Category: Banks & Interest Rates

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Why the Fed should not target inflation

Scott Sumner, Professor of Economics at Bentley University, proposes that the Fed target nominal growth in GDP (“NGDP”) rather than inflation as Ben Bernanke has long advocated:

“Even he [Bernanke] must be surprised and disappointed with how poorly [inflation targeting] worked during the recent crisis.”

The primary problem, Sumner points out, is that measures of inflation are highly subjective and often inaccurate.

“The problem seems to be that, according to the Bureau of Labor Statistics, housing prices did not fall. On the contrary, their data shows housing prices actually rising between mid-2008 and mid-2009, despite one of the greatest housing market crashes in history. And prices did not rise only in nominal terms; they rose in relative terms as well, that is, faster than the overall core CPI. If we take the longer view, the Bureau of Labor Statistics finds that house prices have risen about 8 percent over the past six years, whereas the famous Case-Shiller house price index shows them falling by nearly 35 percent. That is a serious discrepancy, especially given that housing is 39 percent of core CPI……..

There are errors in the measurement of both inflation and NGDP growth. But to an important extent, the NGDP is a more objectively measured concept. The revenue earned by a computer company (which is a part of NGDP) is a fairly objective concept, whereas the price increase over time in personal computers (which is a part of the CPI) is a highly subjective concept that involves judgments about quality differences in highly dissimilar products.”

Inflation targeting also encourages policymakers to think in terms of monetary policy affecting inflation and fiscal policy affecting real growth — “a perception that is both inaccurate and potentially counterproductive”.

“Advocates like Bernanke see [inflation targeting] as a tool for stabilizing aggregate demand and, hence, reducing the severity of the business cycle. This is understandable, as demand shocks tend to cause fluctuations in both inflation and output. So a policy that avoids them should also stabilize output. I have already discussed one problem with this view: The economy might get hit by supply shocks, as when oil prices soared during the 2008 recession……..”

Linking monetary policy (and the money supply) to nominal GDP growth would offer a far more stable growth path than the present system of inflation targeting.

via THE CASE FOR NOMINAL GDP TARGETING | Scott Sumner (pdf)

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Global QE

Observation made by Philip Lowe, RBA Deputy Governor:

Since mid 2008, four of the world’s major central banks – the Federal Reserve, the ECB, the Bank of Japan and the Bank of England – have all expanded their balance sheets very significantly, and further increases have been announced in a couple of cases. In total, the assets of these four central banks have already increased by the equivalent of around $US5 trillion, or around 15 per cent of the combined GDP of the relevant economies. We have not seen this type of planned simultaneous very large expansion of central bank balance sheets before. So in that sense, it is very unusual, and its implications are not yet fully understood……

via RBA: Australia and the World.

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Five steps to fix Wall Street

Some more thoughts on the five steps former FDIC chair Sheila Bair suggested to reform the financial system.

  1. Break up the “too big to fail” banks

    My take is that breaking up may be difficult to achieve politically, but raising capital ratios for banks above a certain threshold would discourage further growth and encourage splintering over time.

  2. Publicly commit to end bailouts

    Just because the bailouts were profitable isn’t a good reason to give Wall Street an indefinite option to “put” its losses to the Treasury and to taxpayers.

    As Joseph Stiglitz points out: the UK did a far better job of making shareholders and management suffer the consequences of their actions. Sweden in the early 1990s, similarly demanded large equity stakes in return for rescuing banks from the financial, leading some to raise capital through the markets rather than accept onerous bailout conditions.

  3. Cap leverage at large financial institutions

    I support Barry Ritholz’ call for a maximum leverage ratio of 10. That should include off-balance sheet and derivative exposure. Currently the Fed only requires a leverage ratio of 20 (5%) for well-capitalized banks — and that excludes off-balance-sheet assets.

  4. End speculation in the credit derivatives market

    Bair pointed out that we don’t get to buy fire insurance on someone else’s house, for a very good reason. How is speculating using credit derivatives any different?

    Again Ritholz makes a good suggestion: regulate credit default swaps (CDS) as insurance products, where buyers are required to demonstrate an insurable interest.

  5. End the revolving door between regulators and banks

    When regulators are conscious that, with one push of the door, they could end up working for the organizations they are today regulating – or vice versa – “it corrupts the mindset”

    A similar revolving door corrupts the relationship between politicians and lobbyists. Enforcing lengthy “restraint of trade” periods between the two roles would restrict this.

via 5 Steps Obama or Romney Must Take to Fix Wall Street.

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Australia: RBA running out of options

The Reserve Bank of Australia must be viewing the end of the mining boom with some trepidation. Cutting interest rates to stimulate new home construction may cushion the impact, but comes at a price. Consumers may benefit from lower interest rates but that is merely a side-effect: the real objective of monetary policy is debt expansion. And Australia is already in a precarious position.

Further increases in the ratio of household debt to disposable income would expand the housing bubble — with inevitable long-term consequences.

Housing Finances

While debt expansion is not in the country’s interests, neither is debt contraction (with growth below zero), which would risk a deflationary spiral. The RBA needs to maintain debt growth below the nominal growth rate in GDP — forecast at 4.0% for 2012-13 and 5.5% for 2013-2014 according to MYEFO — to gradually restore household debt/income ratios to respectable levels.

Credit Growth by Sector

If the RBA’s hands are tied, similar restraint has to be applied to fiscal policy. First home buyer incentives would also re-ignite debt growth. The focus may have to shift to state and local government  in order to accelerate land release and reduce other impediments — both financial and regulatory — to new home development. Lowering residential property development costs while increasing competition would encourage developers to cut prices to attract more buyers into the market. While this would still increase demand for new home finance, lower prices would cool speculative demand fueled by low interest rates.

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We should go further unbundling banks | Andy Haldane | Bank of England

Andrew Haldane, BOE Director of Financial Stability, addresses the too-big-to-fail problem in a recent article and makes the point that reducing complexity would increase investor trust in the banking system and improve liquidity.

…….Today, the Volcker proposals in the US, the Vickers proposals in the UK and the Liikanen proposals in Europe envisage a similar unbundling of banking portfolios. Despite the alarm some have expressed, if implemented faithfully and simply such structural solutions ought to help solve the too-complex-to-price problem, to say nothing of too-big-to-fail. Alongside efforts to strengthen macro and micro-prudential regulation, these initiatives would help mobilise bank funding and lending, just when it is most needed for the economy.

We should go further unbundling banks | Andy Haldane | Bank of England (pdf).

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'The Chicago Plan' criticism by Marshall Auerback

Marshall Auerback wrote a short piece criticizing the recent IMF study of the “Chicago Plan” first put forward by professors Henry Simons and Irving Fisher in 1936.

“Now there are some good things about a 100% reserve backed banking system.  To the extent that we require all institutions to hold liquid reserves of equal value to their deposits then the fear of a bank run is eliminated.

But you would have massive credit constraints and, in the absence of a countervailing fiscal policy that promoted more job growth and higher incomes, there would be the equivalent of a gold standard imposed on private banking which could invoke harsh deflationary forces.”

What he seems to miss is that 100% reserves would be required against demand deposits (checking accounts) and not against savings or time deposits. All that an efficient capitalist system needs is financial intermediaries who can channel savings into credit. It is not essential for them to have the ability to create ‘new money’.

“Note that the current practice is that loans create deposits. Clearly, under a 100-percent reserve system, all credit granting institutions would have to acquire the funds in advance of their lending.”

That is true. And requiring 100% reserves against demand deposits would restrict banks ability to make loans without holding reciprocal savings/time deposits or share capital and reserves. In effect they would be prevented from creating new money by making loans where they don’t have deposits. That is the whole purpose of the proposal: to prevent rapid credit expansion by banks.

“The truth is that the debt explosion that has brought the World economy to its knees was not the fault of private sector credit creation per se.”

Really? What else but private sector credit fueled the housing bubble? The debt explosion was encouraged by lax regulation but the financial sector is far from blameless for its actions.

via ‘The Chicago Plan’ does not deserve to be revisited. – Macrobits by Marshall Auerback.

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Financial ecosystems can be vulnerable too – FT.com

By Robert May

[Andy Haldane, Financial Stability Director of the Bank of England] argues that complexity may obscure more than it illuminates. He illustrates this by comparing predictions about the chances of failure for a sample of 100 global banks in 2006, based on simple leverage ratios (assets/equity) with the corresponding complex, Basel III-style risk-weighted one. The simple metric wins decisively.

via Financial ecosystems can be vulnerable too – FT.com.

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The Chicago Plan (1939)

The 1939 proposal — A PROGRAM FOR MONETARY REFORM — by a group of eminent economists, including Irving Fisher, became known as the “Chicago Plan” after its chief proponent, professor Henry Simons from the University of Chicago. The core proposal is to require banks to hold 100% reserves against demand deposits1, ending the fractional reserve banking system and making the monetary authority (the Fed) solely responsible for creation of new money. This extract describes major features of the plan:

Lending Under the 100% Reserve System
The 100% reserve requirement would, in effect, completely separate from banking the power to issue money. The two are now disastrously interdependent. Banking would become wholly a business of lending and investing pre-existing money. The banks would no longer be concerned with creating the money they lend or invest, though they would still continue to be the chief agencies for handling and clearing checking accounts.

Under the present fractional reserve system, if any actual money is deposited in a checking account, the bank has the right to lend it out as belonging to the bank and not to the depositor. The legal title to the money rests, indeed, in the bank. Under the 100% system, on the other hand, the depositor who had a checking account (i.e., a demand deposit) would own the money which he had on deposit in the bank; the bank would simply hold the money in trust for the depositor who had title to it. As regards time or savings deposits, on the other hand, the situation would, under the 100% system, remain essentially as it is today. Once a depositor had brought his money to the bank to be added to his time deposit or savings account, he could no longer use it as money. It would now belong to the bank, which could lend it out as its own money, while the depositor would hold a claim against the bank. The amount, in fact, ought no longer to be called a “deposit”. Actually it would be a loan to the bank.

Now let us see how, under the 100% system, the banks would be able to make loans, even though they could no longer use their customers’ demand deposits for that purpose.

There would be three sources of loanable funds. The first would be in the repayments to the banks of existing loans of circulating medium largely created by the banks in the past. Such repayments would release to the banks more cash than they would need to maintain 100% reserve behind demand deposits; and this “free” cash they would be able to lend out again. The banks would, therefore, suffer no contraction in their present volume of loans…..

The second sources of loans would be the banks own funds, capital, surplus, and undivided profits which might be increased from time to time by the sale of new bank stock.

The third source of loans would be new savings “deposited” in savings accounts or otherwise borrowed by the banks. That is, the banks would accept as time or savings deposits the savings of the community and lend such funds out again to those who could put them to advantageous use. In this manner, the banks might add without restraint to their savings, or time, deposits, but not to the total of their demand deposits and cash.

However, there would, of course, be a continuous moving of demand deposits from one bank to another, from one depositor to another and from demand deposits into cash and vice versa. To increase the total circulating medium would, nevertheless be the function of the Monetary Authority exclusively.

via A Program For Monetary Reform (pdf)

  1. Demand deposits are bank deposits, such as checking accounts, payable on demand. Savings or time deposits are payable on maturity. An easy way to separate demand from savings/time deposits is to class any deposit that matures within 30 days as a demand deposit.
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The Chicago Plan Revisited | IMF Working Paper

There is growing interest in this IMF Working Paper by Jaromir Benes and Michael Kumhof which discusses removing the role of monetary creation from fractional-reserve banks and assigning it to Treasury. Here is a brief abstract:

At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy…..

I believe that Fisher is right in targeting fractional-reserve banks as a major cause of instability in capitalist systems, facilitating rapid expansion of credit during booms, inevitably followed by rapid contraction during the bust. To introduce a system such as the Chicago Plan would risk an abrupt shock to the monetary system, but gradual increase of bank capital, leverage and reserve ratios could achieve the same eventual end without any noticeable side-effects.

via The Chicago Plan Revisited (pdf)

Hat tip to Ambrose Evans-Pritchard at The Telegraph.

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5 Steps Obama or Romney Must Take to Fix Wall Street

By SUZANNE MCGEE

In [Sheila Bair’s] view ….. we haven’t yet come to grips with many of the problems that produced the crisis.

Too many regulators fall victim to one of several fatal flaws, Bair suggested in a speech to the National Association for Business Economics yesterday. Some of them over or under-regulate (usually at the wrong point in the cycle); they devise impossibly complex rules; they are “closet free-marketeers” proposing convoluted rules to prove it’s impossible to regulate financial institutions, or they are “captive” regulators who, without any corruption or malfeasance involved, have simply subordinated their judgment to those of the organizations they are charged with overseeing.

The former chair of the Federal Deposit Insurance Corporation suggests five steps that presidential candidates should take to fix Wall Street………

via 5 Steps Obama or Romney Must Take to Fix Wall Street.

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