The Thiruvadanthai trilemma

Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:

Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).

I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!

The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.

Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.

Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.

That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.

Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.

Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.

So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.

Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.

In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.

In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.

If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.

If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.

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Only one firm matters

An extraordinary proportion of people with training and experience in finance have worked at the highest levels of every recent presidential administration. Four of the last six secretaries of the Treasury fit this description. In fact , all four were directly or indirectly connected to one firm: Goldman Sachs. This is hardly the historical norm : of the previous six Treasury secretaries, only one had a finance background .

In 2001, following revelations of accounting irregularities, Enron verged on collapse, which meant that Citigroup, a major lender, would lose a significant amount of money. Fulfilling a request made by Michael Carpenter, head of Citigroup’s investment banking unit, Rubin called Peter R . Fisher, then undersecretary of the Treasury and asked him to consider advising the bond – rating agencies against an immediate downgrade of Enron’s debt. In other words , Rubin (a Democrat ) lobbied Fisher (a Republican ) to help bail out Enron. ( So much for Washington’s ideological divide.)

What Rubin did was technically legal, as The Economist explained, only because Bill Clinton , in his last days as president , had canceled an executive order that barred top officials from lobbying their old departments for five years after leaving office.

Source: Zingales, Luigi. A Capitalism for the People: Recapturing the Lost Genius of American Prosperity (p. 68). Basic Books. Kindle Edition.

Today, of course, there is far more money riding on the models than in the 1980s – and when it comes to positive feedback, size matters. Indeed, another example of positive feedback is the relationship between the financial sector and regulators. As the sector increases in size, it gains more influence over the government; this allows it to change regulations in its favor, which allows it to grow even larger, and so on, until it becomes Goldman Sachs.

  • Sometimes called Government Sachs, because of the remarkable ability of its alumni to go straight into senior levels of government, perhaps related to the fact that the firm is a leading corporate donor to political campaigns (Baram, 2009). It is even better represented at central banks. Four of the Federal Reserve’s 12 regional banks  are currently headed by former Goldman Sachs executives. Only five banks have voting power, in a rotating fashion, and in 2017 ex-Goldmanites will hold four of these votes. Together with Mark Carney at the Bank of England and Mario Draghi at the European Central Bank, this means that interest rate decisions for much of the world’s economy are made by people who came from a single firm. Nothing to see here, move along.

Source: Wilmott, Paul; Orrell, David. The Money Formula: Dodgy Finance, Pseudo Science, and How Mathematicians Took Over the Markets (Kindle Locations 4524-4527). Wiley. Kindle Edition.

Steve Bannon on capitalism

In 2014 he did a live Skype interview for a conference on poverty at the Vatican. BuzzFeed ran it during the campaign under the headline “This Is How Steve Bannon Sees the Entire World.”

It shows an interesting mind at work.

The West is currently facing a “crisis of capitalism,” he said. The world was able to recover after the world wars in part thanks to “an enlightened form of capitalism” that generated “tremendous wealth” broadly distributed among all classes. This capitalism was shaped by “the underlying spiritual and moral foundations . . . of Judeo-Christian belief.” Successful capitalists were often either “active participants in the Jewish faith” or “active participants in the Christian faith.” They operated on a kind of moral patrimony, part tradition, part religious teaching. But now the West has become more secular. Capitalism as a result has grown “unmoored” and is going “partly off track.”

He speaks of two “disturbing” strands. “One is state-sponsored capitalism,” as in China and Russia. We also, to a degree, see it in America. This is “a brutal form of capitalism” in which wealth and value are distributed to “a very small subset of people.” It is connected to crony capitalism. He criticizes the Republican Party as “really a collection of crony capitalists that feel they have a different set of rules of how they’re going to comport themselves.”

The other disturbing strand is “libertarian capitalism,” which “really looks to make people commodities, and to objectify people, and to use them almost.” He saw this strand up close when he was on Wall Street, at Goldman Sachs . There he saw “the securitization of everything” and an attitude in which “people are looked at as commodities.”

Capitalists, he said, now must ask: “What is the purpose of whatever I’m doing with this wealth? What is the purpose of what I’m doing with the ability that God has given us . . . to actually be a creator of jobs and a creator of wealth?”

With both these strands, he says, the middle class loses ground. This has contributed to the “global revolt” of populism and nationalism. That revolt was fueled, too, by the financial crisis of 2008. None of those responsible on Wall Street were called to account: “No bonuses and none of their equity was taken.” The taxes of the middle class were used to bail them out. [Link]

This was taken from Peggy Noonan’s recent column in WSJ. Her column is titled, ‘Declarations’. The paragraphs capture the views of Steve Bannon on capitalism. Did not know that he used to be associated with Goldman Sachs too.

I would not characterise it as an ‘interesting take on capitalism’ as Peggy Noonan has done. It is a rather correct/apt view on capitalism. Clearly, a thinking man whom President Trump appears to have dumped in favour of his son-in-law, Jared Kushner. I hope appearances are deceptive.

Shareholder value maximisation

Just managed to read two white papers that James Montier had written in March. One was titled Six Impossible Things to do before breakfast’. He decided to disagree with his Chief Investment Officer, Ben Inker. My sympathies lie with James Montier. I wrote a short piece in January for MINT as to why this time might not be different as Ben Inker and Jeremy Grantham had been inclined to argue, lately. To be clear, there is no presumption that I am right (or James Montier is) and that they are wrong.

The other piece (slightly longer but not very and eminently readable, in any case) was about secular stagnation and neo-liberalism. Again, no marks for guessing where my sympathies lie. I am fully on board with James Montier. If you are reading it, do not miss footnote no. 12.

I was interested in the paper by Asker, et al that James Montier had cited. One complaint about Montier’s pieces is that the references are not fully cited. Not that one is complaining that these good pieces are being made available for free (just a registration required at http://www.gmo.com) and second, it is not that difficult to locate the cited works.

Asker’s piece (co-authored) is about private firms (unlisted) investing more than listed firms in the United States. Very interesting and useful empirical work. Shareholder Value Maximisation has been reinterpreted as Short-term Stock Price Manipulation, in reality and it runs counter to long-term Enterprise Value Added. Only capital investment generates long-term returns and not financial engineering.

All of these are the natural fallout of the neo-liberal agenda that has been in place since the Eighties to which the monetary policy of the Federal Reserve has contributed greatly.  Few at the expense of many and markets at the expense of society.

You can find Asker’s paper here and a presentation on the paper here.

One thought that Donald Trump would fix it, considering how effective and rousing his last campaign advt. was. But, it appears that it is all unravelling too fast. Well, that sad story is another subject for another occasion.

Why is finance pro-cyclical?

There are many explanations to this. I discuss them in my classes. But, a nice and elegant explanation was offered by Mr. Fabrizio Saccomanni, former Minister of Economy and Finance in Italy at a BIS Special Governors’ Meeting in Manila in February 2015 and I quote:

As I have argued in the past (Saccomanni 2008), although global financial intermediaries operate in a highly competitive environment, they have uniform credit allocation strategies, risk management models and reaction functions to macroeconomic developments and credit events. Thus, competition and uniformity of strategies combine, in periods of financial euphoria, when the search for yield is the dominant factor, to generate underpricing of risk, overestimation of market liquidity, information asymmetries and herd behaviour; in periods of financial panic, when the search for safe assets is predominant, they combine to produce generalised risk aversion, overestimation of counterparty risk and, again, information asymmetries and herd behaviour. [Link]

Nice. I like it. The statements are testable hypotheses. I like it because I have long held the view that competition in the financial services industry is not the same as competition elsewhere in the real world. That does not mean that the optimal number of firms in the banking industry is ONE but that competition requires regulation and ‘leaning against the wind’ norms – countercyclical credit buffers come to mind – to ensure that competition in the banking industry is not welfare-subtracting for the economy.

What to do about spillovers?

Our results provide new insights. We find economically and statistically significant spillovers from the United States to EMEs and smaller advanced economies. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify.

We also find that monetary spillovers take place under both fixed and floating exchange rate regimes, which lends some support to the conjecture in Rey (2013, 2014) that the global financial cycle constrains monetary policy irrespective of the exchange rate regime.

From a policy perspective, our findings suggest that neither are interest rates fully independent nor is monetary policy fully unconstrained when economies and financial markets are closely integrated. Even under flexible exchange rates, central banks – though technically able – seem to find it difficult to conduct a monetary policy that is based purely on domestic factors and which ignores monetary developments in core advanced economies. Furthermore, our findings also shed some light on the causes of the persistently low interest rates that have prevailed globally over the past seven years. Back-of-the-envelope calculations based on our results suggest that easy monetary conditions in the United States have exerted considerable downward pressure on interest rates elsewhere. [Link]

These are from the paper, ‘International Monetary Spillovers’ published in the 3Q2015 Quarterly Review of the Bank for International Settlements.

In his Per Jacobsson Memorial Lecture in 2012, Dr. Y.V. Reddy recognises the difficulty of managing spillovers but does not offer solutions:

Public policy is conducted at the national level, but at the same time, globalisation of economies, often driven by technology, is a reality, and the global macroeconomic environment is an outcome of national policies in a framework of nebulous global governance arrangements. The challenge for national central banks is to find space for the conduct of their own policies in an increasingly inter-dependent global economy.

Too much global policy coordination might lead to the universalisation of risks of policy mistakes. The main contention is that good finance is essentially a function of good economic policies, and such good policies are primarily national, though significantly impacted by the global macroeconomic environment – which, as already mentioned, is not a product of design. [Link]

This is interesting, however:

It is true that successful arrangements for global coordination while retaining space for national public policies are working well in certain sectors, such as aviation, telecoms and the internet. But they seem to get into difficulties in regard to macroeconomic policies and finance. Clearly, there is a need to explore why global agreements work reasonably well in some sectors, leading to acceptable and assured outcomes, while when it comes to macro policies and finance such agreements appear difficult to arrive at – and what we can learn from them.

The spillover issue suggests a few solutions in no particular order of importance or categorisation into financial, macro, domestic and global.

(1) Selective and time-bound application of capital controls and quantitative restrictions including the use of higher risk weights for bank exposure to sectors receiving too much credit and equity – from domestic and foreign sources

(2) Regular, gradual and moderate foreign exchange reserve accumulation

(3) Bailing-in of creditors during banking crises. Living wills and insurance funds from premiums paid by banks can be part of the solution

(4) Encouraging domestic consumption and gradually lower reliance on U.S. consumer

(5) United States to de-emphasise the importance of asset prices for macro-economic growth and stability. The Federal Reserve assigns too much weight to the wealth effect transmission to macro aggregates, especially from the stock market. That has resulted in many other problems too, including the leaking of insider information on a systematic basis to financial institutions, investors and the media.

In other words, the United States needs a new monetary policy framework that incorporates financial cycles and financial stability and not just employment, price stability and stability of long-term interest rates.

(6) United States to conduct more symmetric monetary policy than now

(7) Federal Reserve to obsess far less about managing and minimising market volatility

(8) Less emphasis on forward guidance and transparency in the monetary policy framework of advanced countries. This will moderate risk taking in financial markets which are globally integrated and hence the risk-taking goes global. To the extent they are restrained in the United States, the restraint will also spill over to capital markets around the world. This is a virtuous spillover. Indeed, this is the logic behind suggestions (5) to (7) too.

(9) Higher capital requirement for banks. This will restrain endogenous money creation by banks. That will, in turn, moderate credit and capital flows to emerging economies.

(10) Re-introduction of separation of retail-commercial from investment banking. Same outcome as in (9) as it will moderate risk taking by financial institutions.

(11) This last one is admittedly a hypothesis. For many reasons – benign and not-so-benign – policymaking in the United States is captured by China. One of the benign explanations is that, for U.S. policymakers, China has become another ‘Too big to fail’ institution. Hence, their nervousness about conducting normal monetary policy. One more reason for asymmetric monetary policy. This results in a sub-optimal monetary policy in the United States which is then transmitted to the rest of the world with integrated and pro-cyclical capital markets.

Postscript: the possibility of a multi-polar world of currencies must be deemed remote now. China’s yuan might be part of the SDR basket. But, it is unlikely to be an international currency. China does not have the stomach for it. Its actions in recent years have demonstated that its penchant for control overrides the objective of internationalisation. The Euro is unlikely to become an alternative, ever.

Hence, the reform of the American monetary policy framework is the only hope. Will the Chinese ‘capture’ of American policy in benign or not-so-benign ways end?

Will the Trump administration rise to the challenge on both? My answer, five months ago, would have been more optimistic than it is now.

(For completeness, you can find Raghuram Rajan’s suggested solutions for the spillover problem in his speech delivered in New York in May 2015).

Financialisation is hale and healthy

There was so much talk about revolving doors between Wall Street and regulators. Mervyn King who wrote so eloquently about banks in ‘End of Alchemy’ ended up an advisor to Citigroup. Willem Buiter who was in the MPC in BoE did the same. Former Heads of Government do the same. Robert Zoellick and Robert Rubin come to mind. Former as Goldman Sachs advisor and the latter in Citigroup.

It is not for nothing that financial firms pay huge sums to have these people in their rolls. The latest is Blackrock that has agreed to pay a very generous sum to George Osborne, former British Chancellor, for very little work. The story is here.

So, the dominance of Finance has not really ended. The fight still has to be made and the road ahead remains long.

This blogger makes some good comments:

What are they buying? It’s not his economic expertise – he’d struggle to get a minimum wage job on that account – nor even his contacts. Instead, BlackRock is offering an incentive to the world’s finance ministers. It’s telling them that they too can get big money if they behave themselves in office*.

Such behaviour consists of giving the industry a favourable tax regime, lightish regulation, and ensuring a good flow of easy money. Osborne’s policy of fiscal conservatism and monetary activism had the effect of boosting asset prices (pdf), to the benefit of firms like BlackRock**.

It’s through mechanisms like this that capitalists gain undue influence over the state: there of course several other mechanisms, not all of which are exercised consciously or deliberately.

This influence isn’t perfect – we’d probably not have had Brexit if it were – but it exists. The idea that democracy means equality of political power is a fiction in capitalism.

You might think this is a Marxist point. I prefer, however, to think of it as a Cohenist one:

Everybody knows the fight was fixed
The poor stay poor, the rich get rich

Except that not everybody does know the fight is fixed, because the question of how capitalist power is exercised – like other questions such as whether capitalism impedes productivity or whether hierarchy is justifiable – is not on the agenda. But then, the issue of what gets to be a prominent political question and what doesn’t is another way in which power operates to favour capitalists.

I like this blog. Just ‘stumbled’ upon it. Don’t remember how. Even this post is a simple one and it makes sense.