Topic: Finance, Banking & Monetary Policy

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.

A Monetary Policy Primer, Part 3: The Price Level

Few people would, I think, take exception to the claim that, in a well-functioning monetary system, the quantity of money supplied should seldom differ, and should never differ very much, from the quantity demanded.  What’s controversial isn’t that claim itself, but the suggestion that it supplies a reason for preferring some path of money supply adjustments over others, or some monetary arrangements over others.

Why the controversy?  As we saw in the last installment, the demand for money ultimately consists, not of a demand for any particular number of money units, but of a demand for a particular amount of monetary purchasing power.  Whatever amount of purchasing X units of money might accomplish, when the general level of prices given by P, ½X units might accomplish equally well, were the level of prices ½P.  It follows that changes in the general level of prices might, in theory at least, serve just as well as changes in the available quantity of money units as a means for keeping the quantity of money supplied in line with the quantity demanded.

But then it follows as well that, if our world is one in which prices are “perfectly flexible,” meaning that they always adjust instantly to a level that eliminates any monetary shortage or surplus, any pattern of money supply changes will avoid money supply-demand discrepancies, or “monetary disequilibrium,” as well as any other.  The goal of avoiding bouts of monetary disequilibrium would in that case supply no grounds for preferring one monetary system or policy over another, or for preferring a stable level of spending over an unstable level.  Any such preference would instead have to be justified on other grounds.

So, a decision: we can either adopt the view that prices are indeed perfectly flexible, and proceed to ponder why, despite that view, we might prefer some monetary arrangements to others; or we can subscribe to the view that prices are generally not perfectly flexible, and then proceed to assess alternative monetary arrangements according to their capacity to avoid a non-trivial risk of monetary disequilibrium.

The Smoot-Hawley Tariff and the Great Depression

[Reprinted with permission from Alan Reynolds, “What Do We Know about the Great Crash?National Review, November 9, 1979]

 Many scholars have long agreed that the Smoot-Hawley tariff had disastrous economic effects, but most of them have  felt  that  it could  not have caused the stock market collapse of  October  1929, since the tariff was not signed into law  until the following June. Today we know that market participants do not wait for a major law to pass, but instead try to anticipate whether or not it will pass and what its effects will be.

 Consider the following sequence of events:

 The Smoot-Hawley tariff passes the House on May   28, 1929.  Stock prices in New   York   (1926=100) drop   from 196 in March to 191   in June.   On June   19, Republicans   on the Senate Finance Committee   meet   to   rewrite   the   bill. Hoping for improvement, the market rallies,  but  industrial production  ( 1967 = 100)  peaks  in  July,  and  dips  very  slightly through  September.  Stocks  rise  to  216  by  September,  hit­ting their peak on  the  third  of  the  month.  The  full  Senate Finance Committee goes to   work  on  the  tariff  the  following day,  moving  it  to  the  Senate  floor  later  in  the   month.

 On October 21, the Senate rejects, 64 to 10, a move to limit tariff increases to agriculture. “A weakening of the Democratic-Progressive Coalition was evidenced on October 23,” notes the Commercial and Financial Chronicle. In this first test vote, 16 members of the anti-tariff coalition switch sides and vote to double the tariff on calcium carbide from Canada. Stocks collapse in the last hour of trading; the following morning is christened Black Thursday.   On  October 28,  a  delegation   of   senators   appeals   to   President   Hoover to help push a tariff  bill  through  quickly  (which  he  does  on the 31st). The Chronicle  headlines  news  about  broker  loans on  the  same  day:  “Recall  of  Foreign  Money  Grows  Heavier-All Europe  Withdrawing  Capital.” The following day is stalemate. Stocks begin to rally after November 14, rising steadily from 145 in November to 171 in April. Industrial production stops falling and hovers around the December level through March.