Money and Credit in Germany

In its April 2017 Quarterly Report, the Deutsche Bundesbank discusses the role of banks in the creation of money. Findings from a wavelet analysis indicate that in Germany, money and credit move in parallel in the long run.

In an appendix, the report mentions possible welfare costs of curbing maturity transformation, with reference to Diamond and Dybvig’s work. This is not convincing. Unlike in the typical (microeconomic) banking model, aggregate central bank provided money need not be scarce, so there is no a priori social need for the private sector to create money.

Does Greece Need Official Debt Relief?

In a Peterson Institute working paper, Jeromin Zettelmeyer, Eike Kreplin, and Ugo Panizza conclude that the answer to that question depends on your assumptions.

The authors compare several scenarios, including

  • scenarios A–C, the baseline scenario of the European institutions and two more pessimistic variants;
  • scenario I which underlies the IMF reasoning and which assumes that “Greece will not undertake the structural reforms needed to achieve higher potential growth”;
  • and scenario D, which corresponds to what Greece committed to when the third program was agreed, and which represents the German position.

They assume that interest rates on privately held debt rise with the debt-to-GDP ratio, and they use two “sustainability” metrics: The debt-to-GDP ratio (should fall), and gross financing needs as a share of GDP (should be smaller than 20%).

When running Monte Carlos simulations, the authors find that for each scenario, the assumptions about growth and primary surpluses are consistent with the conclusions drawn by the different institutions:

  • In A (borderline) and D, debt is “sustainable.”
  • Not so in B, C, and I, due to “accelerating substitution of official debt by more expensive borrowing from private sources”.

The authors then evaluate the plausibility of the scenario assumptions. They conclude that “international evidence does not support an adjustment path that envisages a primary surplus of above 3.5 percent for more than three to four years on a continuous basis and for more than seven years on an average basis” rendering B and C the most plausible scenarios, and suggesting that the debt is “unsustainable.”

In reaching their conclusions, the authors assume that primary surpluses in Greece will react to debt, inflation, and growth in line with the experience in other (developed) economies. (This means, for example, that surpluses rise as the debt burden increases, which seems to contradict the notion of debt overhang.) This is unconvincing, of course, if one takes the view underlying scenario D which presumes that feasible promises are kept. Or stated differently: Greece might well be able but not willing to pay—after all, in this very case official creditor intervention could have made sense in the first place although private lenders charged high interest rates. (With Harris Dellas, we make this argument precise in a paper in the Journal of International Economics.) Related, one can think of many reasons why the historical experience in other countries may be uninformative for the Greek case. The authors address one concern: They focus on episodes with very high debt-to-GDP ratios and find that in these cases, primary surpluses are maintained for longer. Moreover, there is the important question of measurement: The Greek debt-to-GDP ratio is not easily comparable with the ratio in other countries, see here and here, and most likely overstated.

Zettelmeyer, Kreplin, and Panizza make the case for a delay of Greece’s return to capital markets. In the conclusions, they write that

the debt relief measures put on the table by the Eurogroup in May 2016 could be sufficient to restore debt sustainability, but only if these measures are taken to an extreme. This means accepting an extremely long maturity extension of EFSF debts. In addition, it requires either substantial additional interest rate deferrals, or locking in significantly lower funding costs and hence lower interest rates than the EFSF currently expects, or a combination of both. While these measures are feasible within the red lines described by the Eurogroup, they are likely to be politically and/or technically difficult. Unless the EFSF manages to eke out substantial extra interest relief through creative long-term funding operations, its exposure to Greece will likely have to rise, possibly for decades, before it starts falling. A private sector creditor would not accept this type of restructuring because it gives the debtor country a strong incentive to default (or at least renegotiate) when the debt is at its peak.

… one way out of this dilemma would be to delay Greece’s return to capital markets, continuing to finance Greece through ESM programs until its private sector spreads are much lower than they are now. … this approach would lower the total need for debt relief and/or fiscal effort required to restore Greece to debt sustainability. While it would lead to a significant increase in official creditor exposure to Greece—requiring perhaps €100 billion of extra ESM financing—this is less than the rise in EFSF exposure that would be required in the Eurogroup’s approach, which aims to return Greece to private capital markets in 2018 while relying mainly on EFSF maturity extensions and interest rate deferrals … total official exposure to Greece would decline faster if ESM financing were to continue than if it were to end in 2018.

Importantly, they also point to the incentive effects of debt restructuring:

If [the threat of Grexit is essential to maintain incentives for reform] keeping the sword of Grexit … would help reduce debt levels only so long as Greece is being financed with cheap official funds. If, however, Greece returns to capital markets, any beneficial incentives of this approach would likely be offset by the risk premiums that private lenders would charge to a country whose euro membership remains at risk.

The official creditors will have to make up their minds: Not only the return on their lending is at stake, but also reform in Greece.

Historical Living Standards in International Comparison

On VoxEU, Peter Lindert summarizes his recent work on long-term international comparisons of living standards. Lindert compares nominal incomes per capita, deflated by historical prices (for staple goods). He makes five points:

The real income gap between Northwest Europe and the major Asian countries was greater since the 1500s than even Maddison had estimated.

Contrary to all previous estimates, Mughal India around 1600 was already far behind both Japan and Northwest Europe.

Within Europe, the new estimation procedure shows little bias in Maddison’s estimates.

Average incomes in North America were already higher than in Britain or France in the late 17th century, long before Maddison’s c.1900 catching up date for the US versus Britain. A similar ‘frontier advantage’ has now emerged from estimates for Australia in 1870.

Adding what is known about the ability to buy luxuries and capital goods raises the income of Western Europe relative to all other regions, except possibly resource-rich North America.

Kenneth Arrow’s Work

On VoxEU, Steven Durlauf offers an excellent overview over Kenneth Arrow’s work. Durlauf emphasizes five areas of research:

  • The impossibility theorem, in the tradition of Condorcet.
  • General equilibrium theory and the welfare theorems, in the tradition of Walras.
  • Decision-making under uncertainty, the Arrow-Pratt measures of risk aversion and contingent commodities.
  • Imperfect information, in the context of medical care and as a source of statistical discrimination.
  • Economics of knowledge, anticipating the endogenous growth literature.

Durlauf closes:

Like Faust, limitless curiosity and passion for knowledge meant that Arrow strove without relenting; but unlike Faust, Arrow needed no redemption. His intellectual integrity was pristine and unparalleled at every stage of his life. His character was as admirable and admired as his intellect. Arrow’s personal and scholarly example continues to inspire, nurture, and challenge.

The Kremlin and Russian Criminals

From the European Council on Foreign Relations, Mark Galeotti reports about ties between Russian criminal networks and the Kremlin. From the summary:

The Russian state is highly criminalised, and the interpenetration of the criminal ‘underworld’ and the political ‘upperworld’ has led the regime to use criminals from time to time as instruments of its rule.

Russian-based organised crime groups in Europe have been used for a variety of purposes, including as sources of ‘black cash’, to launch cyber attacks, to wield political influence, to traffic people and goods, and even to carry out targeted assassinations on behalf of the Kremlin.

Mankiw on the Congressional Tax Plan

In the New York Times, Greg Mankiw applauds the tax reform plan discussed in Congress. He emphasizes four points:

  • The reform would move the US tax system toward international norms, from worldwide to territorial taxation.
  • It would move the system from income towards less distorting consumption taxation, by allowing businesses to deduct investment spending immediately.
  • The reform would change the origin-based into a destination-based system (taxing imports and exempting exports, a.k.a. “border adjustment”), with similarities to a value-added tax, making it harder to game the system. “[T]he immediate impact of the change would be to discourage imports and encourage exports. … the dollar would appreciate … The movement in the exchange rate would offset the initial impact on imports and exports.”
  • The reform would abolish tax deductions for interest payments to bondholders, eliminating incentives for corporate leverage. “A business’s taxes would be based on its cash flow: revenue minus wage payments and investment spending. How this cash flow is then paid out to equity and debt holders would be irrelevant.”

Swiss Franc Exchange Rate Index

The Swiss National Bank has updated its exchange rate indices. In an SNB Economic Studies paper, Robert Müller describes how. The upshot is that the SNB considers the Swiss Franc slightly less overvalued than before. From the abstract:

The key aspects of the revision are: the application of the weighting method used by the IMF, which takes into account so-called third-market effects; continuous updating of the countries incorporated into the index; and calculation of a chained index. The methodological changes in the calculation of the new index have only a slight effect on the development of the nominal index. However, the difference between the nominal and real index (CPI-based) has increased with the new calculation. This is explained by the fact that countries with a greater weighting in the new index have higher average rates of inflation than those whose weighting has been reduced.

On the State of Macroeconomics

In a paper, Ricardo Reis defends macroeconomics against various critiques. He concludes:

I have argued that while there is much that is wrong with macroeconomics today, most critiques of the state of macroeconomics are off target. Current macroeconomic research is not mindless DSGE modeling filled with ridiculous assumptions and oblivious of data. Rather, young macroeconomists are doing vibrant, varied, and exciting work, getting jobs, and being published. Macroeconomics informs economic policy only moderately and not more nor all that differently than other fields in economics. Monetary policy has benefitted significantly from this advice in keeping inflation under control and preventing a new Great Depression. Macroeconomic forecasts perform poorly in absolute terms and given the size of the challenge probably always will. But relative to the level of aggregation, the time horizon, and the amount of funding, they are not so obviously worst than those in other fields. What is most wrong with macroeconomics today is perhaps that there is too little discussion of which models to teach and too little investment in graduate-level textbooks.

Models Make Economics A Science

In the Journal of Economic Literature, Ariel Rubinstein discusses Dani Rodrik’s “superb” book “Economics Rules.” The article nicely articulates what economics and specifically, economic modeling is about. Some quotes (emphasis my own) …

… on the nature of economics:

[A] quote … by John Maynard Keynes to Roy Harrod in 1938: “It seems to me that economics is a branch of logic, a way of thinking”; “Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world.”

[Rodrik] … declares: “Models make economics a science” … He rejects … the … common justification given by economists for calling economics a science: “It’s a science because we work with the scientific method: we build hypotheses and then test them. When a theory fails the test, we discard it and either replace it or come up with an improved version.” Dani’s response: “This is a nice story, but it bears little relationship to what economists do in practice …”

… on models, forecasts, and tests:

A good model is, for me, a good story about an interaction between human beings …

A story is not a tool for making predictions. At best, it can help us realize that a particular outcome is possible or that some element might be critical in obtaining a particular result. … Personally, I don’t have any urge to predict anything. I dread the moment (which will hopefully never arrive) when academics, and therefore also governments and corporations, will be able to predict human behavior with any accuracy.

A story is not meant to be “useful” in the sense that most people use the word. I view economics as useful in the sense that Chekhov’s stories are useful—it inspires new ideas and clarifies situations and concepts. … [Rodrik] is aware … “Mischief occurs when economists begin to treat a model as the model. Then the narrative takes on a life of its own and becomes dislodged from the setting that produced it. It turns into an all-purpose explanation that obscures alternative, and potentially more useful, story lines”.

A story is not testable. But when we read a story, we ask ourselves whether it has any connection to reality. In doing so, we are essentially trying to assess whether the basic scenario of the story is a reasonable one, rather than whether the end of the story rings true. … Similarly, … testing an economic model should be focused on its assumptions, rather than its predictions. On this point, I am in agreement with Economics Rules: “. . . what matters to the empirical relevance of a model is the realism of its critical assumptions”.

… on facts:

The big “problem” with interpreting data collected from experiments, whether in the field or in the lab, is that the researchers themselves are subject to the profession’s incentive system. The standard statistical tests capture some aspects of randomness in the results, but not the uncertainty regarding such things as the purity of the experiment, the procedure used to collect the data, the reliability of the researchers, and the differences in how the experiment was perceived between the researcher and the subjects. These problems, whether they are the result of intentional sleight of hand or the natural tendency of researchers to ignore inconvenient data, make me somewhat skeptical about “economic facts.”

Who Voted for Brexit?

In a CEPR Discussion Paper, Sascha Becker, Thiemo Fetzer, and Dennis Novy argue that education and income mainly explain voting outcomes. In the abstract of their paper, the authors write:

We find that exposure to the EU in terms of immigration and trade provides relatively little explanatory power for the referendum vote. Instead, … fundamental characteristics of the voting population were key drivers of the Vote Leave share, in particular their education profiles, their historical dependence on manufacturing employment as well as low income and high unemployment. … within cities, we find that areas with deprivation in terms of education, income and employment were more likely to vote Leave.

Does the Swiss Agricultural Sector Add Value?

In December 2016, the Swiss Federal Council concluded that in international comparison, government support for the Swiss agricultural sector is very high. But critics point out that the government report might understate the social cost of government support. In a separate study the lobby group `Vision Landwirtschaft’ had presented estimates according to which the Swiss agricultural sector adds negative value, on the order of 1 billion CHF per year.

NZZ reports by Désirée Föry: February 9, 2017 and April 2, 2017.

Citigroup Advises Against the `Fiscal Theory of the Price Level’

In a recent Citigroup Global Economics View Research report, Willem Buiter discusses “Bad and Good ‘Fiscal Theories of the Price Level’.” Quoting my own work on the Fiscal Theory, Buiter warns that policy makers start to pay attention to the theory:

It does not often happen that a rather obscure technical bit of economic theory
merits an audience wider than the small band of academics who spend their waking
hours pondering such matters because that is the kind of thing they do. This note
addresses one of those occasions. The obscure economic theory in question is the
so-called fiscal theory of the price level (FTPL) …

The destruction of the logic of the FTPL by Buiter and Niepelt ought to have been
the end of the FTPL – their arguments were never refuted. … Recently, some of the originators of the original FTPL have tried to resurrect it …

 

 

Macroeconomic Effects of Bank Solvency vs. Liquidity

In a CEPR discussion paper, Òscar Jordà, Björn Richter, Moritz Schularick, and Alan M. Taylor suggest that higher bank capital ratios help stabilize the financial system ex post but not ex ante, and that illiquidity breeds fragility.

Abstract of their paper:

Higher capital ratios are unlikely to prevent a financial crisis. This is empirically true both for the entire history of advanced economies between 1870 and 2013 and for the post-WW2 period, and holds both within and between countries. We reach this startling conclusion using newly collected data on the liability side of banks’ balance sheets in 17 countries. A solvency indicator, the capital ratio has no value as a crisis predictor; but we find that liquidity indicators such as the loan-to-deposit ratio and the share of non-deposit funding do signal financial fragility, although they add little predictive power relative to that of credit growth on the asset side of the balance sheet. However, higher capital buffers have social benefits in terms of macro-stability: recoveries from financial crisis recessions are much quicker with higher bank capital.

`Brussels’ to Disrupt European Banking

The Economist reports that forthcoming European payments regulation has the potential to disrupt the industry.

Provided the customer has given explicit consent, banks will be forced to share customer-account information with licensed financial-services providers.

… payment services … could become more integrated into the internet-browsing experience …

With access to account data … fintech firms could offer customers budgeting advice, or guide them towards higher-interest savings accounts or cheaper mortgages. Those with limited credit histories may find it easier to borrow, too, since richer transaction data should mean more sophisticated credit checks.

Portfolio Adjustments in Money Market Mutual Funds

On the Liberty Street Economics blog,

First, institutional prime and muni funds—but not retail or government funds—must now compute their net asset values (NAVs) using market-based factors, thereby abandoning the fixed NAV that had been a hallmark of the MMF industry. Second, all prime and muni funds must adopt a system of gates and fees on redemptions, which can be imposed under certain stress scenarios.

Investors adjusted their portfolios in response to these changes:

… investors’ shift from prime and muni funds to government—and, in particular, agency—funds means that a large segment of the industry still operates under a stable NAV (and therefore is, in principle, vulnerable to runs). … Since the new regulations have resulted in a very large shift of assets into relatively safe government funds, the SEC’s reforms have made runs on MMFs less likely and the industry itself more resilient.

John Cochrane and Janet Yellen

On his blog, John Cochrane discusses the possibility of an alternative monetary policy regime in which the Fed tightly controls expected inflation. He states, repeatedly, that given our current understanding of the matter he would refrain from implementing such a regime if he became Fed chair (rather than stating that he would not currently advise to move in that direction). Given that Janet Yellen is expected to retire next year and John Cochrane is mentioned as a possible successor, I find the statement remarkable.