Money, Banking, and Dreams

In another excellent post on Moneyness, J P Koning likens the monetary system to the plot in the movie Inception, featuring

a dream piled on a dream piled on a dream piled on a dream.

Koning explains that

[l]ike Inception, our monetary system is a layer upon a layer upon a layer. Anyone who withdraws cash at an ATM is ‘kicking’ back into the underlying central bank layer from the banking layer; depositing cash is like sedating oneself back into the overlying banking layer.

Monetary history a story of how these layers have evolved over time. The original bottom layer was comprised of gold and silver coins. On top this base, banks erected the banknote layer; bits of paper which could be redeemed with gold coin. The next layer to develop was the deposit layer; non-tangible book entries that could be transferred by order from one person to another.

The foundation layer has changed over time:

One of the defining themes of modern monetary history has been the death of the original foundation layer; precious metals. … as central banks chased private banks from the banknote layer … and then gradually severed the banknote layer from the gold layer. By 1971, … [b]anknotes issued by the central bank had become the foundation layer. The trend towards a cashless world is a repeat of this script, except instead of the gold layer being slowly removed it is the banknote layer.

Fintech improves the efficiency of the layer arrangement and its connections. It also adds new layers: For instance, some payments made via mobile phone effectively transfer claims on deposits. And it may circumvent layers:

In U.K., the Bank of England is considering allowing fintech companies to bypass the banking layer by offering them direct access to the bottom-most central banking layer.

In contrast, a krypto currency like bitcoin establishes a new foundation layer, on which new layers may be built:

Even now there is talk of a new layer being developed on top of the original bitcoin foundation, the Lightning network. The idea here is that the majority of payments will occur in the Lightning layer with final settlement occurring some time later in the slower Bitcoin layer.

I fully agree with this characterization. In addition to the theme emphasized by Koning—adding layers—I would also stress the theme of untying higher-level layers from lower ones: Central bank money typically is no longer backed by gold; deposits typically are not fully backed by notes; and mobile phone credits may no longer be backed by deposits. The process of untying layers relies on social conventions and trust, and it is fragile. Important questions concern the cost of such fragility, and its necessity. Fragility is not necessary when the social cost of liquidity provision at the foundation layer is negligible.

General Equilibrium Theory up to Arrow and Debreu

On his blog A Fine Theorem, Kevin Bryan discusses the history of economic thought leading from the classical economists and Walras to Arrow and Debreu.

My read of the literature on GE following Arrow is as follows. First, the theory of general equilibrium is an incredible proof that markets can, in theory and in certain cases, work as efficiently as an all-powerful planner. That said, the three other hopes of general equilibrium theory since the days of Walras are, in fact, disproven by the work of Arrow and its followers. Market forces will not necessarily lead us toward these socially optimal equilibrium prices. Walrasian demand does not have empirical content derived from basic ordinal utility maximization. We cannot rigorously perform comparative statics on general equilibrium economic statistics without assumptions that go beyond simple utility maximization. From my read of Walras and the early general equilibrium theorists, all three of those results would be a real shock.

Currency Denomination Risk in the Euro Area

In the FT (Alphaville), Marcello Minnena explains what type of currency denominations of Euro area sovereign debt constitute credit events; and how markets assess the risk of such denominations.

After the Greek default in 2012

new ISDA standards entered into force: contracts made since 2014 protect against euro area countries redenominating their debt into new national currencies [unless the debt is redenominated] into a reserve currency: the US dollar, the Canadian dollar, the British pound, the Japanese yen, or the Swiss franc. In all other cases, the only way to avoid the triggering of a credit event is if the switch to the new currency does not result in a loss for the investor: “no reduction in the rate or amount of interest, principal or premium payable”.

Since 2014 two types of sovereign CDS therefore coexist: the old (ISDA 2003) and the new (ISDA 2014). The latter has always traded at spreads wider than the CDS-2003, but the difference (the ISDA basis) has generally been small: 15-20 bps for Italy, 8-12 bps for Spain, 2-4 bps for France, and 1-2 bps for Germany.

Since January 2017, the spread difference for Italy and France has increased by roughly 20 basis points.

Money without a Government

In the FT, David Pilling reports about Somalia which has managed without central bank issued money for decades.

… up to 98 per cent of local banknotes are fake … With the help of the International Monetary Fund, Mogadishu plans to print official banknotes for the first time in more than a quarter of a century … No official Somali currency has left the presses since the Horn of Africa nation descended into clan warfare after the collapse of the government in 1991.

… warlords, businessmen and breakaway regions printed counterfeit notes or shipped them in from abroad. … several important issues, including what the government would use to back its new currency, were still being discussed. So was the question of what the conversion rate would be of fake Somali shillings for the new official ones. Use of Somali shillings, largely limited to the less well-off rural population, comes a poor third to US dollars and electronic money in what is a mostly dollarised economy. … Some dollars in circulation are also fake …

U.S. Health Care Spending

A blog post on Random Critical Analysis argues that high wealth (proxied by high consumption) rather than GDP explains US health care expenditures.

Total per capita health care spending increases as wealth increases because people actually demand more goods and services (volume) per capita and because it is relatively labor intensive sector that does not enjoy the productivity gains found in some other sectors of the economy, i.e., overall costs increase through both volume and price together (volume * price).  GDP per capita is a relatively weak measure for these purposes and those few other high GDP countries happen to be much more export dependent (which does not independently predict significant increases in expenditures).  If you use a better measure like Actual Individual Consumption (AIC) or run multiple regression analysis on GDP expenditure categories most of the apparent excess health care spending shrinks quite dramatically.

Additional analysis of several major claims here (e.g., high prices due to limited market power of payers, high physician incomes, etc) show that these arguments suffer from similar issues.  The best available evidence show that across multiple measures our healthcare labor costs and overall apples-to-apples price levels are generally very much inline with our material standard of living.  US total per capita costs are probably somewhat more than expected, but this appears to be driven through higher volume (~100% more than EU28 average according to PPP study estimates), though even this is significantly, if not quite entirely, explained by our higher material standards of living.

Economics as Bullshit Detection

In separate blog posts, Russ Roberts and John Cochrane have called for humility on the part of economists. Asking “What do economists know?,” Roberts and Cochrane point out—correctly—that economics is not as strong on quantification as some economists and many pseudo economists pretend, and as is often expected from economists.

Economics is not the same as applied statistics although the latter can help clarify, at least to some extent, the empirical relevance of economic theories. Correlation does not imply causation. Identifying assumptions that aim at establishing causal claims based on correlation analysis deserve skepticism, especially when the process that led to the empirical results remains in the dark (see notes on replicability here, here, here).

Sound economics heavily relies on consistency checking, or bullshit detection in Cochrane’s words. It insists on keeping accounting identities in mind and never forgetting about incentives. And it is acutely aware of the fact that good models are nothing more than consistent stories—but at least they are consistent stories.

Fintech in China

The Economist reports about the fintech revolution in China.

By just about any measure of size, China is the world’s leader in fintech (short for “financial technology”, and referring here to internet-based banking and investment). It is far and away the biggest market for digital payments, accounting for nearly half of the global total. It is dominant in online lending, occupying three-quarters of the global market. A ranking of the world’s most innovative fintech firms gave Chinese companies four of the top five slots last year. The largest Chinese fintech company, Ant Financial, has been valued at about $60bn, on a par with UBS, Switzerland’s biggest bank.

“Fiscal and Monetary Policies,” Bern, Spring 2017

MA course at the University of Bern.

The classes follow chapters 11–13 in this text (updated April 12, 2017) and build on the material covered in chapters 1–5. Uni Bern’s official course page. The course TA is Christian Myohl.

Main contents:

  1. Concepts.
  2. RA model with government spending and taxes.
  3. Government debt in RA model.
  4. Government debt and social security in OLG model.
  5. Neutrality results.
  6. Consolidated government budget constraint.
  7. Fiscal effects on inflation. Game of chicken.
  8. FTPL. Active and passive policies.
  9. Primal and dual approach.
  10. Tax smoothing.
  11. Time consistent policy.

The IMF In Greece

The IMF has released a report with an ex-post evaluation of Greece’s 2012 Extended Fund Facility (Exceptional Access under the 2012 Extended Arrangement under the Extended Fund Facility with Greece).

A critical discussion by Charles Wyplosz on VoxEU.

The Greek authorities are more optimistic than IMF staff about the economy’s outlook.

“Secular” Stagnation, A Return to Trend

On Bank Underground, Gene Kindberg-Hanlon criticizes the secular stagnation hypothesis:

Real interest rates have fallen by around 5 percentage points since the 1980s.  Many economists attribute this to “secular” trends such as a structural slowdown in global growth, changing demographics and a fall in the relative price of capital goods which will hold equilibrium rates low for a decade or more (Eggertsson et al., Summers, Rachel and Smith, and IMF).  In this blog post, I argue this explanation is wrong because it’s at odds with pre-1980s experience.  The 1980s were the anomaly … The decline in real rates over the 1990s and early 2000s simply reflected a return to historical norms from an unusually high starting point.  Further falls since 2008 are far more plausibly related to the financial crisis than secular trends.

Munich Security Report 2017

Topics discussed in the report include:

  • Support for a “strong leader” as opposed to checks and balances has increased in many countries.
  • The share of households with flat or falling market incomes during the 2005-14 period has been around 65% in advanced economies, and 97% in Italy. In the preceding decade, it had been negligible.
  • The Eurasia Group’s top ten risks for 2017:
    1. Independent America
    2. China overreacts
    3. A weaker Merkel
    4. No reform
    5. Technology and the Middle East
    6. Central banks get political
    7. The White House vs. Silicon Valley
    8. Turkey
    9. North Korea
    10. South Africa
  • More than 60 percent of Americans want to keep or increase US commitments to NATO.
  • “Europe” could save 30% of its defense investments by cooperating more closely.
  • “Europe” operates many more weapon systems than the US.
  • In 2016, 94%, 73%, and 20% of US-led, Turkish, and Russian airstrikes in Syria targeted Daesh/ISIS.
  • China and Russia have strongly increased the number of their cultural institutes abroad.
  • Wikileaks has strongly gained support among Republican voters.
  • Most attacks on health care infrastructure are deliberate.

Monetary Policy Implementation in China

The Economist reports that implementation gradually changes:

[T]he way in which the People’s Bank of China conducts monetary policy is changing. It is beginning to look a little more like central banks in developed economies as it shifts towards liberalised interest rates. Rather than simply ordering banks to set specific lending or deposit rates—the focus for many years in China—it is altering the monetary environment around them. China does not yet have an equivalent of the federal-funds rate in America or the refinancing rate in Europe, but it has a few candidates for its new benchmark interest rate. The seven-day bond-repurchase rate, which influences banks’ funding costs, is in pole position.

There is also an element of political intrigue in this transition to a more mature monetary framework. The Chinese central bank sits under the State Council, or cabinet, which has the final say over lending and deposit rates as well as other big policy decisions. Repo rates, by contrast, are seen as sufficiently abstruse for the central bank to decide on its own when it wants to change them.

Re-Denomination Risk in France and Italy

On the FT Alphaville blog, Mark Weidemaier and Mitu Gulati argue that re-denomination risk in the Euro zone is most prominent in France and Italy. Bonds with CACs trade at higher prices.

Most French and Italian [but not Greek] debt is governed by local law. … the governments could pass legislation redenominating their bonds from euros to francs or lira.

… [But] some French and Italian bonds — bonds issued after January 1, 2013, with maturities over a year — have Collective Action Clauses (CACs). … Importantly, these CACs require a super-majority of investors (in principal amount) to approve any changes to the currency of the bond.

… But it’s also possible a local law bond is no different than a local law bond with a CAC. After all, both are ultimately subject to the whims of the local legislature, and the courts may side with them.

The markets seem to have a view, though: CAC bonds in the countries with heightened redenomination risk seem to be valued significantly more.

“Vollgeld, the Blockchain, and the Future of the Monetary System”

Presentation at the Liechtenstein Institute about the Vollgeld initiative, the blockchain revolution, and their possible effects on banks and the monetary system.

Report in Liechtensteiner Vaterland, February 1, 2017. HTML.

Interview in Wirtschaft Regional, February 4, 2017. PDF.

Re-denomination Constitutes Default

In a letter to the editor of The Economist, Moritz Kraemer, sovereign chief ratings officer of S&P Global Ratings, clarifies what it would mean for France to re-denominate French debt:

Buttonwood wondered whether Marine Le Pen’s plan to re-denominate French government euro bonds into new francs might constitute a sovereign default (January 14th). There is no ambiguity here: it would. If an issuer does not adhere to the contractual obligations to its creditors, including payment in the currency stipulated, S&P Global Ratings would declare a default. Our current AA rating on France suggests, however, that such a turn of events is highly unlikely.

To Best Serve the Nation and the World

L. Rafael Reif, President of MIT, in an open letter to the MIT community:

The Executive Order on Friday appeared to me a stunning violation of our deepest American values, the values of a nation of immigrants: fairness, equality, openness, generosity, courage. The Statue of Liberty is the “Mother of Exiles”; how can we slam the door on desperate refugees? Religious liberty is a founding American value; how can our government discriminate against people of any religion? In a nation made rich by immigrants, why would we signal to the world that we no longer welcome new talent? In a nation of laws, how can we reject students and others who have established legal rights to be here? And if we accept this injustice, where will it end? Which group will be singled out for suspicion tomorrow? …

Yet I would like us to think seriously about the fact that both within the MIT community and the nation at large, there are people of goodwill who see the measures in the Executive Order as a reasonable path to make the country safer. We would all like our nation to be safe. I am convinced that the Executive Order will make us less safe. Yet all of us, across the spectrum of opinion, are Americans.

In this heated moment, I urge every one of us to avoid with all our might the forces that are driving America into two camps. If we love America, and if we believe in America, we cannot allow those divisions to grow worse. We need to imagine a shared future together, if we hope to have one. I am certain our community can help work on this great problem, too, by starting right here at home.

Liechtenstein Fact Check

In the NZZ, Simon Gemperli offers a fact check on Liechtenstein.

  • GDP per employed person: CHF 144’000 (Switzerland: CHF 125’000).
  • 10 countries are even smaller.
  • The people can vote the monarch out of office.
  • Banks contribute a quarter of GDP.

 

NAFTA’s Effects on the US

On his blog, Dani Rodrik comments on NAFTA’s implications for US manufacturing and jobs.

So here is the overall picture that these academic studies paint for the U.S.: NAFTA produced large changes in trade volumes, tiny efficiency gains overall, and some very significant impacts on adversely affected communities.

… Mexico has been one of Latin America’s underperformers.

So is Trump deluded on NAFTA’s overall impact on manufacturing jobs? Absolutely, yes.

Was he able to capitalize on the very real losses that this and other trade agreements produced in certain parts of the country in a way that Democrats were unable to? Again, yes.

Collateral Values in ECB Operations

In the NZZ, Kjell Nyborg questions whether the collateral values of the securities the ECB accepts in monetary policy operations reflect market values. He argues that the valuation is discretionary and politicized.

Meine Analyse macht deutlich, dass der Besicherungsrahmen in der Euro-Zone in unterschiedlicher Ausprägung unter all diesen Problemen leidet. Das öffentliche Verzeichnis der zulässigen notenbankfähigen Sicherheiten enthält 30 000 bis 40 000 verschiedene Wertpapiere, von Staatsanleihen bis hin zu unbesicherten Bankanleihen und forderungsbesicherten Wertpapieren (Asset-Backed Securities). Die überwiegende Mehrheit dieser Wertpapiere hat keinen Marktpreis. Ungefähr ein Drittel all dieser Sicherheiten wird in nichtregulierten Märkten gehandelt. Zudem können Banken nichtmarktfähige Anlagen und Wertpapiere mit «privaten Ratings» verwenden, die nicht im öffentlichen Verzeichnis sind. Daher basieren die Werte der Sicherheiten mehrheitlich auf Modell- statt auf Marktpreisen. Interessanterweise ziehen Banken es vor, Sicherheiten zu benutzen, bei denen häufiger theoretische Preise verwendet werden. Generell tendiert die Besicherungspolitik der Euro-Zone zu risikoreichen und illiquiden Sicherheiten. Die untergeordnete Rolle des Marktes sieht man auch an der Häufigkeit, mit welcher die Sicherheitsabschläge für die Repo-Geschäfte des Euro-Systems aktualisiert werden: Dies geschieht lediglich alle drei bis vier Jahre.

Im Kern des Geldsystems in der Euro-Zone gibt es somit wenig Spielraum für Marktkräfte oder Marktdisziplin. Insgesamt kann die Besicherungspolitik des Euro-Systems als expansiv beschrieben werden. Die Liste notenbankfähiger Sicherheiten ist äusserst umfangreich und oft auf die «Bedürfnisse» von Banken in verschiedenen Ländern zugeschnitten. Sicherheiten können, zum Beispiel, durch Staatsgarantien aufgewertet werden. … Weil es im Kern des Euro-Geldsystems an Marktkräften und Marktdisziplin fehlt, entsteht ein Vakuum, das von anderen Kräften, wie Rating-Agenturen und der Politik, aufgefüllt wird.

… Ich dokumentiere, dass DBRS eine ausschlaggebende Rolle innehatte, indem sie über eine lange Zeit hinweg Italien und Spanien ein Rating von A– und Portugal ein solches von BBB– gab. Das hob den Wert der in diesen Ländern begebenen Sicherheiten um ungefähr bis 200 Mrd. € an und kann als unterstützende Massnahme für indirekte Bail-outs interpretiert werden.

Im Dezember 2011 und Februar 2012 hat die EZB eine ihrer wichtigsten geldpolitischen Massnahmen vor dem Beginn des Quantitative Easing implementiert. … Um aus dieser Möglichkeit Vorteil zu schlagen, hat die italienische Regierung gleichzeitig eine präzedenzlose Anzahl von Garantien für Bankanleihen mit niedrigem oder gar keinem Rating gesprochen. Damit erhöhte sie deren Besicherungswert. Darüber hinaus hat die EZB mehr als 10 000 unbesicherte, auf nichtregulierten Märkten gehandelte Bankanleihen der öffentlichen Liste notenbankfähiger Sicherheiten hinzugefügt, obwohl der aggregierte Wert notenbankfähiger Sicherheiten die Nachfrage von Banken nach Zentralbankgeld schon bei weitem überstieg.