Unconventional Monetary Policy in an Interconnected World!

I came across this news item from CNBC about Bernanke and Rajan face-off and that was enough to break the long blogging hiatus!  Rajan raises an important question that should be addressed given today’s closely connected economic systems. In the context of unconventional monetary policies, he asks “If the policy hurts the rest of the world more than it helps the United States, should this policy be pursued?”  This question is important because there has been a lot of debate about the domestic impact of Fed’s QE policies , but not much has been said about the effects of such policies on emerging market economies. In fact, Rajan puts it quite bluntly when he criticizes “the Fed for failing to mention turmoil in emerging economies in its January 2014 policy statement, sending “the probably unintended message that those markets were on their own,” a sentiment reinforced by public comments by regional Fed bank presidents.” (Source)

While some macroeconomists and even the new Fed Chairman continue to argue about the favorable effects of QE and the eventual low interest rate regime, there has been a convincing argument against it made by New Monetarists like Stephen Williamson here and more informally here.  The infromal argument in short goes somewhat like this: if money competes as means of payments with other assets playing similar role (shadow banking) and if QE is increasing their prices, then the only way money can retain value is if inflation goes down. So we have an imminent danger of Japaneese style stagnation as the lowering of interest rates and increase in value of money creates a liquidity trap.  This is quite apparent in the data and hence quite surprising that Fed continues to neglect it when it comes to policy making. Thus, given that the benefits of QE for the US itself are circumspect or unclear at best, Rajan’s criticism seems valid and timely. Of course, Bernanke did not take it well- he does not want any blemish on his legacy! Not sure what to think of his argument about QE being demand augmenting as suggested by required exchange rate intervention.

Notwithstanding this face-off between two first rate scholar central bankers, something definitely needs to be thought about policy making in an interconnected world economy-especially in case of the US who supplies the world’s most prominent reserve currency and the general shortage of safe assets as argued by Caballero. It looks like there was some talk about this in Kansas City Fed in 2012, the Jackson Hole symposium in 2013, and very recently at the IMF. Rajan’s proposal in this regard seems interesting and worth researching. He sees “merit in assigning the International Monetary Fund or a similar institution the responsibility of assessing the spillover effects of major central banks policies – much as the World Trade Organization does with trade rules – but acknowledged this isn’t politically viable.” 

Whether, such a solution is possible or not, the argument against activist monetary policy favoring low interest rates has never been stronger than now. As James Bullard suggests here, there is a strong evidence that low interest rates may have prolonged the recession that started in August 2007, when firms speculated in the international oil markets using the abundantly available cheap funds and literally engineered an oil price shock! Of course, real data available to Fed at that time did not reflect this and significantly understated the extent of actual recession. Talk about lags in policy making eh!

 

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ASSA 2014 Highlights

Despite the awful arctic cold wave, attending ASSA 2014 in Philadelphia was a delight as it is every year! The sheer amount of energy and enthusiasm that comes from such a large professional gathering is really unparalleled. Economists also seem to be getting better at entertaining themselves, if this year’s music and humor sessions are any indicator. But most off all, for me, the highlights were AEA/AFA luncheon with the recent Nobel Laureates Ms. Fama, Shiller and Hansen :) and continuing education series on Economic Growth.

Due to illness, Fama could not actually make it to the luncheon but he was ably represented by his long time coauthor Ken French. The conversations were well facilitated by Luigi Zingales of Chicago Booth. Some interesting highlights:

On bubbles: There is nothing called as bubbles- there is only volatility in asset prices.

Take on market efficiency: Bob Shiller thinks that efficiency of markets is only half truth but nonetheless a very significant one. Hansen responded by saying that the function of financial markets is aiding resource allocation in the economy. Hence, the more important question is about its role in promoting allocative efficiency. This, according to me, is one of the clearer statements of how economists should look at the process of financial intermediation.

While elaborating on the half truth comment, Shiller, who came across as an extremely soft spoken yet a very candid speaker, said that any profession should be wary of ‘group think’. This refers to the blind spots that professionals develop to obvious gaps in understanding a phenomenon as more and more people buy into the dominant thinking framework. That was a very interesting point.

Optimal Investment Strategy: If markets cannot be predicted, what should be the optimal investment strategy? According to Shiller, people should seek advice from paid professionals and there should be more of them available.

The second interesting session I attended was ” What Macroeconomists should know about finance?”. It was a panel discussion constituted by Markus Brunnermeier, Atif Mian, and Arvind Krishnamurthy. Some interesting points about macro-finance linkages that were made in this discussion were as follows:

1. Atif Mian: Debt matters for macro aggregates through:

  • Asset Price Channel: asset prices declined faster in states where foreclosure laws are laxed.
  • Aggregate Demand Channel: HH that suffer higher net wealth shocks cut back on spending. Higher level of leverage means that aggregate losses are going to be shared by levered households disproportionately. Decrease in demand leads to reduction in tradable and non tradable jobs.
  • Financial Rigidity Channel: absence of state contingent debt. Rigidity in financial contracts. Hence, important question is why are private contracts not optimal from macro perspective.
  • Endogenous risk = systemic risk

2.  Arvind Krishnamurthy:

  • Multiple asset prices- Do not respond in synchronous manner.
  • Careful thought to Intermediary asset pricing is needed.
  • Market segmentation: Importance looking at process of intermediation for macro.
  • Changes in risk premia are not included in standard macro.
  • Capital structure of financial firms is not irrelevant as macro assumes.

3. Markus Brunnermeier: Unfortunately I missed this presentation-I definitely blame it on cold weather ;)

The best part was the continuing education series on economic growth. Oded Galor and David Weil did an extremely good job of summarizing the existing research, commenting on intricacies of research designs and giving a clear picture of what we know about economic growth till now. Further, Galor’s Unified Growth Theory is a sure winner according to me. His paper on genetic diversity and comparative economic development was supremely exciting! You can access his research from his IDEAS page. You can access David’s research on health and economic growth here.

Update (January 11, 2014): Not sure why and how I missed this- Claudia Goldin’s Presidential address tops everything-you can watch it here.

Update (January 19, 2014): Interesting presentation on Railways and Famines in India. Check it out here.

 

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On Cows and Central Tenets of Capitalism!

Santosh Anagol has been doing interesting research on several phenomena concerning the Indian economy. In a recent paper, he and his coauthors estimate that returns to owning a cow in India are negative and hence the continued existence of cows violates the central tenets of capitalism.

Daron Acemoglu and James Robinson discuss these findings in their extremely interesting blog here. They argue that social embeddedness could help us understand why cows are still a part of a typical Indian farmer’s portfolio. I think that their arguments certainly makes sense, however, one might also look at new monetarist economics for an answer to this question. For example, Lagos and Rocheteau (2008) analyse an economy with money and capital as competing media of exchange and their model I think could explain this puzzle that Anagol et.al pose.

In their economy, agents over-accumulate capital in a non-monetary equilibrium because the capital asset performs the function of a productive asset as well as a liquid medium of exchange when needed. The introduction and use of money therefore allows the liquidity use to be separated from the productive use and corrects the inefficient over-accumulation of capital. Thus, fiat money plays a welfare enhancing role in this economy. However, that precisely does not seem to be happening in India and that is the puzzle that Anagol and his coauthors are referring to.

So why do Indian farmers seem to be preferring to invest in an asset that has negative returns, despite the availability of a liquid medium of exchange? Here, it is important understand what constitutes return on capital. Lagos and Rocheteau propose that return to capital in such an economy can be thought of being comprised of two parts: a liquidity return referring to capital’s role in exchange process and the intrinsic return associated with the productive use of cows. Anagol’s analysis seems to be capturing only the intrinsic return while cows continue to have a liquidity return (premium) in the minds of Indian farmers. Ideally, this perceived positive liquidity return for cows should not prevail if fiat money does provide the necessary insurance against uncertainty. The fact that it does implies that the insurance provided by access to fiat money is not enough.

Anagol and his coauthors do raise this point but dismiss it citing the proliferation of different forms of microfinance institutions in rural India increasing access to savings. However, research has shown that actual use of these institutions is quite uneven and tends to depend on factors that could be explained using the economics of networks. For example see Matt Jackson’s work here. I think the factors mentioned above still continue to influence the basic uncertainty that farmers face in a substantial way. I am not sure if microfinance would be able to provide enough insurance in case of a crop failure for example. Because provision of funds in such case may require access to a mechanism to transfer funds from non-affected areas to affected areas to meet the demand and microfinance in its current state most likely is not in a position to handle that.

I still think that social embeddedness plays an important role. On the one hand traditional socioeconomic relationships have broken down reducing the access to mechanisms that could serve as partial insurance mechanisms and on the other hand access to modern monetary economy is still hard to come by. Lack of roads, absent storage and refrigeration facilities, ineffective or absent land reforms, inadequate irrigation facilities keeping agricultural output sensitive to rainfall shocks, all imply that the benefits from participating in the market economy only add to the existing uncertainty that these farmers face. Till these issues are addressed Indian farmers will continue continue to hold cows despite their negative intrinsic return.

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Filed under indian economy, macroeconomics, markets and efficiency, money search, social perspectives

Fiscal Stimulus: Old Keynesian vs. New Keynesian

This is fascinating stuff! John Cochranne urges us to call spade a spade and be done with it in this very interesting blog post: New vs Old Keynesian stimulus. Then you have Steve Williamson commenting on Cochranne here: John Cochranne and Keynesian Economics, while Nick Rowe adds his own views on these differences here: On understanding and spinning your own New Keynesian model.

You can find John’s extremely insightful paper here: New Keynesian Liquidity Trap.

Enjoy!

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Austerity or Fiscal Stimulus?

Here is the link to my response to an article in the Economic and Political Weekly. You can also read the not so civil response by the original authors to my response.  I thank them for putting a layer of thick skin on me ;)

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What macro do we teach at the Principles level?

Every time I take a look at the principles level texts, it turns out to be a thoroughly entertaining experience! I usually look at how the authors have dealt with business cycles and more often than not the treatment turns out to be biased. For example take a look at this passage (pp. 273) from Hall and Libermann’s principles text. It looks at changes in labor demand as a cause of business cycles:

A Change in Productivity? One possibility is that the labor demand curve shifts leftward because workers have become less productive and therefore less valuable to firms. This might happen if there were a sudden decrease in the capital stock, so that each worker had less equipment to work with. Or it might happen if workers suddenly forgot how to do things— how to operate a computer or use a screwdriver or fix an oil rig. Short of a major war that destroys plant and equipment, or an epidemic of amnesia, it is highly unlikely that workers would become less productive so suddenly. Thus, a sudden change in productivity is an unlikely explanation for recessions. What about booms? Could they be explained by a sudden increase in productivity, causing the labor demand curve to shift rightward? Again, not likely. Even though it is true that the capital stock grows over time and workers continually gain new skills— and that both of these movements shift the labor demand curve to the right— such shifts take place at a glacial pace. Compared to the amount of machinery already in place, and to the knowledge and skills that the labor force already has, annual increments in physical capital or knowledge are simply too small to have much of an impact on labor demand.

So in making fun of the RBC school or the classical model, they totally forget to mention oil price shocks, creative destruction because of technological changes, weather shocks in developing countries, etc. According to the discussion that follows, business cycles are caused by sudden autonomous miscalculations of demand on the part of producers coupled with herd behavior or changes in spending coupled with malfunctioning credit markets or people keeping unspent money under the mattress!

Dismissing changes in labor supply as a reason for business fluctuations, they say the following:

One way the classical model might explain a recession is through a shift in the labor supply curve. Figure 3 shows how this would work. If the labor supply curve shifted to the left, the equilibrium would move up and to the left along the labor demand curve, from point E to point G. The level of employment would fall, and output would fall with it. This explanation of recessions has almost no support among economists. First, ­remember that the labor supply schedule tells us, at each real wage rate, the number of people who would like to work. This number reflects millions of families’ preferences about working in the market rather than pursuing other activities, such as ­taking care of children, going to school, or enjoying leisure time.  A leftward shift in labor sup-ply would mean that fewer people want to work at any given wage— that preferences have changed toward these other, non work activities. But in reality, preferences tend to change very slowly, and certainly not rapidly enough to explain recessions.

Now here the treatment is somewhat reasonable. However, there is no mention of preferences for work and leisure over time and how they could affect the labor supply curve or the fact that every time there is a recession, graduate enrollment goes up or government policies like welfare programs could affect unemployment duration (The Redistribution Recession story!).

Now I am sure Robert E Hall knows better than that.  For example look at this paper where he talks about preference shifts as causing changes in employment.  So instead of taking sides with one model why not present alternative explanations of an economic phenomenon?  Yes, the economy could be hit by real shocks or aggregate demand shocks or a combination of both or one turning into another. It is important to emphasize this to foster critical thinking and developing a balanced perspective.  When it comes to lack of a balanced perspective, most macro-principles texts are to be blamed and not just the one mentioned above. Thankfully, though, the textbook I use fares better and I kind of feel proud for not bombarding students with only one version of the story.

PS: Came across one more Principles of Macroeconomics that has a balanced treatment: Macroeconomics: Theory through Applications by Russell Cooper and A Andrew John published by Flatworld Knowledge.

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Kalecki-Krugman Deconstructed!

Michael Kalecki is/was one of the favorite authors in Center for Economic Studies and Planning, JNU, India. But frankly speaking I did not understand what he said much while I was a student there. However, recently Steve Williamson has done a very good job of putting Kalecki’s ideas in a very accessible way. Of course, the whole thing began as usual with Krugman trudging up Kalecki’s ghost!

You can read Steve’s analysis here and here.

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