Topic: Finance, Banking & Monetary Policy

The Futility of Stimulus

George Selgin has recently focused on the failure of Federal Reserve policy to finance a normal recovery. The Fed has greatly expanded its balance sheet and created a large quantity of excess reserves, which, for a variety of reasons, commercial banks have not mobilized into credit creation. Instead, banks seem content to earn the 25 basis points of interest the Fed now pays on reserves.

This anomalous behavior shows up in the M1 money multiplier, which is at record lows – less than half its value before the financial crisis. The Fed is creating reserves, but commercial banks are not creating as much bank money as has been historically true. Compounding this is the fact that the velocity of M1 – the rapidity with which each dollar is spent annually – has hit a 40-year low. Consequently, the Fed’s efforts to produce monetary stimulus have failed.

(A similar story can be told for other money supply measures. Data and charts can be found at FRED, the online data center at the Federal Reserve Bank of St. Louis.)

I do not think economists fully understand all of the factors contributing to this policy failure. But Selgin has surely identified one relevant factor, the payment of interest on reserves. On the margin, it creates a disincentive for commercial banks to create money and credit in a normal fashion. There are also fiscal reasons for ending the payments, as they reduce the payments the Fed makes to the Treasury. As it is, the payment of interest on reserves constitutes a fiscal transfer from taxpayers to commercial banks. In a normal world, I would endorse his call to end the interest paid on reserves.

We do not live in a normal world. The Fed has replaced liquid, short-term assets on its balance sheet with illiquid, long-term assets. Normally, to raise the Fed Funds rate, the Fed would sell Treasury bills. It has none to sell. Analysts and pundits speculate on when the Fed will raise interest rates. They should be asking how the Fed will raise interest rates.

Stanford’s John Taylor thinks the Fed will need to increase the interest rate paid on reserves to accomplish that goal. Markets through arbitrage would then increase the interest rates banks pay each other to borrow reserves. I suspect he is correct, with two caveats. First, there is no longer much of a market for federal funds. Banks aren’t lending each other reserves. Second, there are other possible mechanisms for raising short-term interest rates like the tri-party, reverse repo facility at the New York Fed. This, and other facilities, are untested as a means to implement a policy change. Their use would put monetary policy in unchartered waters.

To sum up, monetary policy has failed to simulate economic activity. It has failed even to finance a normal economic recovery. In pursuing a failed stimulus policy, the Fed has tied its policy hands going forward. At some point, interest rates will need to rise. The Fed will need to rely on novel means to accomplish a turn in policy. Paying higher interest rates on bank reserves may be one method. It is an unpleasant reality. It is only one consequence of the Fed’s experiment with extraordinary monetary policy.

[Cross-posted from Alt-M.org]

Venezuela: World’s Highest Inflation Rate

Venezuela’s bolivar is collapsing. And as night follows day, Venezuela’s annual implied inflation rate is soaring. Last week, the annual inflation rate broke through the 500% level. It now stands at 510%.

When inflation rates are elevated, standard economic theory and reliable empirical techniques allow us to produce accurate inflation estimates. With free market exchange-rate data (usually black-market data), the inflation rate can be calculated. The principle of purchasing power parity (PPP), which links changes in exchange rates and changes in prices, allows for a reliable inflation estimate.

To calculate the inflation rate in Venezuela, all that is required is a rather straightforward application of a standard, time-tested economic theory (read: PPP). Using black-market exchange rate data that The Johns Hopkins-Cato Institute Troubled Currencies Project has collected over the past year, I estimate Venezuela’s current annual implied inflation rate to be 510%. This is the highest rate in the world. It’s well above the second-highest rate: Syria’s, which stands at 84%.

Venezuela has not always experienced punishing inflation rates. From 1950 through 1979, Venezuela’s average annual inflation rate remained in the single digits. It was not until the 1980s that Venezuela witnessed a double-digit average. And it was not until the 1990s that Venezuela’s average inflation rate exceeded that of the Latin American region. Today, Venezuela’s inflation rate is over the top (see the accompanying table).

Average Annual Inflation Rates

Is the Fed on Track?

That’s more-or-less the question that Bankrate.com asked Dean Baker, co-founder of the Center for Economic and Policy Research, and me after last month’s FOMC press release. Dean said yep. I said…uh, not really. Our full answers appeared recently in the online publication’s “Wealth of Opinions” column. There’s even a little poll at the end, allowing you to pick your favorite answer. Of course you don’t have to vote. It’s really entirely up to you. I mean, I’m not trying to pressure you or anything like that.

Honest.

No, really!

[Cross-posted from Alt-M.org]

Follow Panama: Dollarize

Most central banks do one thing well: they produce monetary mischief. Indeed, for most emerging market countries, a central bank is a recipe for disaster.

The solution: replace domestic currencies with sound foreign currencies. Panama is a prime example of this type of switch. Panama adopted the U.S. dollar as its official currency in 1904. It is one of the best-performing countries in Latin America (see the accompanying table). In 2014, economic growth in Latin America and the Caribbean was a measly 0.8 percent. In contrast, Panama’s growth rate was 6.2 percent. Not surprisingly, it was the only country in Latin America to have realized an increase in the number of greenfield FDI projects

Panama Selected Economic Data

Is Bitcoin Doomed?

OK, I’m being melodramatic. But the question actually posed by the PanAm Post, “Will Bitcoin’s Fixed Money Supply Be Its Downfall?”, was only slightly less so. They had me take the “yes” position. But as my doubts about Bitcoin’s future are far from certain, I was delighted to see that they got Konrad Graf, a Bitcoin fan who has done some very good work on that cybercurrency’s early development, to oppose me.

The crucial questions, I believe, are whether any exchange medium can become widely adopted without also serving as an economy’s medium of account–that is, the medium to which prices and other payment contracts refer–and whether a new unit is likely to displace an established one unless it’s purchasing power is considered to be relatively stable and predictable. Think about your own employment contract, and of the alternative of having a contract written in Bitcoin, and you have some idea of the challenge. Of course, Bitcoin’s value is bound to be less predictable now than it would be were bitcoins more widely employed in making payments. But its popularity must remain limited unless it can somehow be perceived as offering a relatively stable unit of account.

In this regard it is worth considering Leland Yeager’s plea, in several of his writings, for “separating” the medium of exchange from the unit of account. (Here is a good summary by Bill Woolsey, comparing Yeager’s ideas to those of Market Monetarists.) Although Yeager’s perspective, which argues that it’s better to have a medium of exchange that isn’t also an economy’s medium of account, superficially appears to hold out more promise for Bitcoin than my own arguments, the appearance is deceiving. For what Yeager has in mind is a system in which the unit of account is a stable-value unit, with the value of actual exchange media fluctuating relative to the fixed nominal value of that unit. So while Yeager’s argument does suggest the desirability of a “separated” system, it is only for the sake of being able to have a more stable unit of account that he favors such an arrangement. Otherwise separation doesn’t achieve much, for macroeconomic problems can still arise in consequence of unanticipated changes in the value of the medium of account, and the consequent disruption of contracts that such changes will entail, regardless of the media actually employed in making payments and in settling accounts due. That’s one reason why I, for one, look forward to seeing further experimentation and innovation in the cybercurrency world.

[Cross-posted from Alt-M.org]

Hunting Whales: The Problem with Prosecuting SIFIs

Yesterday, Attorney General Loretta Lynch made the unprecedented announcement that five of the world’s largest banks – JP Morgan, Citi, Barclays, RBS, and UBS – would be pleading guilty to criminal charges.  According to the allegations, traders and executives working at the banks’ foreign exchange (FOREX) desks colluded through the use of chat rooms to fix currency prices on a daily basis.   The fines are in the hundreds of millions, with Barclays total penalty (including those levied by US and UK authorities) at $2.4 billion topping the charts and Citigroup’s $925 million following behind.  According to Assistant Attorney General Leslie Caldwell, these guilty pleas “communicate loud and clear that we will hold financial institutions accountable for criminal misconduct.”

But do they?  Can they?  In the world of “too big to fail,” JP MorganChase and Citigroup are whales among whales.  Dodd-Frank, with its “living will” provision, was supposed to end too big to fail by requiring that systemically important financial institutions (SIFIs) create a plan for an orderly unwinding in the case of failure.  But this provision contains the seeds of its own destruction.  By designating firms as SIFIs, the government has made the too big to fail designation explicit when it was previously only implicit.

If a SIFI behaves badly, even very very badly (and there is no doubt that, if the allegations are true, the FOREX traders at these banks behaved badly indeed), how much can it be punished?  While corporations can be held criminally liable, you obviously cannot imprison a corporation.  Instead, criminal penalties for companies mean two things: (1) public censure and (2) fines.  The big banks are not very popular these days and it’s unlikely the taint of public censure will cause much additional pain. 

So that leaves the government with fines.  For a fine to be a punishment, it must be large enough to hurt.  These fines are not small.  Even for a bank as large as Citi, $925 million is a chunk of change.   But in imposing these fines, the government must walk a fine line.  If Citi is a SIFI, can the government risk imposing a fine large enough that it risks destabilizing the entire company?  Almost certainly not. 

Complicating the government’s position is the fact that three of the banks – RBS, Barclays, and UBS – are foreign (RBS and Barclays are British, and UBS is Swiss).  These banks have large footprints in the U.S. markets but, even if they were to falter, the government would be hard-pressed to offer a bailout even if it wanted to.  Consider what happened during the financial crisis.  Several large foreign banks were put at risk when AIG failed.  Because the U.S. government could not, for political reasons if for no other, directly bail out these banks (even though their failure would impact U.S. markets), it instead engineered the so-called “back door bailout” by which TARP funds injected into AIG wound up in the hands of foreign banks.  If the Department of Justice were to impose a heavy enough fine on RBS, Barclays, and UBS today that it really hurt those banks, that is, that it put any significant part of their business at risk, it could harm U.S. markets.

Secret price-fixing is bad.  It distorts markets and prevents them from performing one of their most essential functions: price discovery.  But having doubled-down on the too big to fail designation, the government has put itself into an impossible situation when it comes to reining in SIFIs’ bad behavior.

How Much Profit Is There in Thwarting Financial Innovation?

Ben Lawsky is resigning as superintendent of financial services in New York. The New York Times says he plans to open his own firm and lecture at Stanford University. The Post reports that he will consult on digital currencies such as Bitcoin.

The move West suggests that Lawsky may want a piece of the action in Silicon Valley. If he does, it’s worth noting that the action is not in New York.

Lawsky was a leading Bitcoin antagonist. Bitcoin has not particularly flourished in New York, and Lawsky’s work makes it unlikely that New York will be a Bitcoin-friendly jurisdiction.

Ben Lawsky welcomed Bitcoin in August 2013 by sending out subpoenas to everyone in the Bitcoin world. He went on television talking about the “real dangers” of Bitcoin, including use by “narco-terrorists.” (Asked for evidence of Bitcoin misuse, he cited a centralized digital currency called Liberty Reserve, which is not Bitcoin.)

Around the same time, Lawsky precipitously announced a plan for a special “BitLicense.” Shortly after producing it, his office violated New York’s Freedom of Information Law by refusing to release the research and analysis that it claimed to have done to validate the regulation. The NYDFS found that the BitLicense would have no impact on employment in the state, after which investors poured hundreds of millions of dollars into Bitcoin companies outside of New York. (See my comments to the NYDFS for more.)