable.  Back to previous comment. Capital can try to flow, but unless goods flow in the other direction, all it does is to lower prices. Unless you can pass a rule to get rid of accounting identities. See above.  Policy makers have responded with a panoply of tools, from capital controls A polite word for expropriation to macro prudential measures aimed at shaping flows, What a lovely little policy-ese phrase  and FX intervention. .... And what does the experience since the crisis say about the optimal opening of the capital account, even in the long run? Translated to English, back to the de-globalized protectionist world. If capital can't flow, neither can goods. 
The International Monetary and Financial System
.... Questions: ... Should we reexamine the rules of the game for exchange rates?   How can we improve on the process of sovereign debt restructuring?

As Olivier's essay moves on, and gradually reverts to the  obfuscatory Orwellian prose of the international policy world, I get more and more animated. I mean just who is this "we?" Who is going to tell you you're not allowed to buy euros for your vacation this summer ("capital controls"), tell your bank not to give you a loan ("macro-produential policy"), decide how many billions to siphon from your pocket to the owners of large banks ("recapitalization" "process of sovereign debt restructuring"), not allowed to expand your business in a new country ("macro prudential measures aimed at shaping flows") and so forth? When there even is a "we," unlike most sentences with no subjects, like "the optimal opening of the capital account."

What should be the role of international forums such as the G20?

Aha, now I get it. 


  1. Olivier had one last thought: "How did we (IMF) miss by 10,4% from 2007 and 2014 with our forecast the GDP of countries such as Italy ? ...Why did we not get that austerity was pushing down GDP 10% more than we thought ?"

    1. Thanks. I should have added "because you did not distinguish 'austerity' of high taxes, unreformed markets, and large spending with 'austerity' of less-distorting taxes, deregulation, structural reform and large spending cuts. Any country spending 50% of GDP is not austere."

    2. Italy is still running a budget deficit of just under 3% of GDP, barely within the official EU limits. I think "Austerity" has almost become a meaningless term as it seems it can be used to describe almost anything.

  2. John,

    Couple of things:

    1. The only progress -- and it's big -- is the slow realization that banks can and should issue lots more equity.

    And who in the "free market" world is going to force banks to use more equity? More importantly, who in the "free market" world is going to force banks to fund government debt purchases with equity sales?

    Bottom line. If you want to change something, start at the top (government) and work your way down.

    2. Three cheers. Wow, Olivier, who wrote one of the most influential calls for announcements of higher inflation targets, looks at the data and calls it wishful thinking. Bravo.

    You and I are in agreement here.

    3. Large balance sheet, interest-paying reserves, open to everyone.

    Interest paying reserves are interest payments that the federal reserve receives from tax payers through the U. S. Treasury on debt the Fed owns. Those interest payments are already open to everyone - go to www.treasurydirect.gov, fill out some paperwork, and buy "interest paying reserves" at any time. You are not adding anything here by putting the central bank in as a middle man.

    4. What is a dangerous level of debt? That which markets doubt you can repay.

    No John, you forget about term structure and rollover. Olivier asks the wrong questions. What is the maximum duration that a government can conceivably borrow at and what is the term premium for that extra duration? If a government can borrow out to an infinite time horizon without a rising term premium, then there is no maximum debt level. The real question is should a government borrow - ever.

    And now the real killer:

    "As Olivier's essay moves on, and gradually reverts to the obfuscatory Orwellian prose of the international policy world, I get more and more animated. I mean just who is this we Who is going to ... tell your bank not to give you a loan (macro-produential policy)...."


    You telling my bank they should issue more equity is no better than Olivier (and his group of we) telling my bank not to give me a loan. My bank doesn't work for either you or Olivier.

  3. Ha! Lots of fun answers, and I think Dr. Cochrane's tone is even more than the IMFer's deserved.

    Remember for government: KISS, Keep It Simple Stupid.

    1. Yes, big equity for banks (if they want deposit insurance). And hopefully, activist shareholders on the bank holding company board! If the financial system doesn't collapse, then neither does the economy. If banks risk equity-money, they should be more shrewd. Although buying CMBS and RMBS seemed like a lead-pipe cinch in 2007....rated AAA by Moody's....

    2. Yes, big time QE, and QE as conventional policy, ala Japan. As stated, you cannot fight deflation with zero interest rates, maybe not even with negative interest rates. And you can't fight deflation with higher interest rates.

    3. But why fight deflation? In general, as I think there are so many structural impediments in Western economies, such as real estate lending, that deflation would be a multi-decade process to seemingly permanent recession. Like Japan.

    There is a second unexplored reason: In big-tax wealthy nations, deflation leads to stupendous amounts of cash holding (paper cash in circulation) and the probably inevitable growth of untaxed grey markets.

    Once people keep $8,000 cash per resident in the house (Japan), or $4,200 in United States, or E3,600 in Europe, it starts to make sense to buy goods and services tax-free---that is in cash. This is inevitable, no? You can pay $1,200 on your credit card for vehicle repair, or $900 cash. Not a hard decision.

    The amount of cash in circulation started rising sharply in Japan in 1992 to present---the deflation years. In Europe cash in circulation exploded 66% since 2008---the deflation years. In the USA, cash in circulation is rising sharply now, the low inflation years (cash in circulation has been rising for years, I suspect in part to cash-pay for immigrant labor and related economies).

    Every advanced nation is a high-tax nation, and if cash appreciates in deflation, well then, people save in the form of cash. Why let Uncle Sam's paw in the pot?

    This will also lead (and has) to a bifurcated economy, one aboveground and taxed and expensive and probably stagnant, and a growing, cheaper untaxed paper cash economy.

    Fine, if one can operate in the untaxed, paper cash side of the ledger. The taxed pay for the nation--the national defense, the roads, the schools, the police, and yes welfare. But not me!

    As long as advanced wealthy high-tax nations have deflation, expect to see rising amounts of cash in circulation, and stagnant growth of the official economy.

    Of course, we could go back to 3%-4% inflation and robust real growth...but that is too simple.



    1. Benjamin,

      "Yes, big equity for banks (if they want deposit insurance). And hopefully, activist shareholders on the bank holding company board!"

      Okay, so a bank elects to forgo deposit insurance and use the Fed's discount window instead. How is this an improvement? I presume that the Fed's role as lender of last resort is still in place.

    2. Frank R---No, no discount window. No regs, no subsidies and you lend only equity if you want deposit insurance.

    3. Ben,

      I am not sure what you are hoping to achieve with this. Suppose a bank does sell equity and makes loans from those equity sales. Presumably the value of the equity will rise and fall with the performance of the loans. That part I understand.

      What I don't understand is two fold:

      1. What does deposit insurance have to do with any of this? A bank can have all performing loans and still experience a run on deposits. A bank can have a string of non-performing loans and still retain deposits.

      2. Why do you even need deposit insurance with QE? Lose your deposit, simply have the central bank print up some replacement dollars.

  4. So, if you keep a primary surplus of 2,3% of GDP (average) from 1994 (world record I believe) you do not fit the definition of austerity ? In the case of Italy, since about 1995 it has been sending more than half of interest on gov bonds abroad, about 1,5%-2% of GDP was sent abroad in interes. Until the Euro project was launched instead, the cost of public debt was bigger, but the money stayed here.
    Does it matter wether a country sends abroad 2% of GDP in interest for 20 years or not ? How do you call it ? I have this little "model" that says that if instead you have the CB buying enough of the debt "Draghi-like" and avoid sending this money abroad your GDP growth is higher...maybe not by 2% a year, but something close... I know, saying that sending abroad 2% of GDP in interest cuts your GDP growth sounds simple, but can it be disproved ?

    [...because foreigners came to own 50% plus of BTP which produce almost 90% of the total even though they are only 70% of totale debt ...]

  5. "Should the balance sheets of central banks return to their pre-crisis size." I am trying to understand how this would happen. In theory, the Fed would sell off the assets they've accumulated. If it did it all at once or even slowly, what kind of signal would that send and would it really be something they would want to happen? It seems to me, for at least the near future, their stuck this balance sheet regardless.

    1. James,

      It would end up being a fiscal decision to reduce the debt owned by the central bank. They're stuck with this balance sheet until Congress get's it act together.


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