The state of economics as a field of study

The unfortunate uselessness of most ’state of the art’ academic monetary economics

by Willem Buiter

"The Monetary Policy Committee of the Bank of England I was privileged to be a ‘founder’ external member ... contained, like its successor..., quite a strong representation of academic economists and other professional economists with serious technical training and backgrounds. This turned out to be a severe handicap when the central bank had to switch gears and change from being an inflation-targeting central bank under conditions of orderly financial markets to a financial stability-oriented central bank under conditions of widespread market illiquidity and funding illiquidity.; Indeed, it may have set back by decades serious investigations of aggregate economic behaviour and economic policy-relevant understanding .; It was a privately and socially costly waste of time and other resources.

Most mainstream macroeconomic theoretical innovations since the 1970s (the New Classical rational expectations revolution associated with such names as Robert E. Lucas Jr., Edward Prescott, Thomas Sargent, Robert Barro etc, and the New Keynesian theorizing of Michael Woodford and many others) have turned out to be self-referential, inward-looking distractions at best.; Research tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes; rather than by a powerful desire to understand how the economy works - let alone how the economy works during times of stress and financial instability.; So the economics profession was caught unprepared when the crisis struck."

I agree...

Hungry in Hungary?

Over at A Fistful of Euros, Edward Hugh discusses the topic of Hungary On The Threshold of a Recession? in some detail. If you hadn't paid attention to economic conditions in Hungary anytime recently, you might be surprised at the poor situation the country is in and the unpleasantness that will result from any of the actions policymakers take. The post includes charts showing change in Hungary's consumption growth, retail sales, and construction investment all in negative territory for much if not all of 2007.

The first thought that came to my mind on reading Edward's post is that shareholders in Swiss lending institutions that are issuing loans to Hungarians at this point should be phoning the boards of directors and asking what is going on. It’s hard to believe that anyone can sell a story that Hungarian homes are going to keep increasing in value, or that loaning against home equity to borrowers who might soon be jobless and are on the ropes financially now anyway is a good idea.

I think that the Hungarian central bank ought to go ahead and ease monetary policy significantly now, since homeowning borrowers who are most likely to default will wind up defaulting regardless; and the benefits of easing to internal economic conditions might offset the damage due to a weakened forint. Of course, this isn’t likely to happen. It would be easier for the central bank to do nothing until truly forced to by events and thus the bank would have an excuse.

Influence of rating agencies on international debt markets

In "The Global Credit Channel and Monetary Policy" Claus Vistesen raises the issue of the importance of credit rating agencies with respect to the effect of global financial liberalisation on the global economy.

With respect to the rating agencies, I think one of the major problems has been that investors, whether institutional or retail, have been accepting the ratings assigned to securities at face value without really digging into the guts of the ratings reports or doing much independent analysis. In the case of portfolio managers for institutions, this is really a kind of failure to perform their job.

I am sure that a conversation between a investment bank rep and an institutional buyer like the following hypothetical has happened many times:

Banker: I have X billion of automaker Y bonds available; they're going fast!

Institution: Moody's says these bonds are BAA; no problem..I'll take $100 million as fast as you can get them to me. I need the yield...

So I agree that the ratings agencies have been incentivized to shade their ratings to the optimistic side, but as always the rule of "buyer beware" applies. Buyers of issues rated by the three major raters used the reputation of the raters to cover their butts in case of default: "Well, Moody's said it was BAA!"...

With respect to the ratings agencies and sovereign debts, I am not all that sympathetic to the agencies. Both the buy-side and the investment banks wanted the agencies in place to help justify pricing of issues, and governments frequently have touted their ratings. All four groups of entities have had a stake in the system as it currently exists. If the raters downgrade a country's debt, instead of complaining about the raters, it's up to that country's policymakers to convince the market that the rating is incorrect by providing information or policy changes that demonstrate that the country's issues warrant the desired pricing.

Central banks tightening?

Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

Interest rate trends are pushing higher not only in the U.S., but globally. One might wonder -- if there is so much "global liquidity," why are interest rates rising everywhere? Credit spreads are perking up modestly too, but haven't yet exploded higher in a way that would reflect an oncoming recession or an easing of general inflation pressures.

What's really going on is not the creation of "global liquidity" -- central banks worldwide are generally tightening. What investors have misconstrued as "global liquidity" is nothing but a combination of a) risk blindness among investors, and b) the U.S. going deep into debt to finance current consumption (both private and government spending), while China and other developing nations run huge surpluses to sell us that consumption. They then take the proceeds and buy a) Treasury securities, and b) our means of production.

From the same linked post:

Ray Dalio of Bridgewater Associates, who manages about $160 billion in assets for clients including central banks and foreign governments, quoted in Barron's:

"Hedge funds and private-equity firms today are like the dot-coms in 2000: Ask for money and you'll get it. They bid up the prices of everything. The amount of money flowing is almost out of control, and it's making everything overvalued. A client of mine said it's like there are 11,000 planes in the sky and only 100 good pilots -- an accident is bound to happen. Just like the dot-com bust, the winners and losers will be sorted out but the technological advances won't stop. There is a greater differentiation of managers now than ever before."

Nothing really new in these comments other than Hussman rejecting the inflationists' idea that central banks are pumping liquidity...the US government's debt isn't that out of the ordinary...see my previous posts, particularly the chart of US debt as a proportion of GDP...

Deflation or inflation?

Excluding food and energy prices, the so-called core CPI rose 0.2%, in line with expectations, and cutting the annual gain in the core down to a one-year low of 2.3%...on the one hand, we have plenty of money supply; on the other, overcapacity in a bunch of industries(housing, autos, retail). I am not one of those who will point fingers at the Federal Reserve; they are looking at data that is difficult to disect, and have to look forward. It's useless to point fingers since no one else has better data...

Likely effects of interest rate hike by Bank of Japan

The Economist describes how "a few brave economists believe, to the contrary, that higher interest rates would actually encourage (Japanese)households to spend more, not less."

I thought the most interesting piece of information from that story was the fact that personal savings rates in Japan have actually been falling essentially since the ZIRP was put into place("the sharp fall in the saving rate during the long period of low interest rates, from 14% of income in 1993 to 3% last year. (Although Japanese households have a massive stock of saving, their saving rate out of new income is now low.") I don't think I've seen that fact mentioned often in the financial media. I think this shows that the Japanese households have been responding to interest rate policy as one would expect. It also shows that the interest rate policy has been biased toward supporting the export markets. I don't see that as necessarily unwise since the BoJ is looking at the same demographic projections that we are and probably expects that since domestic markets will shrink, it is better to focus on export industries.

The article makes a persuasive case for raising rates as far as how that would effect exporters, but ignores the demographic situation when it talks about what the effect on the consumer will be. I think that if rates were raised, that wouldn't necessarily increase personal saving, as the retiring Japanese are going to need to spend what they've saved to support themselves. Younger Japanese might save more, but the large mass of older Japanese are reaching that point where they have to stop saving and start spending.

The article mentions the higher cost of government debt briefly; I think that would be one of the biggest problems with raising rates. Japan's public debt is one of the world's largest, so that higher interest cost might not necessarily be offset by increased GDP(particularly in light of the shrinking consumer base).

Current US inflation situation

Capital Spectator comments on the release of the FOMC minutes yesterday as follows:

"For good or ill, the Fed pays close attention to core CPI, and so the future path of interest rates may very well be determined by this inflation gauge. With that in mind, over the 12 months through February, core CPI rose by 2.7%. Not only is that near the highest level in years, it's also well above the Fed's comfort zone. "On a twelve-month-change basis," the Fed minutes advised, "core CPI inflation in February was considerably above its pace a year earlier, largely because of a sharp acceleration in shelter rents over the past year.""

The minutes also state "the unemployment rate edged down from 4.6 percent in January to 4.5 percent in February."

Likely as a result of this information, the conclusion of the FOMC meeting was recorded as:

"At the conclusion of the discussion, the Committee voted to authorize and direct the Federal Reserve Bank of New York, until it was instructed otherwise, to execute transactions in the System Account in accordance with the following domestic policy directive: “The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5-1/4 percent.”

The vote encompassed approval of the text below for inclusion in the statement to be released at 2:15 p.m.:

“In these circumstances, the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”"

I would strongly recommend reading the FOMC minutes each time they are released.


Here is a recent chart of M2 from Capital Spectator...














and a chart of M1 and M2:













So the amount of money Americans have either under the mattress or in their checking accounts has been flat for over two years, while they have been putting cash into short term savings accounts(see Wikipedia's entry on Money Supply for definitions of M1 and M2). That makes sense, as you want to earn some interest if you can, even if you're planning on spending the money soon.

It makes sense to me that the Fed stopped reporting M3, because M3 just adds eurodollars and repurchase agreements to M2. Since Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve, why report something you can't control?

Wikipedia's discussion of repo's and the Fed is as follows:

"In the United States, as of 2006 the Fed sets an interest rate target for the Fed funds (overnight bank reserves) market. When the actual Fed funds rate is higher than the target, the desk will usually increase the money supply via a repo (effectively lending). When the actual Fed funds rate is less than the target, the desk will usually decrease the money supply via a reverse repo (effectively borrowing).

In the U.S., the Federal Reserve (Fed) most commonly uses overnight repurchase agreements (repos) to temporarily create money, or reverse repos to temporarily destroy money. Alternatively, it may permanently create money by the outright purchase of securities. Very rarely will it permanently destroy money by the outright sale of securities. These trades are made with a group of about 22 banks or bond dealers who are called primary dealers."

Brazil, Russia, India...

Brad Setser says this about these three countries:

"the private markets don’t want to finance a $900b US deficit at current US rates. Not when the BRIs offer a better return. But right now the private money flowing into the BRIs gets sent back by their respective central banks to the US and Europe. The BRIs, by paying more for money borrowed from abroad than they get on lending those funds to the US, effectively subsidize both speculators bringing money into their countries and the United States. To me, it is nuts."

Also: " One thing is clear: the willingness of the central banks of Brazil, Russia and India to turn private flows seeking yield in their markets into demand for US treasuries and agencies has become an increasingly important component of the global financial system. "

I agree with both statements. I think the key is that the central bankers of these countries see the US as the safest place to park the cash; even though all three countries have major political issues with the US.

Elimination of M3 reporting: a problem or not?

Dr. James Hamilton has a good explanation of the measures of money supply used in the US at his post M3 or not M3?. A couple of good quotes and my comments:

1. "Economists define "money" as an asset that is used to pay for transactions. Thus, for example, we don't include your credit card in any measure of the money supply, because it's not an asset. Having a credit card doesn't make you rich-- I hope I'm not the first person to tell you that. We likewise don't count holdings of stock equity, because you can only use your stock wealth to buy your groceries if you first convert it into another asset. The quantity of money in circulation would be of economic interest insofar as it bears a stable relation to the dollar value of transactions that get undertaken."

2. "there is the now-no-longer-published M3. This added to M2 a number of liquid assets used by large institutions or wealthy investors, such as institutional money market funds, time deposits in excess of $100,000 with penalty for early withdrawal, repurchase liabilities of depository institutions, and dollar-denominated accounts held by someone with a U.S. address at certain foreign banks or foreign branches of U.S. banks.

I have to confess that in a quarter century of teaching and research, I never had any occasion to make use of M3. It always seemed to me that this unambiguously failed the definition of an asset that is used to pay for transactions. If you're going to include such assets in your concept of "money", why stop there? Don't you want to include T-bills as well, and if them, why not Treasury bonds? You have to stop somewhere, and I always stopped with M1 or M2.

In addition, a primary reason for focusing on the money supply for policy purposes is that it's a magnitude controlled by the government. The physical dollar bills are of course printed by the government, and a bank that issues checking accounts must hold credits that could be used to obtain physical dollars (known as Federal Reserve deposits) in a certain proportion to the value of the outstanding checkable deposits. However, it is unclear how the government is supposed to control the M3 components. Balances at foreign banks, for example, are clearly outside the control of the U.S. government." I agree with Dr. Hamilton's assessment...

The purpose of the Federal Reserve system

Excellent historical analysis at Econbrowser of why the Federal Reserve system was created and how it has reduced the incidence of financial crises in the US...a quote:

"If you're a smaller country like Korea for which a lot of the short-term debt is denominated in dollars, your central bank does not have the power to create extra dollars if everybody suddenly demands their payment and refuses to extend credit. Trying to flood the market with more of your own currency is just going to make the outflow of capital more severe."

One can see from the chart provided that short-term volatility in commercial paper rates decreased significantly after the creation of the Federal Reserve. In my view this has been beneficial for the US economy as it reduced the variability in access to working capital for businesses.

Milton Friedman on the Euro

is at this post.....the key point that he made was that this is the first currency recognized as official by independent states that is not backed by gold.

The quote:

The euro is going to be a big source of problems, not a source of help. The euro has no precedent. To the best of my knowledge, there has never been a monetary union, putting out a fiat currency, composed of independent states.

There have been unions based on gold or silver, but not on fiat money—money tempted to inflate—put out by politically independent entities...