Changing role of Central Banks?

The focus of modern central banking has been to provide price stability by controlling inflationary pressures on the prices of goods and services commonly traded in the real economy. It was also argued that they should desist from trying to prick asset bubbles in financial markets and smoothing the booms and busts of business cycles.

This orthodoxy was best exemplified by a famous paper co-authored by the present Fed Chairman Ben Bernanke with Mark Gertler, and presented at the annual Jackson Hole enclave in 1999. Central Bankers led by Alan Greenspan have dutifully followed this strategy, even as the world economy developed serious macroeconomic imbalances and financial asset bubbles during the last two decades.

They have believed that it was not possible to accurately assess whether and when asset price increases assume the character of a bubble. Further, even if a bubble was developing, assessment of the time, extent and scope of the intervention required was thought to be beyond the abilities of policymakers. And compounding the problem is the difficulty in choosing the right mix of instruments to deploy in such situations. The dilemma facing central bankers is - when to intervene, by what extent and using what instruments? The risk was of intervening either too early and/or too aggressively, and thereby adversely affecting economic growth.

However, in light of the dramatic events of the past fifteen months and the havoc wreaked by the systemic risks that got built up due to the passivity of Central Banks, it appears that the momentum may have shifted in the direction of more aggressive Central Bank intervention to deflate asset price bubbles and stabilize the business cycle.

I have blogged earlier about using Markov regime-switching analysis for a variety of major global market events to detect advance signs of emerging market turbulence and manifestation of systemic risk building up. Further, as the figure below indicates, it is amply clear that asset prices have exhibited "irrational exuberance" on multiple occasions due to varying factors since late nineties.



WSJ points to the work (see this presentation) of Princeton Professor Hyun Song Shin and New York Fed researcher Tobias Adrian, draws attention to the impact of monetary policy on the funding conditions of financial institutions and development of financial asset bubbles. They show that the credit bust was preceded by an explosion of short-term borrowing by US securities dealers such as Lehman Brothers and Bear Stearns. They point to the borrowing in the so-called repo market (where Wall Street firms put up securities as collateral for short-term loans), which more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. Further, as the value of the securities rose, so did the value of the collateral and the firms' own net worth, in turn spurring firms to borrow even more in a self-feeding loop. And when the value of the securities started to fall, the loop went into reverse and the economy tanked.

In other words, "the most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices". The commonest policy intervention to prevent the build up of such levels of debt, and thereby pre-empt these busts, is to raise interest rates. Accordingly, Adrian and Shin highlight the need to factor in the trends and directions in credit flows ("balance sheet quantities") into Fed interest-rate calculations. They feel that small additional increases in rates in 2005 might have tamed the last bubble, and claim that interest rate is the "most effective instrument" for regulating risk-taking by firms.

However, this too runs into the same aforementioned uncertainties, risks, and inefficiencies. Interest rate decisions not only affect these financial institutions, they also impinge on all types of consumer spending and business investment decisions. Further, its universal sweep means that even the more prudent and responsible financial institutions are penalized for the excesses of their greedy and irresponsible compatriots. Or are there broader systemic parameters, which reflect the build-up of more universal distortions, that can be used to time such interventions?

A more effective and systemic intervention to prevent such debt spirals would be higher and uniform (across all types of financial institutions) capital adequacy ratios or tighter collateral requirements on borrowings. And these ratios should also take into account the varying extents of systemic risks posed by different financial institutions - remember the too-big-to-fail (TBTF) institutions! A sliding scale of increasing capital requirements as debt levels increase may help offset the amplified risks posed during such borrowing binges. Restricting leverage would have to become the primary control mechanism. Differential provisioning requirements, based on the investment risk profiles, are another excellent means to limit excessive build up of credit in high-risk sectors.

Update 1
Mark Thoma draws attention to Paul Volcker and Ben Bernanke who both advocate an important role for the Fed in regulation and supervision of banking sector, especially in light of recent events which conclusively demonstrates that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined.

Bernanke's arguement rests on two issues - such powers significantly enhances the Fed's ability to carry out its central banking functions (the Federal Reserve’s ability to effectively address actual and potential financial crises depends critically on the information, expertise, and powers that it gains by virtue of being both a bank supervisor and a central bank); the twin functions of consolidated supervision of individual banks and assessing macroprudential rystemic risks require expertise that only the Fed possesses.

Update 2
Rajiv Sethi feels that it "might be possible to obtain information about the prevalence of beliefs about an asset bubble by looking at the prices of options... In the case of a bubble involving a large class of securities (such as technology stocks) a widespread belief that prices exceed fundamental values should be reflected in higher prices for index straddles: a combination of put and call options with the same expiration date and strike price, written on a market index."

Paul Samuelson RIP

Paul Krugman's description of the man who wrote the nation's (and even the entire profession's) "economics textbooks" is most appropriate, especially now

"He never forgot that markets can malfunction terribly... good macro policies come first. Monetary and fiscal policy had to be employed to assure more or less full employment. Exchange rates had to be adjusted to assure competitiveness. Only then could the virtues of markets come into play. It was a lesson that too many economists forgot, as they immersed themselves in the lovely math of perfect markets. But Samuelson’s realism – his understanding that markets are great things but need to be supported by government activism — has never seemed more relevant than it does now."

See also this and this (from Paul Krugman), on his prescience about the ineffectiveness of monetary policy in deep slumps and how monetary expansion just piles up in bank reserves, extremely relevant now...

"Even if the authorities should succeed in forcing down short-term interest rates, they may find it impossible to convince investors that long-term rates will stay low. If by superhuman efforts, they do get interest rates down on high-grade gilt-edged government and private securities, the interest rates charged on more risky new investments financed by mortgage or commercial loans or stock-market flotations may remain sticky. In other words, an expansionary monetary policy may not lower effective interest rates very much but may simply spend itself in making everybody more liquid...

In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. 'You can lead a horse to water, but you can’t make him drink'. You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs. You can get some interest rates down, but not all to the same degree. You can tempt businessmen with cheap rates of borrowing, but you can’t make them borrow and spend on new investment goods."

See this and this from MR, this from Mark Thoma, this from TCA Srinivasa Raghavan, and this superb homage from Ed Glaeser ("Samuelson gave economists our toolbox"). Mostly Economics has this linkfest. See also Avinash Dixit here.

Four problems with prevailing SHG model

That the existing Self Help Groups (SHGs) based micro-finance model has achieved remarkable successes is delivering both social and basic economic empowerment of women in many developing nations cannot be disputed. However, the prevailing model, especially in the government led micro-finance schemes, suffers from important limitations that come in the way of achieving goals that go beyond the modest initial objectives.

Here are four fundamental problems with the micro-finance based poverty eradication model of delivering development.

1. The rigidly structured (10-15 members and lack of flexibility with changing its composition and size) group account oriented micro-finance model does not have the required flexibility to accommodate the differential savings habits of members within the group. Since there is only one servicing account for the group, all the members generally save the same amount and equally share any benefits. Therefore, instead of need-based loan uptake, more often than not the loans are equally divided among the members and resultant sub-optimal utilization. This becomes critical, especially when the group has achieved a level of empowerment, and the differential credit needs of group memebers assumes importance.

2. In the absence of access to innovative and beneficial financial products, the SHG members may not be able to make the most efficient use of the inculcated savings habits and financial inclusion. In fact, currently the high opportunity cost (given the scarce income and multi-farious competing needs) thrift is being locked up in the low yielding savings bank account of the group. Unfortunately, even as the focus has been to get people to save and open bank accounts, important issues like the returns on their savings have been lost in the maze of priorities. Further, not enough attention has been paid towards leveraging the savings to minimize the risks associated with the universal and commonplace needs like health care and children's education.

3. The present arrangements also do not place the required premium on the vital forward and backward linkages like access to intermediates and capital goods, markets, and training required for making the most optimal use of the financing available for self-employment generation opportunities. It may be more appropriate if the financing, especially for starting new businesses or expanding existing ones, be bundled with all the required forward linkages.

4. It does not more explicitly acknowledge the reality that SHGs and microfinance are at best an entry-point activity that should be used to propel the group members into a higher growth trajectory. This would require that the groups leverage on the platform provided by the SHGs to access the formal institutions that support them and then its members get gradually equipped to chart out their fortunes independently. It needs to be acknowledged that while the strength of the group is an excellent platform to address the problems facing a group of poor people struggling to survive, it may not be the most efficient vehicle for addressing the challenges faced by those positioned to move up the economic ladder.

Food price inflation and speculation

Businessline has this graphic capturing the price trends for 16 major food items over the year, which have cumulatively shown a 35% increase in price.



In response to mounting pressure linking increases in prices to futures trading, the Government had banned trading in wheat, tur, rice and sugar futures since last year.

However, contradicting the commonly held view that speculative activity is behind price increases, based on the aforementioned price trends, it is being claimed that "there was a nil or modest rise in prices of traded items, price rise was maximum in articles such as vegetables, fruits, tur, rice and sugar that are not traded".

Further, the price of wheat has been remarkably stable, despite the government lifting the ban on its futures trading since May this year. The price of sugar has risen by nearly 50% since sugar futures were banned in May, on the face of fears that speculative activity was behind price rise.

CP Chandrasekhar and Jayati Ghosh draw attention to the sharp spikes in commodity (both foodgrains and cash crops) prices since second half of 2007 and early 2008 and the absence of any satisfactory enough demand-side explanation for such price increases to lay the blame on the doors of speculative activity triggered off by the flood of capital into deregulated exchange-traded futures and over-the-counter forward markets. See also this on the pronounced impact of global foodgrain price volatility on developing countries.

The arguement of Chandrasekhar and Ghosh rests on the claim that foodgrain prices have been experiencing larger than normal volatility in the last few years, as these graphics indicate





However, this inflation adjusted long-term graphic of foodgrain prices appears to indicate that the inflexion of 2007-08 may not be as large an outlier as is being made out ...



... and this graph of annual international price indexes for food and energy raw materials, 1960 to 2007 (2000 = 100)



However, it cannot be denied that speculative activity may have had atleast some effect on sugar prices, by way of the impact of futures price signals on wholesale market prices (and then transmitted down to the retail market). The true extent of this impact can be gleaned only by closely comparing and examining the spot prices with the prices of sugar futures (not able to lay hands on data). But given the imperfections in the transmission of such signals here, it may only have been a minor contributory factor towards the rises in prices.

Further, see also this, this, and this examination of the reasons for the commodity price increases. Also this Vox article which feels that the food price volatility wll persist.

Puzzle #1

Jack is looking at Anne, but Anne is looking at George. Jack is married, but George is not. Is a married person looking at an unmarried person?

(a) Yes

(b) No

(c) Can not be determined

--------------------

Common answer is (c), and the right answer is (a). Here is why,

Anne is either married or unmarried. If she is unmarried then married Jack is looking at her, and if she is married then she is looking at unmarried George!

(HT: A Blank Slate via Steven Landsburg)

Save to Win - incentivizing savings through lottery!

After "Save More Tomorrow" and "Give More Tomorrow", here comes "Save to Win". It seeks to structure the "choice architecture" in such a way as to encourage people to save more by drawing on insights from behavioral economics that people tend to over-estimate the odds of rare events.

Peter Tufano of HBS has devised "Save to Win" as a cross between a Certificate of Deposit (CD) and a lottery ticket, and it was launched for members of eight credit unions in Michigan. Under the Michigan scheme, members of the credit union who put $25 or more into a Save to Win one-year CD (which pays a rate slightly lower than rates offered by conventional CDs) are entered into a monthly "savings raffle" for prizes up to $400, plus one annual drawing for a $100,000 jackpot. In other words, they get both interest return from the CD and the (over-estimated!) prospect of hitting the jackpot.

Another example of such savings-cum-lottery instruments are the Irish Prize Bonds, offered in units of €6.25 with a minimum purchase of 4 units, which are a unique form of tax and risk-free, state guaranteed investment offering you the chance to win big cash prizes in a weekly lottery.

Nudges on restaurant menu cards

Marginal Revolution draws attention to an extract from William Poundstone's new book, Priceless: The Myth of Fair Value (and How to Take Advantage of It), which dissects the marketing tricks built into restaurant menus.



An explanation of the typography, location of items etc is available here.

Update 1
Times has this article about how restaurants are embracing techniques from behavioural psychology to beat the recession - "magic combination of prices, adjectives, fonts, type sizes, ink colors and placement on the page can coax diners into spending a little more money". It draws attention to the considerable new research into the science of menu pricing and writing.