Topic: Finance, Banking & Monetary Policy

Nigeria’s Growing Economic Troubles

On May 20th, the Financial Times reported the surprising contraction recorded in Nigeria’s economy. The first negative year-over-year quarter for GDP in six years. This will be the start of more negative news from Nigeria.

Without a major currency reform (read: the installation of a currency board), the weakness of Nigeria’s naira will not end anytime soon. This is bad news for inflation, which, according to my Cato Troubled Currencies Project estimate, has exploded to an annual rate of 58.6 percent. This is a long way from the official estimate (see the chart below).

This large discrepancy between the most recent official annual inflation rate of 12.77 percent and my implied inflation rate of 58.6 percent calls again for the use of a lie coefficient. The formula for utilizing this lie coefficient is as follows: (official data) × (lie coefficient) = real estimate. At present, the Central Bank of Nigeria’s lie coefficient is 4.6.

Posner on the Legality of the Fed’s Last-Resort Lending

A recent Marginal Revolution post has alerted me to Eric Posner’s January 2016 working paper, “What Legal Authority Does the Fed Need During a Financial Crisis?”  Posner’s paper is remarkable, both for its assessment of the legality of the Fed’s emergency lending operations during the recent crisis, and for the policy recommendations Posner offers based on that assessment.[1]

Posner’s account of the Fed’s actions reads like a long bill of indictment.  The Fed’s Bear Stearns rescue, for starters, “was legally questionable.”  The Fed couldn’t legally purchase Bear’s toxic assets, and it knew it.  Instead it created a “Special Purpose Vehicle” (SPV), named it Maiden Lane, and lent Maiden Lane $28.82 billion so that it could buy Bear’s toxic assets.  Voila!  What would have been an illegal Fed purchase of toxic assets was  transformed into a Fed loan “secured” by the very same assets.

But clever as the Fed’s gambit was, it  wasn’t so clever as to render it entirely innocent of legal hanky-panky.  “The problem,” Posner observes,

is that the transaction provided that the value of the Fed’s interest would be tightly connected to the value of the underlying assets.  If the assets fell in value by as little as 4%, the Fed would lose money… By contrast, in a [properly] secured loan…the lender bears very little to no risk from the fluctuation of asset values.  Functionally, the Maiden Lane transaction was a sale of assets, not a secured loan.

In rescuing AIG, the Fed resorted to the same “legally dubious” bag of tricks it employed in saving Bear, creating two more Maiden Lane vehicles, and again assuming considerable downside risk.  The Fed also grabbed a 79.9 percent equity stake in AIG, which it placed in a trust established for the sole benefit of the U.S. Treasury.  That transaction was later held by the Court of Federal Claims to have been been unauthorized by the Federal Reserve Act, and therefore illegal.

Some Simple Monetarist Arithmetic of the Great Recession and Recovery

The familiar chart below illustrates the depth of the decline in real output during the 2007-09 Great Recession (the shaded period), and the failure of the recovery to return real output to its “potential” path (in other words, to eliminate the estimated “output gap”) during the subsequent years up to the present day. The second chart puts the same 2007-16 period in the context of the previous decades, showing how exceptionally prolonged the current below-potential period is by contrast to previous postwar recessions and recoveries.

White Graph 1, cropped

White Graph 3

It is instructive to decompose the path of real GDP into its components, nominal GDP and the price deflator. Here are the natural logs of nominal GDP (call it Y) and real GDP (call it y). From the definition y = Y/P, it follows that ln y = ln Y – ln P, so the growing vertical difference between the two series reflects the rising price level.

Insider Trading: The Unknowable Crime

Under our criminal justice system, ignorance of the law is no defense.  But what if the law is undefined?  Or what if it seems to change with every new case that’s brought?  What if unelected judges (with life tenure) started to invent crimes, piece by piece, case by case?  Holding people accountable for knowing the law is just only if the law is knowable, and only if those creating the law are accountable to the people. 

On Friday, Cato filed an amicus brief in Salman v. U.S. that is aimed at limiting the reach of just such an ill-defined, judicially created law. “Insider trading” is a crime that can put a person away for more than a decade, and yet this crime is judge-made and, as such, is ever-changing. Although individuals may know generally what is prohibited, the exact contours of the crime have remained shrouded, creating traps for the unwary.

The courts, in creating this crime, have relied on a section of the securities laws that prohibits the use of “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security. The courts’ rationale has been that by trading on information belonging to the company, and in violation of a position of trust, the trader has committed a fraud.  The law, however, does not mention “insiders” or “insider trading.”  And yet, in 2015 alone, the Securities and Exchange Commission (SEC) charged 87 individuals with insider trading violations.  

Broadly speaking, insider trading occurs when someone uses a position of trust to gain information about a company and later trades on that company, without permission, to receive a personal benefit.  But what constitutes a “benefit”?  The law doesn’t say.

Left to their own devices, the SEC has pushed the boundaries of what constitutes a “benefit,” making it more and more difficult for people to know when they are breaking the law.  In the case currently before the Court, Bassam Salman was charged with trading on information he received from his future brother-in-law, Mounir Kara, who had, in turn, received the information from his own brother, Maher.  The government has never alleged that Maher Kara received anything at all from either his brother or Salman in exchange for the information.  The government has instead claimed that the simple familial affection the men feel for each other is the “benefit.”  Salman’s trade was illegal because he happens to love the brothers-in-law who gave him the inside information.

Under this rationale, a person who trades on information received while making idle talk in a grocery line would be safe from prosecution while the same person trading on the same information heard at a family meal would be guilty of a felony.  Or maybe not.  After all, if we construe “benefit” this broadly, why not say that whiling away time chit-chatting in line is a “benefit”?    

No one should stumble blindly into a felony.  We hope the Court will take this opportunity to clarify the law and return it to its legislative foundation.  Anything else courts tyranny. 

The IMF Predicts a Collapse of Venezuela’s Bolivar

In January, the International Monetary Fund (IMF) told us that Venezuela’s annual inflation rate would hit 720 percent by the end of the year. The IMF’s World Economic Outlook, which was published in April, stuck with the 720 percent inflation forecast. What the IMF failed to do is tell us how they arrived at the forecast. Never mind. The press has repeated the 720 percent inflation forecast ad nauseam.

Since the IMF’s 720 percent forecast has been elevated to the status of a factoid, it is worth a bit of reflection and analysis. We can reverse engineer the IMF’s inflation forecast to determine the Bolivar to U.S. greenback exchange rate implied by the inflation forecast.

When we conduct that exercise, we calculate that the VEF/USD rate moves from today’s black market (read: free market) rate of 1,110 to 6,699 by year’s end. So, the IMF is forecasting that the bolivar will shed 83 percent of its current value against the greenback by New Year’s Day, 2017. The following chart shows the dramatic plunge anticipated by the IMF.

A Monetary Policy Primer, Part 4: Stable Prices or Stable Spending?

Changes in the general level of prices are capable, as we’ve seen, of eliminating shortages or surpluses of money, by adding to or subtracting from the purchasing power of existing money holdings.  But because such changes place an extra burden on the price system, increasing the likelihood that individual prices will fail to accurately reflect the true scarcity of different goods and services at any moment, the less they have to be relied upon, the better.  A better alternative, if only it can somehow be achieved, or at least approximated, is a monetary system that adjusts the stock of money in response to changes in the demand for money balances, thereby reducing the need for changes in the general level of prices.

Please note that saying this is not saying that we need to have a centrally-planned money supply, let alone one that’s managed by a committee that’s unconstrained by any explicit rules or commitments.  Whether such a committee would in fact come closer to the ideal I’m defending than some alternative arrangement is a crucial question we must come to later on.  For now I will merely observe that, although it’s true that unconstrained central monetary planners might manage the money stock according to some ideal, that’s only so because there’s nothing that such planners might not do.

The claim that an ideal monetary regime is one that reduces the extent to which changes in the general level of prices are required to keep the quantity of money supplied in agreement with the quantity demanded might be understood to imply that what’s needed to avoid monetary troubles is a monetary system that avoids all changes to the general level of prices, or one that allows that level to change only at a steady and predictable rate.  We might trust a committee of central bankers to adopt such a policy.  But then again, we could also insist on it, by eliminating their discretionary powers in favor of having them abide by a strict stable price level (or inflation rate) mandate.

Two Cheers for the Leverage Ratio

In a previous blog posting, I suggested that there is no case for capital adequacy regulation in an unregulated banking system.  In this ‘first-best’ environment, a bank’s capital policy would be just another aspect of its business model, comparable to its lending or reserving policies, say.  Banks’ capital adequacy standards would then be determined by competition and banks with inadequate capital would be driven out of business.

Nonetheless, it does not follow that there is no case for capital adequacy regulation in a ‘second-best’ world in which pre-existing state interventions — such as deposit insurance, the lender of last resort and Too-Big-to-Fail — create incentives for banks to take excessive risks.  By excessive risks, I refer to the risks that banks take but would not take if they had to bear the downsides of those risks themselves.

My point is that in this ‘second-best’ world there is a ‘second-best’ case for capital adequacy regulation to offset the incentives toward excessive risk-taking created by deposit insurance and so forth.  This posting examines what form such capital adequacy regulation might take.

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