Ending shadow banking means ending modern central banking

Ann Petitfor has a not-so-long essay in ‘Prospect’ magazine on how the world could exit QE. It is an interesting and thought-provoking essay. Some extracts:

As Claudio Borio of the Bank for International Settlements explained in 2019: “bar a few who have sailed into these waters, money has been allowed to sink by the macroeconomics profession. And with little or no regrets.”

This one is elegantly put:

… What’s forgotten is that if the world’s economic activity actually had to be calibrated to fit an arbitrarily fixed volume of circulating cryptocurrency, then—exactly as under the gold standard—the world would experience prolonged and painful depressions.

This is a good way of arguing that economic activity dictates the demand for money and that the supply of money should not dictate the level of economic activity. But, we have now swung to the other extreme: We don’t care what the economic activity is. We will provide unlimited amount of money and we believe that this should cause economic activity to pick up! In a way, the QE-adherents are presenting the other side of the coin of the Gold bugs. In doing so, they make many of us – including yours truly – crave for the discipline imposed by the Gold Standard.

But, then, this goes back to the quote attributed to Claudio Borio. We have not quite figured out the role for money.

Between 1981 and 2014, 30 countries fully or partially privatised their public mandatory pensions. Coupled with cross-border capital mobility, the move to private retirement savings steadily generated vast cash pools for institutional investors…

…Note that this whole system avoids reliance on the social construct of credit, upheld by trust and enforced by law, which traditional banks had to work within. Instead, the system is one of deregulated exchange in which cash is simply one more commodity—no more regulated than any other.

These sentences, arranged separately in the article, lay out the rationale for QE:

Today one asset management firm, BlackRock, manages in excess of $8 trillion of the world’s savings. Such companies have outgrown the capacity of “main street” banks to provide services. No traditional commercial bank could absorb these sums; few governments are willing to guarantee individual accounts of more than $100,000. ….Like pawnbrokers, who practised an earlier form of unregulated credit, shadow banks exchange the savings they hold for collateral. … Replete with cash, they can provide “liquidity” on a vast scale to businesses or investors who need it….private financiers rely heavily on government bonds as the safest collateral for their repo trades….

… It is estimated that two out of three euros borrowed through shadow banks are underpinned by the collateral of sovereign bonds issued within the Eurozone. Any decline in the value of government bonds as a consequence of shadow banking activity will influence the government’s cost of borrowing, and—ultimately—fiscal decisions….Which brings us back to quantitative easing—the remedy that central bankers reach for in the face of this recurrent threat.

It clarifies a lot of things, actually. In other words, without QE, the shadow banking system will cease to exist. If it ceases to exist, then the real economy crashes. So, central bankers can assuage themselves by saying that by providing the liquidity that the leveraged shadow banking system needs, they are indirectly supporting the real economy or preventing the real economy from collapsing.

Her conclusion is quite appropriate:

Whenever the vast shadow banks wobble, there is the threat of a disastrous contraction of the credit for the real economy, which could bring everything crashing down. As long as the system is allowed to stand, there is no alternative to taxpayer-backed central banks rescuing private markets.

The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by a responsibility not to take undue risks. And if footloose capital responds by skipping across borders and away from oversight, then we may also need to look at controls on that front too. Only then will the world stand any chance of kicking the QE habit, address those dangerous imbalances and finally escape this grim shadowland of money.

But, on their own, central banks will be afraid to do the job of deconstructing and reconstructing. It is a political project because, in reality, it would amount to cutting both shadow banking and central banking to size. That is why central bankers would resist it actually. Ending the last forty years of financialisation will also end central banking as it has evolved in the last forty years. Central bankers will go back to operating in the shadows, if shadow banking were to be ended!

Will politicians be up to the task? I doubt.

The risk is that, in doing so, the ‘House of cards’ aka ‘the real economy’ will collapse. No one wants it on their watch. If the world of shadow banking has to end, it will happen through exogenous shocks. Both QE (i.e., modern central banking) and the world of shadow banking have to collapse from being unable to bear the sheer weight that they have grown into.

Demography and inflation

Researchers from the Bank of Finland and the Bank for International Settlements have published a paper on the relationship between demography and inflation – that is a topic that Charles Goodhart and Manoj Pradhan have been at, in the last few years, through op.-eds., papers and a book too. BIS Working Paper No. 656, published in 2017, authored by them, is one of them.

The collaborative paper by economists at the Bank of Finland and BIS, ‘Demography and inflation through time’ arrives at the following conclusions:

we find a robust and stable relationship between demography and inflation. In terms of age structure, the dependents (the young and the old) are generally associated with higher, and the working age cohorts with lower inflation. In other words, a higher dependency ratio is associated with higher inflation. The only substantial exception to this pattern is the very old cohort (80 + year olds) that has a negative effect on inflation. Yet, this cohort is more heavily affected by longevity than the other cohorts. We also find significant positive association between population growth and inflation, and negative association between increasing longevity and inflation.

The authors concede the possibility that the effects could interact and that the combined effect on inflation would depend on which effect dominates:

One difficulty with this hypothesis is that the effects of (i) and (iii) can lead to ambiguous effect with respect to the share of old population. The reason is that increased longevity, which would have a negative effect according to (iii), also shows up in population data as an increase in the number of old individuals, which according to (i) should have a positive effect all else equal. Thus, the overall effect of the share of old population depends on which of these two effects dominate.

Other conclusions:

The demographic effects are economically significant for trend inflation, both in individual countries and at the global level. For example, demography accounts for around a seven percentage point increase in inflation from the 1950s to the mid-1970s in the United States, and a similar decline thereafter. In line with this finding, demography also matters for inflation persistence.

The demographic shifts are smaller in those countries, which have seen less strong demographic shifts. For instance, the baby boom was smaller in Germany, and so was correspondingly the demographic uptick in trend inflation. The deflationary pressures during the recent decades arise because the deflationary impact of the declining share of the young cohorts has dominated the inflationary impact of the increasing share of the old. But this balance is currently shifting.

reduction in the share of 20-25 year olds due to military deaths during the war leads to a reduction in the share of 40-45 years olds 20-years later. And since our previous results suggest that this category is significantly and negatively correlated with inflation, we should see an increase inflation 20 years after the war. This is indeed what we find. Furthermore, the finding remains robust even after controlling for other confounding factors and excluding the main participant countries in the wars. Similarly, we find that the lost birth rate is associated with lower inflation 10-15 years after the wars, again in line with our previous results.

Our findings are particularly relevant because the global population is set to age fast according to UN population projections. Over the next half-century, the share of the old will increase massively. According to the “interest rate misalignment”explanation, this will increase the natural rate and, if monetary policy does not adapt, will in turn lead to rising inflation. We estimate that in this case inflation would rise by approximately 3 percentage points on average. This is in sharp contrast to the past 50 years, where the increasing share of working age population lowered average inflation by around 3 percentage points. At the current juncture, the shrinking number of young cohorts largely offsets the effects of increasing number of old ones, keeping inflation low and stable.

The paper is available here.

Examples of intellectual brilliance and not

I just happened to read an amazingly brilliant review by Prof. Indira Rajaraman of Kaushik Basu’s autobiography. It was published on the 8th July 2021 in ‘The Wire’. It is a devastating review and it is so effective because it does so with minimal and deliberate effort. The reviewer simply draws upon all the hard work the author himself has put in and he certainly has worked hard. The analogy is that of batters using the bowler’s pace to get maximum runs. It is also a very important lesson in writing. In fact, in the process, we learn of what Dr. Indira Rajaraman thinks that CEAs should be doing:

The CEA is also head of the Indian Economic Service (IES), set up to generate a trained cadre of professional economists, with experience of the Indian system gained from working their way up the ladder. Basu found them a useful source for “so many tricky aspects of Indian policymaking that I still do not fully understand.  I have to keep calling them to explain things to me.” He is too modest to say what he did for them in return, by way of strengthening the service or enriching them intellectually. 

To frame successful policy in India, one has to be a fiscal plumber by profession, know budget heads and how funds flow and the points at which they can be covertly or overtly obstructed. One has to know that legislated limits on fiscal deficits have led to a number of stratagems, like delaying expenditures in seemingly legitimate ways. (Basu comments sarcastically on his wife Alaka’s struggles to extract her delayed salary from a public university: “Hats off, India”). Those delays result among other things in the high working capital requirements of Indian business.  The CEA is actually well positioned to get that kind of grunt work done, but sadly, many of them, unfamiliar as they were with the Indian system, or not interested in anything other than themselves, did not even know such work needed to be done.

I have been wanting to post a review of his article published on the 1st of February in ‘Project Syndicate’. The article is an attempt to predict which Asian countries would perform well, economically, in the coming decade. You can read it here. In the view of the author, India cannot be a growth champion for this reason:

Yet, fundamentally, India is one of the strongest emerging economies. It has a world-class information-technology sector, a strong pharmaceutical industry, and a small segment of highly educated workers. The stumbling block is the country’s divisive politics, which have eroded trust and caused the investment rate to fall steadily over the last few years.

I have no problem with his observation, per se. My agreement or disagreement is immaterial. He is proposing a hypothesis here, mind you: that eroding trust and divisive politics have caused the investment rate to fall. It is not a conclusion. For his hypothesis to be accepted as a serious argument or conclusion, I would have expected any good economist, worth his salt, to do is the following:

To prove that ‘divisive politics’ will drive growth or has driven investment away, I would have liked him to set up a criteria to establish what ‘divisive politics’ is, how he would measure it (number of communal incidents, number died, cases filed by the government against members of other religions, number of newspaper articles, number of google searches, whatever), show that under such criteria, which countries in the world have been divisive in past and for how long; how, in such periods, those countries suffered low growth, low investment (capital formation) and much else, etc.; how India qualifies to be a country of ‘divisive politics’ under the criteria he had set up and, therefore, how India would suffer a growth setback as long as India scored high on his index of divisiveness.

That is what I would expect my students to do, if they were advancing a hypothesis as an argument.

A forensic farewell to Andrew Haldane

Andrew Haldane, after more than three decades at the Bank of England, is going to foray into the world of art. His ‘goodbye’ speech delivered on the 30th June is as impressive as the man’s three-decade experience has been. His career is the dream of many who aspire to be in public policy. He has played a hand in monetary policy, in regulation, in forecasting. His speeches, particularly after the 2008 financial crisis, touched upon all aspects of modern finance and banking. His speeches were the equivalent of well-researched papers with lots of references, charts and data tables.

He also covered a wide array of topics in his speeches. Also, he made it a point to speak at many forums within the UK – from professional bodies to schools to colleges to labour union forums. He supported the initiative of students at the University of Manchester to refashion the economics curriculum. It did not bear fruit. But, he saw the need for addressing the problem at its roots – namely, economics education.

My disappointment – and it is a big one – with him is with respect to his attitude towards the ultra-loose monetary policy post-2008, especially its prolonged application, unmindful of effects, costs and unintended consequences. At the minimum, these needed to be assessed, estimated, discussed, considered and then accepted as premises for policy changes or continuity. Nothing of that sort was done in the UK or in the US. Considering how thoughtful he has been in many other areas, his failure reflected a stubborn and somewhat inexplicable blindspot, as far as I am concerned. Unfortunately, that comes through in the farewell speech as well. But, there are many, many useful elements as well.

I will copy and paste the interesting and controversial portions (in my view) with my comments below them:

At the end of this exhaustive process, the forecasts were sent around the Bank, as well as to HM Treasury.

There, I have it on good authority, they quickly became landfill (as recycling wasn’t an option at the time). Like the UK’s entry at Eurovision, the Bank economists’ contribution was spirited but ultimately pointless. The Bank’s analytical brain did not connect to any hands. John Kenneth Galbraith said that economics was extremely useful as a form of employment for economists. At the time, that was the Bank’s view too.

He is describing the process and the conclusion of the exercise of forecasting M4, money supply, for the UK. This is quite realistic and down-to-earth with a good touch of humour.

With my bag of nerves now full to overflowing, I peered through the fog of Rothmans to see Eddie staring back at me. Both eyebrows were raised. This was bad news. In central bank circles at the time, the double eyebrows was career-defining for all of the wrong reasons. Most of my subsequent 25-years has been managing that decline as gracefully as possible.

That is typical classic British understatement and humour combined. He is referring to the technological glitch that greeted his first presentation to the Bank of England’s monetary policy committee – the pre-MPC presentation made by the Economics Department. Eddie George was the Governor and smoking cigars in closed rooms was then permitted. Of course, Haldane’s career was anything but managing a graceful decline over a quarter century.

On the nominal anchor for monetary policy:

It is no coincidence that durability in monetary policy processes has been accompanied by improved
macro-economic outcomes. Since 1992, inflation has averaged 2% – exactly in line with target (to one decimal place) and 6 percentage points lower than in the preceding 25 years. The volatility of output has fallen by around half over the same period.footnote[6] Contrary to everyone’s expectations, inflation-targeting has lasted and delivered a twin-win, with greater stability on both the nominal and real sides of the economy.footnote[7] Given the UK’s previously chequered monetary history, this truly is a transformation.

Of course, there is a question about how much of this improved performance reflects good luck rather than good monetary management.

This is a huge disappointment although there is a small concession to honesty and intellectual openness in his contemplation of a possible role for good luck in ensuring ‘good macro-economic outcomes’. Second, what are good ‘macro-economic outcomes’. Is it just low and stable inflation rate? Did he not find out enough in the post-2008 research of the role played by leverage accumulated by financial institutions in precipitating and aggravating the crisis? If post-crisis efforts have attenuated the leverage in regulated entities (as he points out later), does it mean that the problem has been solved?

He, of all people, should know that if the price of debt is kept too low for too long, taking out all considerations of risk, the leverage does not vanish but goes elsewhere and possibly hidden, just as it was the case with financial institutions pre-2008 through opaque structures. Now, it must be hidden in some other crevices. Lack of acknowledgement of that possibility – a very high likelihood, in fact – is puzzling, to say the least.

In the next two pages (text of his speech), he details his concerns and reservations over the current monetary policy accommodation, post-Covid. Again, he states his concerns with inflation turning out to be higher and persistent. For a man who was the director in charge of financial stability, his apparent lack of concern over financial stability risks is remarkable. Perhaps, he knows more than I do about the state of play on financial stability in England and that he is very confident about it not being an issue. Perhaps. Nonetheless, it strikes me as odd and as a serious omission.

In any case, his inflationary concerns were well documented in his article for the ‘New Statesman’. See here.

He gets closer to the real risks in this paragraph but not quite:

A dependency culture around cheap money has emerged over the past decade. Only a minority of those with mortgages have ever experienced a rise in borrowing costs. Fewer still have significant inflation in their lived experience. Easy money is always an easier decision than tight money. But an asymmetric monetary policy reaction function is a recipe for a Minsky mistake. Having followed the right script on the way in, central banks now need to follow a different script on the way out to avoid putting 30 years of progress at risk.

The reason why he is not where he should be is because of this: what is happening now with the post-Covid response is a logical culmination of what was done post-2008. He should have seen this coming. The lesson that policymakers have drawn from the post-2008 policy response is that it was not enough. The dosage was weak, in their assessment. So, now they have upped it massively. They never have bothered to contemplate if it was the right medicine at all and if it was right to administer it for more than short-term demand management and to facilitate immediate recovery. Andy Haldane does not contemplate this question seriously either.

On financial stability:

I wrote a note and sent it to the Governors in 2005. It was titled “Public Policy in an Era of Super-Systemic Risk”. It made some bold claims about financial system resilience, most of which jarred with the prevailing orthodoxy…..I am still waiting for comments on my 2005 memo. With hindsight, one of my career regrets was not to make more of the results until it was too late. …As best I can tell, no-one got the crisis completely right, despite a number of people subsequently exhibiting supernatural powers of hindsight. Rather, the crisis illustrated the limits of our collective knowledge, our collective lack of imagination. It demonstrated that, in a world of uncertainty as distinct from risk, it is better to be super-safe ex-ante than super-sorry ex-post, better to be roughly right than precisely wrong.

Nice touch again on people with super-natural powers of hindsight. That apart, the certitude with respect to the application of post-2008 crisis monetary accommodation is at odds with the ‘limits of our collective knowledge’.

Recapitalising banks:

When UK banks were finally recapitalised that Autumn, around £65 billion was injected into them by the UK Government. Our calculations had been roughly right, good enough to save the ship. To this day, I believe that if greater amounts had been injected then – perhaps £100 billion? – UK banks would have been more willing to lend and the recovery would have been less anaemic. It would have been better to be super-safe ex-ante than super-sorry ex-post.

I wonder if this lesson has been lost on India since it continues to grapple with anaemic credit growth.

On Macro-prudential regulation:

The macro signalled two important ideological shifts from the past. First, banking needed to be managed at the level of the system as a whole, like any other eco-system. Second, as important as the resilience of the financial system was its interaction with the macro-economy to avoid adverse feedback effects between the two, such as credit crunches. Finance was to be servant of the economy, not master. This, truly, was a regulatory revolution.

He is making some important points. Finance sector interaction with the macroeconomy has been ignored for the better part of the last four decades. Before that it did not matter because finance was mostly bank-driven and banks were tightly regulated. But, once the underlying arrangement changed, regulation was far too slow to catch up. Indeed, the zeitgeist, 1980s onwards was no-or-lite regulation as the markets knew best. So, there was no question of regulation catching up at all. It was simply not in the race.

But, interaction with the macroeconomy is not just about credit crunches but also about credit excesses. Indeed, the latter has been a bigger problem leading to instability. Credit crunch is about risk aversion on the part of lenders and borrowers. Time overcomes them or higher bank capital or both. His omission of ‘credit excesses’ is conspicuous. It is very important that he mentions that finance has to be the servant of the economy and not the other way around. He deserves a shout-out for that. But, is it? To what extent post-2008 policies achieved that? Even if regulatory policy tried to establish that order, to what extent did monetary policy undermine that? Not only he does not pose those questions here but he has avoided them for the most part or, as far as I can remember, throughout the last decade.

I wonder whether central banks ignoring the quantity of money since the Eighties has also contributed to the problem of ignoring the feedback role of credit for the macroeconomy.

As you did not fight fire with fire, you did not fight financial complexity with regulatory complexity. That risked making a bad situation worse, a complexity problem squared rather than halved.

As a matter of principle, this is an important one to keep in mind. But, the devil is in the details or that the satan is in the specifics.

In the UK, the Vickers Commission reforms created a fire-break between banks’ services to the domestic economy and their other activities.

This too deserves praise. The UK might have done better than the USA in this regard.

The Global Financial Crisis had laid bare the costs of separating finance and the economy, the micro and macro – a separation that had also been a feature of the Bank in the past. Crisis needed to be the catalyst for change, forging a link between the Bank’s analytical brain and its regulatory hands.

The Financial Stability reports that many central banks are an acknowledgement of the financial and macro linkages. To the extent that central banks have dedicated brains and hands examining financial stability, it can only be a good thing. But, to what extent do they inform policy or if it is a case of form over substance, judgement has to be reserved until the blowback from the recent combined monetary and fiscal stimulus is felt and played out. In other words, the tide has to go out for us to spot those swimming naked. That might include the central banks too.

Crucial for the success of both the FPC and PRC is operational independence of decision-making, set in statute. Independence for financial regulation and supervision has received far less attention, analytically and practically, than on the monetary policy side. But, for me, the case for independence is at least as strong as for monetary policy.footnote[23] If anything, decisions on withdrawing the punchbowl are harder, and even more important, during raucous credit parties.

Andy Haldane does well to lay out the case for independence of the Financial Policy Committee and the Prudential Regulation Committee. But, withdrawing the punchbowl has to be done in a coordinated manner. It cannot be the case that the FPC and the PRC withdraw the punchbowl and the MPC puts it back. Again, strange that someone as experienced and as perceptive as Haldane is does not see the connection between the two.

Mission accomplished?

More than a decade on from the crisis, the financial system is a fundamentally different animal – leverage far lower, liquidity far higher.footnote[24] The UK’s largest banks’ activities are protected, additionally, by a ring-fence and systemic surcharges. While I still doubt big banks can fail safely, they are far less likely to inflict collateral damage on depositors and the wider financial system. In all of these respects, the regulatory reform agenda of the past decade has been strikingly successful.

And the benefits of this have already been felt. During the Covid crisis, the global banking system has lived up to the expectations set for them by Mark Carney at its start: they have been part of the solution, not the problem.

These observations are striking for they confirm the failure to connect monetary policy to financial stability. Indeed, if the earlier failure was one of refusing to see the feedback from finance to economics, now it seems to be the other way around.

Lending to real businesses:

Constrained credit to companies was, in turn, a potent factor behind the UK’s anaemic subsequent recovery….

These same fault-lines were re-exposed during the Covid crisis. The good news, this time around, was that large numbers of loans – in excess of one and a half million of them – were made to UK businesses by UK banks in the space of a few months. The bad news is that the vast majority of these loans would not have been made at that speed without a 100% guarantee from Government. Only by effectively nationalising SME lending were the Macmillan gaps bridged in crisis….

To my mind, what is needed to bridge the Macmillan gaps, durably and comprehensively, is the equivalent of a UK Development Bank, operating on a decentralised basis. As other countries have found, the scale and scope created by a Development Bank is necessary to reach SME start-ups and scale-ups across all sectors and all regions. The best time to have put in place a UK Development Bank would have been 1929. The second best time is now.

Many important points are made here. There are important omissions too. We will start with the latter. What was the point of ultra-loose monetary policies including QE if lending to businesses did not pick up, post-2008 and that the recovery was anaemic subsequently? What is the policy audit here? Should it not be done?

If, post-Covid, lending picked up only because there was 100% State guarantee – effective nationalisation of SME lending as he puts it, – to what extent did low interest rates play a role and if they did so at all?

Put differently, one of the ‘excuses’ for monetary policy to have played such a big role post-2008 was that fiscal policy did not step up to the plate. But, post-Covid, with fiscal policy kicking in big time, is there a need for monetary policy to be as big as well?

If the response is that borrowing cost would have risen too much without monetary policy underwriting the fiscal expansion, then does it not confirm the failure of the monetary policy post-2008 to create a durable recovery with productive asset creation? Indeed, the above extract is the most severest indictment of the post-2008 monetary policy. It also constitutes the biggest disappointment with Haldane’s personal failure to hold the post-2008 monetary policy accountable for its failure to achieve the economic goals which were never clearly spelt out in the first place.

It appears that it has been left to the Economic Affairs Committee of the UK House of Lords to ask some of the fundamental questions that one would have expected a man of Haldane’s experience and erudition to pose, at least now. I am yet to read the report. FT reports on it here and here.

[Somewhat independently, in the Indian context, there has been a development bank to cater to small businesses. That is the Small Industries Development Bank of India (SIDBI). But, has it accomplished its mission or does it continue to accomplish its mission? How should the mission be defined in the first place? Just amount of borrowing facilitated or refinanced? In quantitative terms, as a percentage of GDP and as a percentage of overall credit? Or, should it be about the number of micro enterprises that became small, medium or large, the number of small enterprises that became medium or large and the number of medium enterprises that became large, before and after the advent of SIDBI?]

On digital currency and its benefits

On financial stability, a widely-used digital currency could change the topology of banking fundamentally. It could result in something akin to narrow banking, with safe, payments-based activities segregated from banks’ riskier credit-provision activities. In other words, the traditional model of banking familiar for over 800 years could be disrupted…. Specifically, this could lead to a closer alignment of risk for those institutions, new and old, offering these services – narrow banking for payments (money backed by safe assets) and limited purpose banking for lending (risky assets backed by risky liabilities).

While this sounds reasonable, he proceeds to (deliberately) obfuscate the issue of negative interest rates on Central Bank Digital Currencies (CBDC). Read the following:

At root, the ZLB arises from a technological constraint – the inability to pay or receive interest on physical cash. This is a technological constraint that every form of money, other than cash, has long since side-stepped…. In principle, a widely-used digital currency could mitigate, perhaps even eliminate, this technological constraint. Specifically, CBDC would enable interest to be levied on central bank issued monetary assets or digital cash. The extent to which this relaxed the ZLB constraint depends, in addition, on the elasticity with which physical cash is provided to the public alongside CBDC. Access to physical cash is an issue well above the pay grade of central bank technicians; it is a political-cum-social issue…..

Nonetheless, the potential macro-economic benefits of easing the ZLB constraint are large and have grown over time. Studies suggest the ZLB constraint can result in significant shortfalls in output relative to potential (of around 2%) and inflation relative to target (of as much as 2 percentage points).footnote[31] These are potentially enormous gains in macro-economic terms. To those benefits needs to be added the gains to digital cash users of holding a remunerated instrument, helping protect their purchasing power.

He is conflating issues. Negative interest rates are about charging the lender. In physical cash, a central bank issues a zero coupon bond. The so-called ZLB is the inability of the central bank to charge the public an interest rate for issuing them physical cash even though cash is a central bank liability! What he is hinting at and not stating openly is that with digital currencies, he thinks that the issuance of currency notes can be done at negative rates of interest. In other words, public pays interest to hold paper currency in its wallets! Otherwise, it will all be CBDC. They can choose.

This brings to my mind the comment I posted on the article by Ken Rogoff in FT on negative rates. Brilliant minds are captivated by their own intellectual acrobatics. They lose sight of the forest for the mastery of the details of growing different trees. What is the tree for? What economic purpose does it serve? That too, after acknowledging that post-2008 policies did not lead to higher lending to businesses and that it was a government guarantee – effective nationalisation – that made the difference, post-Covid. Who benefits from negative interest rates? How big is the ‘cost of capital’ constraint?

On communication and transparency, Haldane deserves much credit for taking the Bank to the public and in de-mystifying it. He also rightly takes credit for bringing people with diverse backgrounds, experiences, etc., to the bank. Those are positives. But, on the issue of transparency which he does not go into, central banks have not struck the right balance between being transparent and non-transparent to financial markets. Again, like with many things, there is no discussion and there is no accountability, hence. Why is transparency needed? What public purpose does it serve? What are the costs? Is it still worth it, after considering the costs? There has never been an open and honest discussion of these questions.

To some extent, Haldane addresses the question of ‘transparency’ with a discussion on forward guidance:

The provision of public policy signals may dampen incentives among market participants to invest themselves in understanding the economy. These risks have I think been realised in practice, with forward guidance encouraging too much poring over central banks’ words and too little poring over the data on which monetary policy decisions are based. That is the wrong way around.

I think the drawback of ‘forward guidance’ or ‘policy transparency’ is not just one of dumbing market participants down. They seem to need not much incentive to do so, these days. It is also about encouraging excessive risk-taking which is what Alan Greenspan’s gradual normalisation of monetary policy achieved between 2004 and 2006. To a considerable extent, it played a role in fomenting capital market risk.

On ‘Forward Guidance’, Haldane concludes with the right advice:

My takeaway for forward guidance from this experience echoes my takeaway for the Bank’s approach to communications generally. Where possible, keep it short and simple. And focus the message on the needs of those shaping our economy, companies and households, not those trading financial instruments. [Emphasis mine].

He is heading over to head the Royal Society of Arts. As I stated at the beginning, there is much to envy in the career trajectory of Andrew Haldane. He steered clear of politics and did not conflate his policy competence with political ambitions. By all accounts, he has achieved a lot. There is much to admire and much to applaud. But, equally, there is much to criticise too for a fair and objective assessment of a man’s contribution to public policy has to encompass a much longer time line since policy itself makes its presence felt with a long and variable lag.

Scare-mongering boggles the mind

FT had uploaded a news article yesterday. It was both amusing and disappointing. If you are in a worse mood, you can call it ‘disgusting’. It is about the UK’s proposed relaxation of NPIs from Monday.

Amusement #1: ‘Global health experts’ in line 1 morphs into “The online event, organised by UK scientists opposed to ending the restrictions”.

Amusement #2: ” The prime minister is now caught in a political vice, with Tory MPs and rightwing newspapers urging him to strike out for “freedom”, while public opinion wants him to be far more cautious.”

Journalist Jemima Kelly (of FT!) had exposed the preference for caution revealed by ‘public opinion’. It should not be too difficult to find those articles. The Ipsos Mori poll findings depend on how the questions are asked.

Interested readers should check out the chart on total deaths and hospitalisations in the UK at worldometers.info.

Dr. Bienen is a public-health researcher at Oregon Health and Science University-Portland State University School of Public Health. Dr. Gandhi is an infectious-disease physician and professor of medicine at the University of California, San Francisco. Eric Happel contributed to this article. Their article in WSJ dated 15th July 2021 is well worth a read by FT journalists:

It is curious to know why FT is engaging in scare-mongering journalism avoiding a sober take on risks of opening up (vs. risks of not opening up), precautions to be taken and the thresholds for reimposing curbs. Just recently, the UK had warnings of potential deaths from cancer screening and treatment ignored.

Why it is far more important to avoid ‘death from Covid’ than death from cancer? What criteria did FT adopt to arrive that conclusion?

Financial journalists are so keen to tout transparency of policymaking as a virtue. But, can they practise a bit of it themselves? Can they make their criteria adopted to prioritise avoiding Covid-induced hospitalisations and deaths (not yet an issue now) transparent?


The new masters of the universe

An article that captures everything that has gone wrong with economics and economists before and since the financial crisis of 2008.  The article also confirms that they have not learnt much from the things that went wrong.
He may be right that a little inflation is no bad thing but he is assuming that central banks have the tools and the ability and the track record to stop it when and where they want it.
Were they able to generate inflation since 2008 no matter how valiantly they tried? Since the answer i NO, what gives us the reassurance that they would stop a raging inflation on its tracks without imposing huge costs on the economy, on asset markets, on debtors, etc.?
His paper on being able to impose negative rates on electronic money confirms one thing. Technically brilliant people will revel in finding technical answers to questions loaded with political economy, distributional and unintended consequences. They don’t have answers for those questions.
More importantly, they will also avoid answering the question of whether their proposed trick is the right solution to the problem being faced
As someone else has commented on the article, generating enough of unanticipated inflation is the Fed’s policy goal since the problem being addressed is the mountain of debt. Remember, that is what Charles Goodhart and Manoj Pradhan write as well in ‘The Great Demographic Reversal’.
Everything else is academic.

A cataclysmic climax

Just read Sohrab Ahmari’s article in unherd.com with the header, ‘President Kamala would destroy America’. Brilliant. What has not been discussed in the comments below and mostly passed over – and that is a pity – is the article’s reference to the lack of unity on the ‘Right’ that brings about the cataclysmic climax that it imagines. Well done!

So, in the end, it is all about the failure of leaders to put society above self – it just comes in different garbs, different ideologies, arguments and slogans.

If the article evokes derision, laughter, mirth or worse, it might be good to pause and also read this article in ‘Newsweek’.  This is about how Democrats are finessing the ongoing Cuban protests even though the Cuban protesters are black! Their lives don’t seem to matter.

If this too is not enough, then the observations of Andrew Sullivan about the Democratic Party and that of Shekhar Gupta about the Congress Party in India would help complete the picture:

(1) This is what Andrew Sullivan wrote in his ‘Weekly Dish’ column this weekend (10-11 July):

Or check out Kevin Drum’s analysis of asymmetric polarization these past few decades. He shows relentlessly that over the past few decades, it’s Democrats who have veered most decisively to the extremes on policy on cultural issues since the 1990s. Not Republicans. Democrats.


On immigration, Republicans have moved around five points to the right; the Democrats 35 points to the left. On abortion, Republicans who advocate a total ban have increased their numbers a couple of points since 1994; Democrats who favor legality in every instance has risen 20 points. On guns, the GOP has moved ten points right; Dems 20 points left.

It is also no accident that, as Drum notes and as David Shor has shown: “white academic theories of racism — and probably the whole woke movement in general —have turned off many moderate Black and Hispanic voters.” This is why even a huge economic boom may not be enough to keep the Democrats in power next year.

(2) This is what Sekhar Gupta wrote about the Congress Party in India in May:

The future of their party is now hard-Left. That’s why it allies with the Left Front and draws a blank while fighting it in Kerala. If only it had aligned with Mamata instead, on whatever terms, it might have had a clearer pitch against the Left in Kerala, a state it could have won. And may have won at least a few seats in West Bengal.

Anything would be better than zero. But this Congress is besotted with the Communists, especially the younger ones. For evidence, watch who runs their social media operations, and how.

Do the rich finance unproductive household debt?

A Chicago Booth school research review note (or article or brief) published in May talks of the research by Sufi, Mian and Straub on how the top 1% investment in Treasury bills, notes and bonds and deposits in financial institutions end up as household debt for the bottom 99% which is relatively and mostly unproductive. The paper is problematic because it is looking at at the wrong place for the causes. Both the phenomenon they describe – the wealthy ending up with too much wealth and hence cash to invest and the lower-income households taking on more debt – are traceable to a common factor. That is monetary policy of the Federal Reserve.

By training their guns on the top 1% – not that I have a particular problem with it – they are not holding the Federal Reserve accountable for perpetrating huge wealth and income inequality. 

Ultra-loose monetary policy through a combination of low interest rates and liquidity provision fuel asset markets. Rich hold assets and they are able to enhance the return on such asset holdings through leverage as well that low interest rates amply facilitate and amplify as well.

To the extent that extraordinarily loose monetary policies fuel a much greater rise in equity prices than in real estate prices, then monetary policy can boost the wealth of the top 1% or 10% compared to the rest of the 99% or 90% and that is what has been happening.

In fact, this was pointed out in a brief but useful essay in the BIS Quarterly Review of March 2016. The essay is titled, ‘Wealth inequality and monetary policy’. Some extracts:

While low interest rates and rising bond prices have had a negligible impact on wealth inequality, rising equity prices have been a key driver of inequality. A recovery in house prices has only partly offset this effect. Abstracting from general equilibrium effects on savings, borrowing and human wealth, this suggests that monetary policy may have added to inequality to the extent that it has boosted equity prices.

Considering the tails of the wealth distribution – not shown here – generally reinforces this picture. The share of securities holdings, equity in particular, tends to be even higher at the top 5% or 1% of the distribution. Conversely, housing accounts for a higher share in the lowest net wealth quintile, for which low net wealth is in many cases a reflection of high levels of mortgage debt. In a number of cases, net wealth is negative, suggesting that liabilities, in the form of mortgage, consumer and other debt, exceed assets.

Since 2010, high equity returns have been the main driver of faster growth of net wealth at the top of the distribution.

What is interesting is that this essay points out that even in Japan, which is one of the least unequal among advanced nations, ultra-loose monetary policy has played a part in fomenting a rise in equity prices and hence a rise in inequality. This is what footnote no. 16 of the essay says:

Frost and Saiki (2014) study the impact of unconventional monetary policy on income inequality in Japan in a vector autoregression (VAR) framework. Using household survey data, they find that quantitative easing widened income inequality, especially after 2008 when policy became more aggressive. They identify capital gains resulting from higher asset prices as the main driver.

Corporate businesses do not invest in productive assets in America. They used to do that a lot in other countries to save on costs. They engaged in share buyback and the managers paid themselves very well. Workers were laid off as production went offshore. Worker insecurity restrained wage growth. Workers made up for it through borrowings and mortgage debt thinking that the rising value of their homes would keep them safe and offset weak income growth.

Loans are fixed and legal obligations. Real estate prices can go up and down and hence low income households bore the brunt of the real estate crash of 2008. The cycle repeats.

To say that banks recycle the excess savings of the top 1% into unproductive debt for low-income households is to misunderstand how banks create assets. The authors have not taken into consideration BoE research published in 2014 and which is borne out by empirical research (Richard Werner) as well that banks do not wait for deposits to create assets. They create money and THEN create deposits, in its wake.

Banks engaging in real estate lending (what the authors call unproductive debt) is partly lazy banking. Real estate loans carry lower risk weight because they are collateralised (Alan Taylor, et al) and mortgage loans are easier to securitise and get off the books as well. Third and a weaker consideration is that real estate loans to lower income households also gets a relatively freer pass on politically correct considerations.

So, the paper rests on flimsy foundations or is empirically unfounded. The common problem is the excessive and prolonged reliance on monetary policy to drive long-run economic performance as opposed to using them as short-run business-cycle management (or, aggregate demand management) tools.

Second, the review states:

Mian, Straub, and Sufi lean toward the global savings glut theory. Mian and Sufi argue in 2018 research that a rapid flow of foreign funds into the US triggered a credit-supply expansion that boosted household debt, which they say was a major factor in igniting the financial crisis.

This too is problematic and faulty. There are proximate and seemingly logical causes and there are longer-term considerations. Foreign funds flowed to America because extremely low US interest rates caused a surge in the value of other currencies against the US dollar. The ‘too-much-too-quick’ appreciation met with natural and unsurprising resistance from other countries. They accumulated foreign exchange reserves and those reserves were deployed in US Treasury and agency debt, etc. Even in stocks. Again, the underlying cause and the proximate cause are different.

Third, the authors appear to have recycled stale and impractical solutions to the problems that they had identified. Given that the problem identification was wrong, naturally the solutions were superficial too:

Their proposed solutions involve taxation—either a more progressive tax system or a wealth tax—through which the government can finance spending and investment, or redistribution programs that benefit lower-income households. 

The review does well to point out, citing other researchers, the practical difficulties of implementing a wealth tax:

As of 1990, there were 12 countries in Europe taxing net wealth, but now that is down to Norway, Spain, and Switzerland. When France did away with its version in 2018, the prime minister said it had caused many millionaires to flee. 

That is why any proposal to tax the wealth of the rich has to come from the rich themselves as part of a broader social compact. But, that is the stuff of fantasy and dreams these days, for the most part.

The practical suggestion:

Research by Booth’s Eric Zwick and Princeton’s Owen Zidar suggests that reforms such as rolling back special deductions for pass-through businesses, which they say collectively generate more taxable income for the top 1 percent than do big C corporations, could be a key part of a tax plan that raises up to $5 trillion over the first decade of implementation. Pass-through businesses typically include medical and law practices and other types of consultancies.

This makes sense. I do remember reading about the magnitudes of these pass-through in ‘The Captured Economy’ by Brink Lindsey and Steven M. Teles. Perhaps, it is a relatively unheralded book. It offers specific solutions and backs up its assertions with data and evidence. In a way, it provides the all-important evidential backing for the assertion that capitalism needs to be saved from capitalists.

In conclusion, one can speculate on why academics, in general and for the most part, tend to give a free-pass to central bankers. But, it is, well, speculative. Further, to be fair, it is not just academics who give a freer pass to fellow academics. This piece by Daniel Moss in Bloomberg on the (subtle or not) policy shift by the European Central Bank is proof that the cosy network is bigger and wider.

Shareholder capitalism and consumer welfare

Dr. Sumita Kale drew my attention to the article on Big Tech and anti-trust in the Wall Street Journal by Greg Ip via the newsletter she gets from ‘foundingfuels.com’. The name rang a bell. I had met Charles Assissi in the annual Aavishkaar-Intellecap led Sankalp Forum in 2018 (I think). He was talking about it, then. Glad to see it up and running.

The article by Greg Ip was interesting. It is great discussion material in economics and in public policy classrooms. Perhaps, in business schools too.

I did not know that Robert Bork was the counterpart to Milton Friedman on shareholder capitalism. The latter argued that the mission of companies was only shareholder returns. Bork appeared to have argued that the only thing that would militate against size was consumer welfare. If that was not affected, then size did not matter. That is the view that most judges have taken since the 1980s. I am not convinced of that logic.

Equally, I am not convinced of Greg Ip’s argument that it is about democracy. Questioning bigness is not a political issue as he is making out to be. Stakeholders, if broadly defined, go beyond shareholders. Similarly, size goes beyond consumer welfare. Suppliers, workers, small entrepreneurs and start-ups are part of the economic system.

Andrew Haldane argued that ‘Theory of Moral sentiments’ was a book for the 21st century as much as ‘The Invisible Hand’ became a book for the 20th century.

This is part of the foreword he wrote for the report on economics education by the Post-Crash Economics Society at the University of Manchester:

It is time to rethink some of the basic building blocks of economics. And in this rethink we could do worse than return to Adam Smith. For just prior to the Wealth of Nations, Smith had produced a rather different book. It was called The Theory of Moral Sentiments and was published in 1759.
In it, Smith emphasizes cooperation, as distinct from competition, as a way of satisfying society’s needs. It places centre-stage concepts such as reciprocity and fairness, values rather than value.
If the Wealth of Nations was the book for the 20th century, the Theory of Moral Sentiments may be the book for the 21st.

Whether it is shareholder returns or stakeholder returns or small or big sizes, there is no capitalism without fairness. Every other argument is obfuscation.

Hurting more than helping

‘Economic Times’ headlines a story from Bloomberg as such: ‘Hunger crisis forces even middle-class Indians to line up for rations’. Sure, the click-bait approach worked. A knowledgeable friend shared it in the morning. I read it just now. It is lame. It underwhelms. It is based on anecdotal stories, a stray remark here and there, dog’s whistles, innuendo and the citing of a research report that has been flogged for over three months now, by all comers.

When one sees the headline, one expects to see a substantial large sample-size based survey from several states of PDS food purchases which was very different from what had gone on before, in the pre-pandemic years.

Stories such as these hurt the underlying cause of helping the Covid-affected India’s poor and low-income classes from reclaiming their livelihoods rather than helping them. Policymakers will be vindicated in their cynicism of such sensational stories that are meant to shock readers rather than inform them or policymakers and serve as reliable weather-vane or dipsticks on the economy.