Dr. Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.
This slow movement of the financial system from stability to crisis is something for which Minsky is best known, and the phrase "Minsky moment" refers to this aspect of Minsky's academic work.
Tuesday, September 22, 2009
1) The Blog Wars : De Long & Krugman vs. the New Classicals
2) Nick Rowe explains why money is not like other goods and assets and hence, not neutral in a non-barter economy, here and here.
3) Steve Keen
Keen is a Minsky style Post-Keynesian. He has written a book called Debunking Economics, which is highly critical of neoclassical economics.
He laments the usual equilibrium analysis of the economy in the mainstream and tries to model the economy as a non-linear dynamical system using differential equations. He argues that money is endogenously created (money is there iff. there is debt). He also sees the modern capitalist economy as inherently unstable (which ties up with the dynamical model) because of the financial fragility hypothesised by Minsky.
4) Barry Eichengreen and Kevin O Rourke on the comparison between this depression and the original great depression.
Yellen is the governor of the Federal reserve of San Francisco. She argues that there is a pressing need to incorporate finance into mainstream macro, that there indeed are asset price bubbles and it may be desirable for a proactive central bank to deflate them. She also says that not all bubbles are equal, and that credit market bubbles and deleveraging need more proactive intervention than equity market booms and busts. She is however skeptical about how a central bank can go about doing it, and suggests countercyclical capital requirements (which go up in times of liquidity and go down in times of distress) as a robust policy measure.
6) 2006 paper by Alan Blinder on the main monetary policy challenges faced by central banks everywhere.
Blinder's only blind spot in the paper was his strong assertion on the issue of asset price bubbles. He asserts that central banks should not be concerning themselves with such bubbles, and gives the example of the tech bubble and bust to demonstrate how asset price fluctuations can be effectively handled post facto. In the light of recent events, it is a particularly bad example. Oh well, hindsight is perfect.
The insights on exchange rate interventions (intervene in extreme volatility), transparency of output and unemployment objectives (its necessary) and bank supervision (it may be required), and the deliberations on interest rate are quite brilliant. Do read the whole thing though - it's clear, smoothly written and really gives the lowdown on the practice of central banking.
7) Minsky & Minsky-like
Paul McCulley's Minsky inspired take on the 'shadow banking system', a term that he coined. Incidentally, Janet Yellen also refers to McCulley approvingly in her address. Oh well, PIMCO is just a great bond fund.
8) The history, development, state and relevance of macro (the non-vitriolic not-just-post-crisis series),
Robert Gordon, on why 1978 era macro might be the best guide to the crisis. Some insightful ideas about the differences in goods that have 'auction markets' (like oil) and others that don't and what that means for macroeconomic theory.
Arnold Kling, in a smart little piece about how shortage of data affects macroeconomic debates of all hues, as a small review of Mankiw's paper.
Michael Woodford, papers on revolution and evolution in 20th century macro (1999), and a somewhat ill-fated celebration of a then new neoclassical 'consensus' in macro. (2007)
Robert Lucas, asserting that smoothening short run demand flucatuations ought to be subservient to looking at long term supply driven growth. This address forms the basis of part of the analysis in the Laidler paper. Recent events don't bear him out too well either.
Saturday, September 19, 2009
Recently, I've found myself reading a lot on the crisis, monetary policy and macroeconomics. This includes the usual suspects, some newly discovered stuff and a book. But most of all, I've been reading research papers, including some that were published a few decades ago. Some sort of clarity and a framework have begun to emerge and I'm now finally able to get the drift on some of the more technical discussions on the relevant issues. There are two prominent themes in these readings that emerge often and that I find myself agreeing with most strongly.
The first is that there is a pressing need to incorporate finance and into macroeconomics. Earlier, this incorporation had stopped at understanding the role of money in the economy with a cursory glance at the banking system. The basic channel that unifies money, the banking system and the real economy is credit and credit has never really been incorporated into mainstream macro. If there is only one thing that we learn from Minsky, it should be this: incorporate credit as the concept and the financial sector as the context to inform macroeconomic policy.
The second theme is that dynamic monetary disequilibrium is a consistent feature of the modern credit economy. If you take a look at the criticisms of the New Classical school (esp. John Cochrane) coming from De Long and Krugman and many others in the recent online economic wars, there is one constant refrain: the New Classical school has failed to grasp the role that money can play in the modern economy. The New Classical school has an implicit belief in the Say's Law, and thus believes that there can be no general supply glut, that excess supply in one sector is offset by excess demand in another, that savings always equal investment and hence recessions are temporary readjustments in overall social preference from some goods and sectors to other. It thus believes in the 'neutrality of money', i.e the idea that money only functions as a medium of exchange, that investment and consumption decisions are made in real terms and hence the only source of demand for money is the 'transactions demand'. As many have pointed out, this is a model that could perhaps accurately describe a barter economy, or to a monetary economy where the velocity of money is a fixed technological constant subject only to exogenous shocks and thus behaves as if it were a barter economy.
While the barter system has not existed for a long time now, the relatively simpler economy of the past, say until the 19th century, could perhaps be approximated by such a model. In an explicitly monetary economy, however, money also seems to perform the function of a store of value and thus there could be disequilibrium, especially a monetary disequilibrium. A fully fledged 'finance economy' has since become the reality in the 20th century, and such a finance economy seems to have the ability to magnify and reinforce the monetary disequilibriums.
There are, of course, a number of people and streams of thought that have tried to incorporate credit into their understanding of macroeconomics and business cycles. Apart from Minsky, the Austrian Business Cycle theory is one such. Broadly, it says that money is easy in good times due to actions of market participants and artificially low interest rates set by the central bank. This excess money causes businesses to over-invest, thus temporarily causing a bubble. Ultimately this bubble bursts, resulting in a temporary under-investment that brings the economy back to its 'normal' state. Central banks should not try to increase liquidity during such a crisis, for that will just create another such bubble. Murray Rothbard's version of the business cycle also has people over-inesting irrationally only in the presence of the central bank!
Because of the resemblance of the boom-bust hypothesis to the technology bubble to mortgage bubble shift of the past decade, and because of its incorporation of credit, this theory has gained some credence in the past year. It has however, been criticized on various grounds at various times by several economists, including both Keynes and Friedman. The central issue with the theory is that it also seems to believe in the neutrality of money. Moreover, the theory seems to treat irrational over-investment as a moral evil and recessions are seen as having the salutory effect of bringing people back to the preferred state of rationality. This can seem as a Great Depression-apologist stance and Krugman has indeed attributed part of the blame for the broad-based central bank failures during the depression to the Austrians.
Apart from the Austrians and Minsky, there was at least one other economist whose ideas seem strikingly close to the events unfolding of the crisis, but who doesn't seem to have gotten much attention. Henry Simons is considered one of the founders of the Chicago school. Simons recognised and distrusted the high volatility of the liquidity demand of money and believed that the credit cycle and short term debt issued by banks and corporations exposed any financial system built on it to severe fluctuations through asset liability mismatches, which could then spread the fluctuation to the real sector. He was also concerned a lot about maintaining the price level. In one theory, we see the amalgamation of several strands of thought that have come to dominate academic thought in the crisis.
Though Simons's understanding of the inherent fragility and positive feedback of the financial system is similar to Minsky's and Bernanke's, his policy prescriptions differ. He recommends full reserve banking, the gold standard, the complete absence of short term debt, and strict monetary management by the government. If these frameworks are in place, it seems to me that the rest of the economy starts resembling an 'as if' barter system and his favoured policy stance of laissez faire becomes workable.
A full reserve banking solution has also been provided by others wary of the financial system or the government, including Rothbard and intermittently, Friedman. The causes of course, differ. The generation of money through fractional reserve banking has been compared to counterfeiting by more than a few respected economists, including Maurice Allais. The debate is not only interesting (though perhaps lop-sided), it is critical to understanding the tenuous relationship between money and credit in the financial economy.
Credit is endogenous, it comes about from the interaction of the financial and the real sectors. Indeed, it is also the main channel of transmission between the two. Proponents of fractional reserve banking argue that it is just the way to implement the 'monetization' of credit. Proponents of full reserve banking are concerned either about the supposedly illusory money (Rothbard, Allais) or about financial fragility (Simons).
Of course, even within the 'monetization of credit' philosophy, one can ask where does the money itself come from. While the monetarists and many Keynesians believe that money, though inevitable, is still exogenous and comes from the government and the central bank as a way to monetize the credit, the circuit theorists argue that money is an endogenous property of a credit economy itself. Indeed, in their view, credit IS money. Of course, there are the agnostics in between these two views.
We can thus summarize the broad ways of looking at the theory and concept of money, arranged in a roughly free market to interventionist order.
1) Money is neutral and always in equilibrium.
2) Money is neutral but there are temporary, required credit disequilibria.
3) Money is not neutral and sometimes in disequilibrium, but exogneous.
4) Money is not neutral and often in disequilibrium, and may be exogenous or endogenous.
5) Money is not neutral, often in disequilibrium and endogenous.
My own views are closest to 4.
(This post has left out several contextually required links. The next one is going to be a mega link fest)
Sunday, September 13, 2009
If you read Ajay Shah's blog, you will notice that he is an ardent supporter of inflation targeting, rule based central banking and by and large critical of RBI's policy actions. Specifically, he believes that in an emerging country likely to have weak institutions, like India, the central bank has no business using discretion, that currency depreciation should not be fought using fx reserves, that modern academic macroeconomic insights (of the Monetarist-New Keynesian variety) like inflation targeting are widely used and widely effective and that RBI's heavy handed approach to regulation has drastically stunted financial markets and innovation and thus stunted entrepreneurship and growth. Ila Patnaik, with whom he has collaborated on several papers and other research initiatives, has more or less similar positions. I refer to the two of them because of two recent pieces - this op-ed by Dr Shah in FE and this one by Dr. Patnaik in the Indian Express.
Before we turn to the op-eds in question, it is interesting to explore each of the broader positions in some detail. Rule based central banking is thought to stabilize market expectations and prevent the central bank from committing policy mistakes which it might otherwise do on account of insufficient data, incompetence or vested interests. However, it also takes away some important tools that central banks have to fight pro-cylicality. Dr. Shah is however ok with de facto if not de jure central bank positions, but seems to insist that India cannot afford de facto positions because our institutions are weak. This characterization of Indian institutions, while broadly correct if we were only talking in generalities, fails as a logical argument when one specific institution is being discussed, whether the RBI or any other. Rule based central banking could be a great idea if there was sustained evidence of RBI policy failure, otherwise there is no specific need for us to be pessimistic about RBI simply because on the average, Indian institutions are weak. And how has the RBI done? We'll turn to that in some time.
The specific measures of inflation targeting and using fx reserves to fight currency depreciation are trickier issues. Basically, as this article by Raghuram Rajan points out, the two objectives cannot be managed well together with a single instrument - interest rate - at your disposal and currency defences are widely thought to be ineffective at best (as in the case of England, 1992) and ruinous (Indonesia & Malayasia, 1997) at worst. Combine that with the hypothesized effectiveness of the Taylor Rule in combating stagflation, and we seem to have a no-brainer: open capital account completely, let the currency fluctuate and manage the price level through inflation targeting. Broadly, this makes complete sense. However, there are important nuances that are probably being missed out in such a simplified narrative.
For one, emerging market currencies tend to be strongly correlated with all other asset markets in the country. Most capital inflow into emerging markets is on the basis of perceptions of macroeconomic and political risks and stability. In India, the situation is further complicated by the fact that foreign institutional investors are not allowed to buy and sell rupees in the spot (cash) market, unless it is for the explicit purpose of buying equities or some other assets. Now anyone who has any knowldge of trading desks will tell you that such correlations are often speculated on, or other speculations are often based upon assumptions of such correlations. In a crisis, when there is sudden asset deleveraging, such speculations can form a strong postive feedback looop, further aggravating the deleveraging. It is futile to try to establish the cause and effect chain in such feedback cycles - to counter them, one or both the legs of the cycle may be attacked, and this could be the fx market or the correlated asset market (equity, for example). It is interesting to note that the darling of the free market, Hong Kong, had managed to avert the 1997 crisis to a great extent through such operations. The nature of the operations may be different for an economy like India, for the degree and even the direction of the correlations may run different, but point is - it is possible and perhaps desirable to defend a currency provided one does so judiciously. And without discretionary monetary policy, such actions are impossible.
What of inflation targeting? Though the evidence has been mixed, IT gives a robust way to achieve price stability, which is key in an economy with fiat currency, fractional resevrve banking and credit. The question is not whether IT is a worthy goal - it surely is. The question is - should IT be the only focus of the central bank, or are there other objectives just as worthy? Specifically, should the central bank pro-actively intervene in asset price bubbles? This paper by Janet Yellen (governor of Federal Reserve of SSan Francisco and one of the economists touted as Bernanke's successor) discusses the issue in great detail. Yellen notes that not all asset price fluctuations are created equal and broadly says that while equity market booms and busts may be left alone, credit markets deserve a deeper look as credit is the main mechanism of transmission between the financial and the real economy. In either case, praising and echoing Minsky, she emphasizes the need to bring the financial sector and financial stability as explicit constructs in macroeconomics and monetary policy.
Next, what about capital account liberalization? Let's treat the restrictions on corporate debt investments later. First, let's recall what exactly is forbidden in the Indian currency market - FIIs are not allowed to speculate on the spot value of the rupee. They can buy and sell NDFs (non-deliverable forwards) though, and these are short-dated enough to be considered close proxies for the spot market by most trading desks. What this ensures, however, is that the very short term rupee liquidity in the market is insulated from manpulation, allowing RBI greater room to act as a manipulator itself. Raghuram Rajan, whose committee has recommended full capital account convertibility, himself finds in this paper that
Cross-country regressions suggest little connection from foreign capital inflows to more rapid economic growth for developing countries and emerging markets. This suggests that the lack of domestic savings is not the primary constraint on growth in these economies, as implicitly assumed in the benchmark neoclassical framework.
and goes on to suggest a 'pragmatic' way for the process of capital account liberalization. In another paper, he and his co-authors conclude that
even successful developing countries have limited absorptive capacity for foreign resources, either because their financial markets are underdeveloped, or because their economies are prone to overvaluation caused by rapid capital inflows.
seemingly confirming some of the common sensical arguments around the 'hot money' of capital inflows.
Now finally, we turn to the recent critiques that Dr. Shah and Dr. Patnaik have dished out to the RBI. Dr. Patnaik asserts that India is not the only country that has remained relatively unscathed in the crisis and hence there is no evidence that RBI has done a spectacular job and that the world has nothing to learn from RBI. She criticizes the self-praise that some recent RBI establishment people have heaped upon themselves (perhaps Dr. Y V Reddy) and points to the micro and macro-prudential frameworks of east Asia as being worthy of emulation. She concludes memorably
A villager with no roads may foolishly boast of having no accidents, but he cannot teach people how to regulate traffic on busy intersections. It is important for policy makers to remember that India has no lessons to offer to regulators operating in the sophisticated world of finance, and proposals suggesting that they should learn our style of regulation only makes us look foolish.
Let's take a look at what RBI and Dr. Reddy have praised themselves for. This NY Times article provides a clue.
One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans....Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive — as American banks did not — to see those loans paid back.Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 percent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Mr. Reddy was creating liquidity even before there was a global liquidity crisis.
Now, if these aren't micro and macro-prudential measures, I don't know what are. I fail to see why Dr. Patnaik feels that these measures are something that no one can learn from. Interestingly, Yellen also notes that a way for central banks to induce financial stability is to manage liquidity requirements
Capital requirements could serve as a key tool of macro-prudential supervision. Most proposals for regulatory reform would impose higher capital requirements on systemically important institutions and also design them to vary in a procyclical manner. In other words, capital requirements would rise in economic upswings, so that institutions would build strength in good times, and they would fall in recessions. This pattern would counteract the natural tendency of leverage to amplify business cycle swings—serving as a kind of “automatic stabilizer” for the financial system."
Now compare this with D V Subba Rao's speech, the one that has come under fire from Dr. Shah. Subba Rao, outlining the measures that the RBI recommends to stave the crisis, says
24. It may be relevant to highlight some of the specific features of our system that have contributed to financial stability:• Banks are required to hold a minimum percentage of their liabilities in risk free government securities under the statutory liquidity ratio (SLR) system. This stipulation ensures that banks are buffered by liquidity in times of stress.• We managed the capital account actively. In the face of large capital inflows during 2006-08, we sterilised the resultant excess liquidity through calibrated hikes in the cash reserve ratio (CRR) and issue of market stabilisation scheme (MSS) securities. When the flows reversed during the last quarter of 2008, we reversed the measures too. We cut the CRR and bought back the MSS securities to inject liquidity into the banking system.
Seems like Subba Rao and teh RBI, through design or default, have integrated Minsky and Yellen's insight into the system already. He also outlines the fundamental philosophy of RBI's monetray policy and management
20. In contrast to the minimalist formula of ‘single objective, single instrument’, the conduct of monetary policy by the Reserve Bank has been guided by multiple objectives and multiple instruments. In general, our three main objectives have been price stability, growth and financial stability, with the inter se priority among the objectives shifting from time to time depending on the macroeconomic circumstances.
The RBI's philosophy then, is nothing more than what Minsky suggests in his financial instability hypothesis. It is ahead of its time in explicitly recognizing the importance of financial stability as a goal beyond price stability, though I consider Yellen's skepticism about central bank intervention in asset price bubbles healthier than Subba Rao's conviction.
By stark contrast, Dr. Shah's and Dr. Patnaik's op-eds seem like rants that assert what they want to argue. They smirk at RBI's gloating, but this is what Subba Rao says
Sure, we have been hurt by the crisis, but much less than most others. It will be a folly though to let that lull us into complacency and to believe that there is something inevitable about India’s financial stability.
Now let's be charitable and remove all the smirking and rhetoric in the op-eds and look at RBI's philosophy on the main issues - capital account liberalization, financial sector regulation, inflation targeting and currency defence. The RBI has a medium term inflation target of 5% and intervenes in the fx market only when there is "excess volatility'. RBI let the rupee fall from 40 to 52 against the dollar in the crisis, intervening only in most difficult phases. Fx reserves have not been depleted by any significant amount, and as Prof. J R Varma points out, the sterilizing of capital inflows that RBI did during the boom years meant that it was long US treasuries and short Indian equity, an immensely profitable trade in 2008. And this is what DVS says about the capital account liberalization process
We view capital account liberalisation as a process and not an event.
Indeed, this resonates with Rajan's paper. Where the RBI has really been messing up is the regulation of the corporate debt market, which irrespective of its relation to economic growth, is a trade that loses India lots of money, pointed out by Prof. Varma in the same post. This is also the ground on which Subba Rao's integration of financial stability into monetary policy objectives seems the weakest
The policy framework encourages equity flows, especially direct investment flows but debt flows are subject to restrictions which are reviewed and fine-tuned periodically.
If Dr. Shah and Dr. Patnaik were to restrict their critiques of the RBI on this account, and in a juicier more content-filled manner, one would feel bound to agree with them. However, they dilute their strong arguments with a plethora of weak ones, and rather than show some effects of the stunting of the corporate debt market (as Prof. Varma does), take potshots at the RBI's 'gloating'.
This is a classic policy debate situation. The central argument that Dr. Shah espouses is made to look weaker than it is by his undercooked takedown of his intellectual opponent.