Jhong-Wha Lee & Ju Hyun Pyun argue that globalisation (specifically growth in trade) reduces the probability of conflict:
"The results may derive from the fact that an open global trading system will prevent a state from initiating a war against any trading partner because other trading partners in global markets prefer to do business with a "peaceful" player. Hence, global trade openness of the dyad can reduce the incentive to provoke a bilateral conflict. We also think that open states can be more peaceful because they become more susceptible to political freedom and democracy. They apply international law better and employ good governance. Trade openness can also lead to an "expansion of bureaucratic structure," which concerns itself with economic interests in addition to security interests — and is thus less likely to support military action."
Does that mean "engagement" is better than "sanctions"? Shall we then engage more with Iran, Myanmar and North Korea?
Jon Danielsson says more regulation is not the answer for financial market reform:
"In a financial crisis, where financial institutions are required by regulations to hold minimum capital, just that fact is destabilising. If asset prices are falling, the financial institutions need to sell high-risk assets which depress the price and therefore by itself erode their capital. This is why risk-sensitive capital increases systemic risk and forces banks to withdraw lending...Indeed, the banks are now doing what they are supposed to do. They are being prudent. It is a bit disingenuous of regulators and politicians demanding that the banks increase lending when the banks are just following the regulations designed by the very same regulators and approved by the very same politicians."
Friday, March 27, 2009
Thursday, March 26, 2009
Exchange Rate Policy 3: Equilibrium exchange rates
How does one tell whether an exchange rate is over- or under-valued? Driver and Westway (2004)* lists 11 different methodologies on how to do this. If you recall from my first exchange rate policy post, structural models have the potential for making this determination. The insight into using these types of models is that exchange rates are affected by many factors, not just one or two, i.e. currencies should move in relation to the underlying fundamentals of an economy. If this sounds familiar, it’s because this is a common refrain of Tan Sri Zeti when talking about the level of the MYR. By implication, the fundamental equilibrium view rejects the concept of purchasing power parity or PPP, or alternatively that the PPP changes across time (depending on which model you use).
*Rebecca L Driver & Peter F Westaway, "Concepts of equilibrium exchange rates", Working Paper no. 248, Bank of England (2004). Link is here - warning! PDF link.
Which fundamentals are important to which currency can be radically different – a lot of the time spent in specifying these models is determining which variables actually matter. For instance, for countries like Malaysia with strong natural resources, commodity prices are an obvious starting point, although there are many more factors to take into account. A non-exhaustive list of fundamentals would include:
1. Government consumption, which is presumed to fall more on non-tradables. Higher government consumption in that case should in theory (through the Balassa-Samuelson Hypothesis) cause an appreciation of the exchange rate;
2. Relative real interest rates, where higher rates cause appreciation;
3. Openness to trade, where higher openness allows for greater tradable goods arbitration. This will equate to a depreciation of the exchange rate;
4. Net foreign assets, which measures capital stocks. A typical approach is to take changes in stocks as the variable i.e. a flow approach using changes to the current account, or the international investment position. The impact depends on the policy stance and structure of the economy – where economic growth is slower, a higher net foreign asset position implies greater income flows which result in an appreciation. However, empirical evidence suggests in high growth periods or for fast growing developing economies, capital inflows can appreciate the currency despite decreasing the net foreign asset position;
5. The terms of trade, which measures the price of exports in terms of imports. The result on the exchange rate here depends on the relative strength of income and substitution effects, although the empirical evidence suggests the former. This implies an appreciation of the exchange rate;
6. Relative productivity, both internal (between the non-tradable and tradable sectors) and external (in tradables). Higher international productivity in the tradable sector suggests a depreciation, while higher productivity in the tradable sector relative to the non-tradable sector implies an appreciation;
7. Demographic structure, such as the dependency ratio.
I have seen a lot of variations and proxy alternates in the variables used, some due to specific country effects and others due to data limitations. Some of the variables, such as trade openness, are subjective. Government consumption sometimes is not significant, but the government deficit might if borrowing is primarily external.
The different modeling approaches also yield different estimates of the equilibrium value of the exchange rate. There is in fact no single, correct way to go about this. The consensus is to always apply two or three different modeling approaches, which should give a good ballpark figure as to how far a currency is off its “true” equilibrium value. If on the other hand all the models are pointing in one direction, then that is something our fictional central banker has to take seriously. In terms of actual use, I would take the following three models as the most prevalent:
1. Macroeconomic Balance model (MBM) – measures the difference between projected medium term current account balance with an estimated equilibrium current account balance.
2. External sustainability model (ESM) – a variant of the MBM model, but measures the difference between actual current account balances with the balance that would stabilise the net foreign asset position at some benchmark.
3. The Reduced Form Structural Model – equates the medium term equilibrium exchange rate as a direct function of medium term fundamentals. The term "reduced form" indicates that variables that don't impact the exchange rate are dropped from the specification i.e. these aren't "full" structural economic models.
These are the models in general use by the IMF* in assessing currency misalignments, and where possible all three are calculated to get a balanced view of a currency’s equilibrium position. I’m not about to lay out in any length of how the models are calculated – even within the broad categories above, you can use different statistical approaches in the estimation, and results may vary according to the sample period chosen as well as the presence of any structural breaks.
* Press statement here, PDF document here
Neither is data gathering a trivial exercise. If you take the 15 currencies I’m using in my short term broad MYR index, that means you have to have the required data for all the variables for all the currencies involved, and in the correct frequencies for the full sample period selected. Secondly, some of the theoretical concepts don’t translate well to real world data – such as for example trade openness – which requires using some form of proxy. Third, some data is just not collected, or available for limited periods or not accurately measurable, such as net foreign assets. There’s thus a lot of room for specification error and measurement error.
Even with those caveats, there’s still no alternative to making the attempt at measuring currency misalignments. Any currency that is not following a full free float with open capital account regime can get into serious misalignment problems, with potentially expensive adjustments required to regain equilibrium either through currency adjustments, real economy adjustments or both. The worse case of course, is when these adjustments are imposed by the market, as we saw in 1997-98.
This naturally takes us to the choice of exchange rate regime, which will be covered by the next post.
*Rebecca L Driver & Peter F Westaway, "Concepts of equilibrium exchange rates", Working Paper no. 248, Bank of England (2004). Link is here - warning! PDF link.
Which fundamentals are important to which currency can be radically different – a lot of the time spent in specifying these models is determining which variables actually matter. For instance, for countries like Malaysia with strong natural resources, commodity prices are an obvious starting point, although there are many more factors to take into account. A non-exhaustive list of fundamentals would include:
1. Government consumption, which is presumed to fall more on non-tradables. Higher government consumption in that case should in theory (through the Balassa-Samuelson Hypothesis) cause an appreciation of the exchange rate;
2. Relative real interest rates, where higher rates cause appreciation;
3. Openness to trade, where higher openness allows for greater tradable goods arbitration. This will equate to a depreciation of the exchange rate;
4. Net foreign assets, which measures capital stocks. A typical approach is to take changes in stocks as the variable i.e. a flow approach using changes to the current account, or the international investment position. The impact depends on the policy stance and structure of the economy – where economic growth is slower, a higher net foreign asset position implies greater income flows which result in an appreciation. However, empirical evidence suggests in high growth periods or for fast growing developing economies, capital inflows can appreciate the currency despite decreasing the net foreign asset position;
5. The terms of trade, which measures the price of exports in terms of imports. The result on the exchange rate here depends on the relative strength of income and substitution effects, although the empirical evidence suggests the former. This implies an appreciation of the exchange rate;
6. Relative productivity, both internal (between the non-tradable and tradable sectors) and external (in tradables). Higher international productivity in the tradable sector suggests a depreciation, while higher productivity in the tradable sector relative to the non-tradable sector implies an appreciation;
7. Demographic structure, such as the dependency ratio.
I have seen a lot of variations and proxy alternates in the variables used, some due to specific country effects and others due to data limitations. Some of the variables, such as trade openness, are subjective. Government consumption sometimes is not significant, but the government deficit might if borrowing is primarily external.
The different modeling approaches also yield different estimates of the equilibrium value of the exchange rate. There is in fact no single, correct way to go about this. The consensus is to always apply two or three different modeling approaches, which should give a good ballpark figure as to how far a currency is off its “true” equilibrium value. If on the other hand all the models are pointing in one direction, then that is something our fictional central banker has to take seriously. In terms of actual use, I would take the following three models as the most prevalent:
1. Macroeconomic Balance model (MBM) – measures the difference between projected medium term current account balance with an estimated equilibrium current account balance.
2. External sustainability model (ESM) – a variant of the MBM model, but measures the difference between actual current account balances with the balance that would stabilise the net foreign asset position at some benchmark.
3. The Reduced Form Structural Model – equates the medium term equilibrium exchange rate as a direct function of medium term fundamentals. The term "reduced form" indicates that variables that don't impact the exchange rate are dropped from the specification i.e. these aren't "full" structural economic models.
These are the models in general use by the IMF* in assessing currency misalignments, and where possible all three are calculated to get a balanced view of a currency’s equilibrium position. I’m not about to lay out in any length of how the models are calculated – even within the broad categories above, you can use different statistical approaches in the estimation, and results may vary according to the sample period chosen as well as the presence of any structural breaks.
* Press statement here, PDF document here
Neither is data gathering a trivial exercise. If you take the 15 currencies I’m using in my short term broad MYR index, that means you have to have the required data for all the variables for all the currencies involved, and in the correct frequencies for the full sample period selected. Secondly, some of the theoretical concepts don’t translate well to real world data – such as for example trade openness – which requires using some form of proxy. Third, some data is just not collected, or available for limited periods or not accurately measurable, such as net foreign assets. There’s thus a lot of room for specification error and measurement error.
Even with those caveats, there’s still no alternative to making the attempt at measuring currency misalignments. Any currency that is not following a full free float with open capital account regime can get into serious misalignment problems, with potentially expensive adjustments required to regain equilibrium either through currency adjustments, real economy adjustments or both. The worse case of course, is when these adjustments are imposed by the market, as we saw in 1997-98.
This naturally takes us to the choice of exchange rate regime, which will be covered by the next post.
Department of "Huh"?
Apologies to Brad DeLong for the title, but this op-ed in the Star had me scratching my head:
Control speculative trading in commodities
Making a Point - By Jagdev Singh Sidhu
Quote:
"The price of crude oil has been kept from falling through a combination of planned supply cuts by oil-producing cartel Opec to meet an anticipated reduction in demand in 2009, and the hope of demand increasing as the global economy recovers...The argument is that too low a price will mean trouble for the energy markets as higher costs have already seeped into the business. Refining costs have gone up and so too have exploration and drilling costs over the past few years as oil companies venture off the deeper waters and harder-to-access places in search of the commodity."
This is an argument that the current highish oil price is being supported by a restriction in supply as well as a higher cost structure - an argument based on fundamentals.
This is then followed by:
"Plans to limit excessive speculative trading in commodities by hedge funds must be carried through and enforced. The world doesn’t need higher priced commodities raising inflation, hitting the public’s wallets and slowing any recovery in the economy."
This suggests that speculators are driving up the price of oil - an argument based on market manipulation. So which is it? Given the current deleveraging and risk aversion going on, does anybody have the stomach for "speculating" at all?
Control speculative trading in commodities
Making a Point - By Jagdev Singh Sidhu
Quote:
"The price of crude oil has been kept from falling through a combination of planned supply cuts by oil-producing cartel Opec to meet an anticipated reduction in demand in 2009, and the hope of demand increasing as the global economy recovers...The argument is that too low a price will mean trouble for the energy markets as higher costs have already seeped into the business. Refining costs have gone up and so too have exploration and drilling costs over the past few years as oil companies venture off the deeper waters and harder-to-access places in search of the commodity."
This is an argument that the current highish oil price is being supported by a restriction in supply as well as a higher cost structure - an argument based on fundamentals.
This is then followed by:
"Plans to limit excessive speculative trading in commodities by hedge funds must be carried through and enforced. The world doesn’t need higher priced commodities raising inflation, hitting the public’s wallets and slowing any recovery in the economy."
This suggests that speculators are driving up the price of oil - an argument based on market manipulation. So which is it? Given the current deleveraging and risk aversion going on, does anybody have the stomach for "speculating" at all?
Tuesday, March 24, 2009
Exchange Rate Policy 2: Measurement
In Malaysia, it’s common to take the bilateral rate of the Ringgit (MYR) against the US Dollar (USD) as the exchange rate. This is understandable because not only does Malaysia have substantial trade links with the USA, the USD is important as a reserve currency and as the currency of international trade contracts. However, the USD bilateral rate is not the sole influence on MYR movements – other countries like Singapore also have substantial trade and capital links. How then to capture the multiplicity of influences on a currency? What we need is a single composite measure of a currency, an index of movement.
Let’s take the example of Malaysian trade with Aruba. Since this trade is pretty much non-existent, the exchange rate between the Ringgit (MYR) and the Arubian guilder (AWG) shouldn’t matter to Malaysia very much. From this example we can take the basic principle for constructing a composite view of the Ringgit or any other currency – taking the trade share* as the basis of a weighting scheme. Obviously, the greater the trade share, the more important a particular currency should be. The general rule is that weights don’t need to be changed very often (the IMF changes weights every ten years or so), although if a country’s trade patterns change substantially you can get gross errors in the index without knowing it.
* A more complicated scheme also uses the concept of third-country export competition as part of the weights. The IMF and Federal Reserve incorporate this in their currency indexes, but most do not. New Zealand uses share of global GDP as a proxy.
There is also a choice to be made at this point – which currencies to put in the “basket”. The more currencies involved the more work is required in gathering data and calculations, but the more accurate the measurement. The Federal Reserve uses a 0.5% export or import share threshold for their broad index, while the BOJ uses 1% overall trade share. I favour using 1% of exports or imports as giving a broad enough selection of currencies, without losing too much information – 15 currencies altogether based on 2007 Malaysian trade data. This also nicely allows me to avoid tracking Middle East countries, where data holes are a serious problem.
Having gathered the required trade and exchange rate data, we now have enough to construct a nominal effective exchange rate index. This is what MYR has been doing for last eight years (2000=100):
Ideally of course, real prices (net of inflation) are more important, so inflation data has to be incorporated in our measurement. This is complicated by having multiple types of inflation – consumer inflation (Consumer Price Index), producer inflation (Producer Price Index or Wholesale Price Index), and whole economy inflation (GDP deflator). Since trade competitiveness is the basis of our exchange rate measurement, PPI** is probably the best series to use (CPI and the GDP Deflator include non-tradable goods inflation). Unfortunately, PPI is not often available particularly in emerging markets, so CPI is often used as a proxy. In practice, most researchers have found that the price series used doesn’t really matter.
** The OECD use changes in real manufacturing wages
Deflating each currency by their respective inflation measures, we arrive at the real effective exchange rate index, here contrasted with the nominal index:
There's little to choose from between the two, which suggests the MYR is tracking pretty well with the currencies of our trade partners.
So now we have a pretty accurate idea of MYR movements holistically. Unfortunately, this still doesn’t tell our poor central banker very much, because all it shows is the movements of the currency relative to any other specific period - it says nothing of where the currency should be. While it’s better than nothing, he still has no idea of the valuation of the currency relative to all the others. This is where econometric models come in, which I'll cover in my next post.
However, even using the nominal and real charts can tell us something. First, here's a graph of trade shares (exports and imports), relative to the trade within the currency basket I'm using:
Note the massive decline in trade share to and from the US and the corresponding rise of China. Next, the nominal and real exchange rates against the G3 currencies:
The general interpretation is that if there is a difference in inflation experience between two currencies, there will be pressure for the nominal rate to close on the real rate. By that standard, MYR is about 17% overvalued against the JPY, but close to even with USD and EUR. Not surprising since Bank of Japan intervention to prevent JPY appreciation is common. This second batch of currencies also shows relatively high misalignments relative to the real rate:
The MYR appears overvalued against the HKD and TWD, but undervalued against the KRW, on about the same order as the misalignment against the JPY.
This last batch is so ridiculous, I had to triple check my calculations (please note the respective scales):
The differences here range from 33% against the PHP and IDR, to 87% (!!!) against the INR. These are serious misalignments that can only be explained by highly restricted capital accounts or heavy intervention (definitely true for the Reserve Bank of India). Given that the MYR is relatively close to “fair value” against the G3 currencies, it follows that the four currencies above are seriously out of whack with the rest of the world too.
Bear in mind, however, that I’m using inflation as the only currency alignment metric here – other forces can be at work as well that may explain these gross divergences.
Either that or you’re looking at the next good candidates for speculative attacks. I suspect the Rupee especially, might be in for some rough times ahead.
Update:
I should point out that because these are index numbers, measuring misalignments can be problematical because the index year has an impact on the perceived divergence. If I had taken 2005 as the base year for example, the misalignments would appear considerably smaller. The underlying assumption behind the analysis I'm using here is that currencies were largely in alignment in 2000. This weakness doesn't apply to econometric models.
Also forgot the acknowledgements:
1. (Free) foreign exchange data from the PACIFIC Exchange Rate Service. Forex data used are monthly averages.
2. CPI data from IMF International Financial Statistics (IFS) and the International Labour Organization, supplemented by national sources where necessary.
3. Trade data is from DOS and various issues of BNM Monthly Statistical Bulletins.
Let’s take the example of Malaysian trade with Aruba. Since this trade is pretty much non-existent, the exchange rate between the Ringgit (MYR) and the Arubian guilder (AWG) shouldn’t matter to Malaysia very much. From this example we can take the basic principle for constructing a composite view of the Ringgit or any other currency – taking the trade share* as the basis of a weighting scheme. Obviously, the greater the trade share, the more important a particular currency should be. The general rule is that weights don’t need to be changed very often (the IMF changes weights every ten years or so), although if a country’s trade patterns change substantially you can get gross errors in the index without knowing it.
* A more complicated scheme also uses the concept of third-country export competition as part of the weights. The IMF and Federal Reserve incorporate this in their currency indexes, but most do not. New Zealand uses share of global GDP as a proxy.
There is also a choice to be made at this point – which currencies to put in the “basket”. The more currencies involved the more work is required in gathering data and calculations, but the more accurate the measurement. The Federal Reserve uses a 0.5% export or import share threshold for their broad index, while the BOJ uses 1% overall trade share. I favour using 1% of exports or imports as giving a broad enough selection of currencies, without losing too much information – 15 currencies altogether based on 2007 Malaysian trade data. This also nicely allows me to avoid tracking Middle East countries, where data holes are a serious problem.
Having gathered the required trade and exchange rate data, we now have enough to construct a nominal effective exchange rate index. This is what MYR has been doing for last eight years (2000=100):
Ideally of course, real prices (net of inflation) are more important, so inflation data has to be incorporated in our measurement. This is complicated by having multiple types of inflation – consumer inflation (Consumer Price Index), producer inflation (Producer Price Index or Wholesale Price Index), and whole economy inflation (GDP deflator). Since trade competitiveness is the basis of our exchange rate measurement, PPI** is probably the best series to use (CPI and the GDP Deflator include non-tradable goods inflation). Unfortunately, PPI is not often available particularly in emerging markets, so CPI is often used as a proxy. In practice, most researchers have found that the price series used doesn’t really matter.
** The OECD use changes in real manufacturing wages
Deflating each currency by their respective inflation measures, we arrive at the real effective exchange rate index, here contrasted with the nominal index:
There's little to choose from between the two, which suggests the MYR is tracking pretty well with the currencies of our trade partners.
So now we have a pretty accurate idea of MYR movements holistically. Unfortunately, this still doesn’t tell our poor central banker very much, because all it shows is the movements of the currency relative to any other specific period - it says nothing of where the currency should be. While it’s better than nothing, he still has no idea of the valuation of the currency relative to all the others. This is where econometric models come in, which I'll cover in my next post.
However, even using the nominal and real charts can tell us something. First, here's a graph of trade shares (exports and imports), relative to the trade within the currency basket I'm using:
Note the massive decline in trade share to and from the US and the corresponding rise of China. Next, the nominal and real exchange rates against the G3 currencies:
The general interpretation is that if there is a difference in inflation experience between two currencies, there will be pressure for the nominal rate to close on the real rate. By that standard, MYR is about 17% overvalued against the JPY, but close to even with USD and EUR. Not surprising since Bank of Japan intervention to prevent JPY appreciation is common. This second batch of currencies also shows relatively high misalignments relative to the real rate:
The MYR appears overvalued against the HKD and TWD, but undervalued against the KRW, on about the same order as the misalignment against the JPY.
This last batch is so ridiculous, I had to triple check my calculations (please note the respective scales):
The differences here range from 33% against the PHP and IDR, to 87% (!!!) against the INR. These are serious misalignments that can only be explained by highly restricted capital accounts or heavy intervention (definitely true for the Reserve Bank of India). Given that the MYR is relatively close to “fair value” against the G3 currencies, it follows that the four currencies above are seriously out of whack with the rest of the world too.
Bear in mind, however, that I’m using inflation as the only currency alignment metric here – other forces can be at work as well that may explain these gross divergences.
Either that or you’re looking at the next good candidates for speculative attacks. I suspect the Rupee especially, might be in for some rough times ahead.
Update:
I should point out that because these are index numbers, measuring misalignments can be problematical because the index year has an impact on the perceived divergence. If I had taken 2005 as the base year for example, the misalignments would appear considerably smaller. The underlying assumption behind the analysis I'm using here is that currencies were largely in alignment in 2000. This weakness doesn't apply to econometric models.
Also forgot the acknowledgements:
1. (Free) foreign exchange data from the PACIFIC Exchange Rate Service. Forex data used are monthly averages.
2. CPI data from IMF International Financial Statistics (IFS) and the International Labour Organization, supplemented by national sources where necessary.
3. Trade data is from DOS and various issues of BNM Monthly Statistical Bulletins.
Exchange Rate Policy 1: Concepts
If it seems I’ve taken a break from blogging, it’s because I’ve been hard at work reconstructing my MYR exchange rate indexes. Since I’m still in the midst of refining them, this post should serve as a holdover until that’s done.
Nothing in economics is quite so confusing as exchange rates. The problem is that exchange rates are in essence relative prices, not absolute prices, and because in a world of multiple exchange rate regimes, making sense of exchange rate movements can be complicated. For instance the chart below shows the cumulative movements of the Ringgit against the G3 currencies since 2000 (2000=100):
Relative to the start date, Ringgit (MYR) is 6.9% stronger against Dollar (USD), 9.5% weaker against Yen (JPY), and 26.9% weaker against the Euro (EUR). Can we therefore say that the Ringgit is generally weaker or stronger? More to the point, what are the implications for policy and trade? At what stage should authorities decide that a currency is overvalued or undervalued enough to merit intervention? These and other questions will be the topic of this series of posts I’m embarking on.
The most intuitive and attractive concept of exchange rates is the theory of purchasing power parity, or PPP. In its strong form, PPP states that the same good should have the same price everywhere (aka The Law of One Price). Therefore the exchange rate of any two currencies should equate this price in local currency terms. For example if a Big Mac is RM8 in Malaysia, and US$2 in the USA, then the PPP exchange rate should be US$0.25 if we use MYR as the base and RM4.00 if we use USD as the base. If PPP is true, and the actual exchange rate is RM3.80, then we could consider the MYR as being 5% overvalued against the USD.
Unfortunately, empirical evidence for strong form PPP is patchy even over periods of hundreds of years. There is better evidence for weak-form PPP, where prices differ but the difference is constant. Even here, the proof is not absolute as exchange rates appear to deviate from the PPP predicted value for extended periods. The last 60 years has seen a lot of effort to decipher how this can be, given the importance of the exchange rate to international trade and the balance of payments.
One notion, called the Balassa-Samuelson effect, suggests that only tradable goods face price arbitrage in international markets and PPP should hold for these goods, but not for non-tradable goods and non-tradable components such as tax structures, property rentals, and so on. This effect should be particularly strong in services, which by definition are difficult to trade (imagine the relative value of the haircut for instance). The general effect of a strong non-tradable sector is an appreciation of the exchange rate.
Another school of thought focused purely on monetary effects and the impact of real interest rate differentials, called the concept of uncovered interest parity. The idea is that capital flows to where the real yield is highest, which in turn moves the exchange rate to equate the relative differences. Since investors view countries as having different risk profiles, a risk premium can also affect the exchange rate, which is the concept of covered interest rate parity. Inflation should also have an impact, as it is a measure of the relative supply of each currency – the higher the relative inflation rate, the more a currency is expected to depreciate.
The problem with these and other theories is that, taken in isolation, none do a good job of explaining exchange rate movements in the floating rate period (1972 onwards). The best statistical model of short term exchange rate movements is and remains the random walk, which in statistical notation is:
X(t) = X(t-1) + ε
Notice that this differs substantially from a simple regression model in that there is no intercept and no slope to the equation. What the random walk model states is that the best predictor of tomorrow’s market price is today’s price!
So what is a poor central banker to do? What finally made sense, at least in identifying medium to long term movements of the exchange rates, were structural models which put a lot of these concepts together. In real life therefore, it’s a combination of factors that influence the exchange rate, not one or two. But before models like these can be used, we have to figure out how to actually arrive at a single view of a currency rather than the multiplicity of rates that any currency is subject to, which will be the subject of the next post.
Nothing in economics is quite so confusing as exchange rates. The problem is that exchange rates are in essence relative prices, not absolute prices, and because in a world of multiple exchange rate regimes, making sense of exchange rate movements can be complicated. For instance the chart below shows the cumulative movements of the Ringgit against the G3 currencies since 2000 (2000=100):
Relative to the start date, Ringgit (MYR) is 6.9% stronger against Dollar (USD), 9.5% weaker against Yen (JPY), and 26.9% weaker against the Euro (EUR). Can we therefore say that the Ringgit is generally weaker or stronger? More to the point, what are the implications for policy and trade? At what stage should authorities decide that a currency is overvalued or undervalued enough to merit intervention? These and other questions will be the topic of this series of posts I’m embarking on.
The most intuitive and attractive concept of exchange rates is the theory of purchasing power parity, or PPP. In its strong form, PPP states that the same good should have the same price everywhere (aka The Law of One Price). Therefore the exchange rate of any two currencies should equate this price in local currency terms. For example if a Big Mac is RM8 in Malaysia, and US$2 in the USA, then the PPP exchange rate should be US$0.25 if we use MYR as the base and RM4.00 if we use USD as the base. If PPP is true, and the actual exchange rate is RM3.80, then we could consider the MYR as being 5% overvalued against the USD.
Unfortunately, empirical evidence for strong form PPP is patchy even over periods of hundreds of years. There is better evidence for weak-form PPP, where prices differ but the difference is constant. Even here, the proof is not absolute as exchange rates appear to deviate from the PPP predicted value for extended periods. The last 60 years has seen a lot of effort to decipher how this can be, given the importance of the exchange rate to international trade and the balance of payments.
One notion, called the Balassa-Samuelson effect, suggests that only tradable goods face price arbitrage in international markets and PPP should hold for these goods, but not for non-tradable goods and non-tradable components such as tax structures, property rentals, and so on. This effect should be particularly strong in services, which by definition are difficult to trade (imagine the relative value of the haircut for instance). The general effect of a strong non-tradable sector is an appreciation of the exchange rate.
Another school of thought focused purely on monetary effects and the impact of real interest rate differentials, called the concept of uncovered interest parity. The idea is that capital flows to where the real yield is highest, which in turn moves the exchange rate to equate the relative differences. Since investors view countries as having different risk profiles, a risk premium can also affect the exchange rate, which is the concept of covered interest rate parity. Inflation should also have an impact, as it is a measure of the relative supply of each currency – the higher the relative inflation rate, the more a currency is expected to depreciate.
The problem with these and other theories is that, taken in isolation, none do a good job of explaining exchange rate movements in the floating rate period (1972 onwards). The best statistical model of short term exchange rate movements is and remains the random walk, which in statistical notation is:
X(t) = X(t-1) + ε
Notice that this differs substantially from a simple regression model in that there is no intercept and no slope to the equation. What the random walk model states is that the best predictor of tomorrow’s market price is today’s price!
So what is a poor central banker to do? What finally made sense, at least in identifying medium to long term movements of the exchange rates, were structural models which put a lot of these concepts together. In real life therefore, it’s a combination of factors that influence the exchange rate, not one or two. But before models like these can be used, we have to figure out how to actually arrive at a single view of a currency rather than the multiplicity of rates that any currency is subject to, which will be the subject of the next post.
Sunday, March 22, 2009
What Kind Of Economist Am I?
WY asks what school of economic thought I support. The answer in a nutshell is...whatever works.
Here's the story - strike that, here's my summary of the history of economic thought:
The classical school - Adam Smith, David Ricardo, Hume, Bentham, Marx, Marshall and many others - really set the foundations of economic thought. They gave rise to many competing ideologies which didn't necessarily agreed with each other. For instance libertarianism and the Austrian school take freedom as the sole guiding principle of economic organisation, while Marx suggests the diametric opposite. Both are considered on the lunatic fringe in modern economics.
The classical school eventually gave way to the neo-classical school, which attempted to describe economics within a mathematical framework. The Great Depression and the rise of the Keynesian revolution derailed this movement momentarily, but it revived and assimilated Keynesian thought under the neo-classical synthesis starting with John Hicks (the ever popular and still relevant IS-LM model).
The 1970s brought stagflation and the breakdown of heretofore established macro-relationships, bringing about a resurgence of classical ideas, with an emphasis on micro-foundations for macro analysis - the new classical school.
The 1960s-70s also coincided with the rise of monetarism, which combined some of the ideas of the Austrian school with the neo-classical synthesis. Also known as the Chicago School from its identification with Milton Friedman, monetarism reduced economic policy management to essentially one tool: "2% money supply growth" (see Goodhart's law to see why this failed).
The new keynesian school essentially takes a cue from the new classical school by applying micro-foundations to keynesian macro analysis. These two competing schools of thought comprise mainstream economics today.
Then there is the heterodox school. Well not really a school per se, but rather a loose term covering economists who don't fall under a convenient label. These include people like Joseph Schumpeter and JK Galbraith.
The reason why you see economists disagree in the current crisis on seemingly basic questions like the effectiveness of fiscal stimulus or its structure, or whether it will work at all, goes back to their basic ideologies:
1. New classicals believe in complete markets and rational agents, and that government is less efficient in allocating resources. As such fiscal stimulus is less likely to be effective, and if stimulus has to be done, tax cuts are preferred.
2. New keynesians believe that markets can fail and prices are sticky, in which case there is a strong case for government to step in. Inefficient allocation of resources is better than no use of resources at all.
3. Monetarists don't believe fiscal stimulus works. All we need is 2% money supply growth.
4. Austrians and libertarians don't believe in government. All we need to do is go back to the gold standard and abolish all the central banks.
5. Marxists believe capitalism is doomed to fail. All we need is...never mind.
Where do I stand in this milieu? I admit I began my career a monetarist, with some leanings toward libertarianism. Age and (hopefully) some wisdom now puts me somewhat left of centre - markets do fail, frequently in fact. I also have some sympathy for some of Galbraith's and Schumpeter's ideas, which while often in conflict, do a better job of describing the real world then either mainstream school. It's hard to accept the efficiency of price signals, when competitors are essentially oligopolistic.
Having said that, I think my approach to economics is purely pragmatic. Some ideas work at some times, but not at others. It is a mistake to take a one-size-fits-all approach, especially when contemplating a developing country with immature markets and institutions. Just as important, I lean on empirical evidence rather than relying purely on the dictates of theory.
Theory only provides a framework for thinking, and it pays to listen a little to all the schools of thoughts - even Marxists and Austrians occasionally have something worthwhile to say.
Here's the story - strike that, here's my summary of the history of economic thought:
The classical school - Adam Smith, David Ricardo, Hume, Bentham, Marx, Marshall and many others - really set the foundations of economic thought. They gave rise to many competing ideologies which didn't necessarily agreed with each other. For instance libertarianism and the Austrian school take freedom as the sole guiding principle of economic organisation, while Marx suggests the diametric opposite. Both are considered on the lunatic fringe in modern economics.
The classical school eventually gave way to the neo-classical school, which attempted to describe economics within a mathematical framework. The Great Depression and the rise of the Keynesian revolution derailed this movement momentarily, but it revived and assimilated Keynesian thought under the neo-classical synthesis starting with John Hicks (the ever popular and still relevant IS-LM model).
The 1970s brought stagflation and the breakdown of heretofore established macro-relationships, bringing about a resurgence of classical ideas, with an emphasis on micro-foundations for macro analysis - the new classical school.
The 1960s-70s also coincided with the rise of monetarism, which combined some of the ideas of the Austrian school with the neo-classical synthesis. Also known as the Chicago School from its identification with Milton Friedman, monetarism reduced economic policy management to essentially one tool: "2% money supply growth" (see Goodhart's law to see why this failed).
The new keynesian school essentially takes a cue from the new classical school by applying micro-foundations to keynesian macro analysis. These two competing schools of thought comprise mainstream economics today.
Then there is the heterodox school. Well not really a school per se, but rather a loose term covering economists who don't fall under a convenient label. These include people like Joseph Schumpeter and JK Galbraith.
The reason why you see economists disagree in the current crisis on seemingly basic questions like the effectiveness of fiscal stimulus or its structure, or whether it will work at all, goes back to their basic ideologies:
1. New classicals believe in complete markets and rational agents, and that government is less efficient in allocating resources. As such fiscal stimulus is less likely to be effective, and if stimulus has to be done, tax cuts are preferred.
2. New keynesians believe that markets can fail and prices are sticky, in which case there is a strong case for government to step in. Inefficient allocation of resources is better than no use of resources at all.
3. Monetarists don't believe fiscal stimulus works. All we need is 2% money supply growth.
4. Austrians and libertarians don't believe in government. All we need to do is go back to the gold standard and abolish all the central banks.
5. Marxists believe capitalism is doomed to fail. All we need is...never mind.
Where do I stand in this milieu? I admit I began my career a monetarist, with some leanings toward libertarianism. Age and (hopefully) some wisdom now puts me somewhat left of centre - markets do fail, frequently in fact. I also have some sympathy for some of Galbraith's and Schumpeter's ideas, which while often in conflict, do a better job of describing the real world then either mainstream school. It's hard to accept the efficiency of price signals, when competitors are essentially oligopolistic.
Having said that, I think my approach to economics is purely pragmatic. Some ideas work at some times, but not at others. It is a mistake to take a one-size-fits-all approach, especially when contemplating a developing country with immature markets and institutions. Just as important, I lean on empirical evidence rather than relying purely on the dictates of theory.
Theory only provides a framework for thinking, and it pays to listen a little to all the schools of thoughts - even Marxists and Austrians occasionally have something worthwhile to say.
Thursday, March 19, 2009
Why I Don’t Like Gold As The Monetary Base
After yesterday’s verbal diarrhea, this post will hopefully be shorter and easier to digest. I argued yesterday that using gold as the basis for money is inappropriate, as the slow rate of increase means money will always have a deflationary impact on real output, and the conflation of gold-as-money=wealth results in mercantilism with all its evils. The second contention is largely ideological, and can be disputed. The first contention is more amenable to examination, along with its implications such as the function of gold as a store of value.
The following is based on the estimate of a stock of 145,000 tonnes of gold as of 2001 (source: World Gold Council), global gold production data from the US Geological Survey, and real GDP growth data from the IMF World Economic Outlook Oct 2008:
So much for that - I think its pretty clear that over the last half century, gold supplies could not have kept up with global growth. This implies that this growth would not have happened under a gold standard or a continuation of Bretton Woods, as deflation and recession would have been required to equalize growth with the real money supply. Incidentally, here’s the corresponding comparison for silver:
As further proof, I converted a number of commodity series* from USD value to gold value (specifically, per troy ounce). I expected to find relatively flat and declining price trends over time. What I found instead was absolutely fascinating, and requires some explanation. Here, I’m showing the price of Beef in troy ounces:
The rest of the charts are broadly similar, with the exception of pepper, which was highly cyclical against gold (incidentally, pepper looks like a 5 year bull market waiting to happen). What struck me immediately were three things:
1. The relatively low volatility from the 1980s onwards;
2. The sharp decline in price in the 1970s, which I more or less expected;
3. The relatively high volatility both in and prior to the 1970s.
My take on this is that because of the expansion of the USD money supply in the mid to late 1960s due to Vietnam and Lyndon Johnson’s domestic policies, the USD became increasingly overvalued relative to its convertible price to gold – i.e. real activity in excess of the monetary base. When Nixon took the USD off gold convertibility, the next decade saw a combination of inflation and stagnation, which may have been an adjustment process of real goods and services with the nominal money supply. Equivalently, the USD had to fall to its ‘true’ value against gold. Thereafter in the 1980s, market forces (and Paul Volcker) took over and gold became just another commodity.
The 1960s however, is harder to explain, with volatility an order of magnitude higher than the 1980s. It is somewhat ironic to me that Bretton Woods (which was essentially a gold standard but without the necessity of holding gold reserves) provided nominal price stability, but real price instability, and the floating rate period the exact opposite. While this is insufficient empirical evidence against using gold as the monetary base, it tends to confirm my doubts about the stability of such a system.
Sources:
Gold Stocks - World Gold Council
Silver stocks - http://www.gold-eagle.com/editorials_99/mbutler110799.html
Gold and silver production data - US Geological Survey
Commodity price statistics - Unctad Handbook of Statistics
*Beef, Cocoa, Coffee, Cotton, Palm Oil, Pepper, Rice, Rubber, Tin, Wheat
The following is based on the estimate of a stock of 145,000 tonnes of gold as of 2001 (source: World Gold Council), global gold production data from the US Geological Survey, and real GDP growth data from the IMF World Economic Outlook Oct 2008:
So much for that - I think its pretty clear that over the last half century, gold supplies could not have kept up with global growth. This implies that this growth would not have happened under a gold standard or a continuation of Bretton Woods, as deflation and recession would have been required to equalize growth with the real money supply. Incidentally, here’s the corresponding comparison for silver:
As further proof, I converted a number of commodity series* from USD value to gold value (specifically, per troy ounce). I expected to find relatively flat and declining price trends over time. What I found instead was absolutely fascinating, and requires some explanation. Here, I’m showing the price of Beef in troy ounces:
The rest of the charts are broadly similar, with the exception of pepper, which was highly cyclical against gold (incidentally, pepper looks like a 5 year bull market waiting to happen). What struck me immediately were three things:
1. The relatively low volatility from the 1980s onwards;
2. The sharp decline in price in the 1970s, which I more or less expected;
3. The relatively high volatility both in and prior to the 1970s.
My take on this is that because of the expansion of the USD money supply in the mid to late 1960s due to Vietnam and Lyndon Johnson’s domestic policies, the USD became increasingly overvalued relative to its convertible price to gold – i.e. real activity in excess of the monetary base. When Nixon took the USD off gold convertibility, the next decade saw a combination of inflation and stagnation, which may have been an adjustment process of real goods and services with the nominal money supply. Equivalently, the USD had to fall to its ‘true’ value against gold. Thereafter in the 1980s, market forces (and Paul Volcker) took over and gold became just another commodity.
The 1960s however, is harder to explain, with volatility an order of magnitude higher than the 1980s. It is somewhat ironic to me that Bretton Woods (which was essentially a gold standard but without the necessity of holding gold reserves) provided nominal price stability, but real price instability, and the floating rate period the exact opposite. While this is insufficient empirical evidence against using gold as the monetary base, it tends to confirm my doubts about the stability of such a system.
Sources:
Gold Stocks - World Gold Council
Silver stocks - http://www.gold-eagle.com/editorials_99/mbutler110799.html
Gold and silver production data - US Geological Survey
Commodity price statistics - Unctad Handbook of Statistics
*Beef, Cocoa, Coffee, Cotton, Palm Oil, Pepper, Rice, Rubber, Tin, Wheat
Financial Fragility and Fractional Reserve Banking
This post touches on one of the fundamental attributes of banking systems in the present day, and how it contributes to financial fragility. I've known about the fractional reserve system since my student days, but never really thought about it much in terms of the impact on systemic risk or stability. The thinking really started when my brother in law pointed me to Web of Debt by Ellen Brown, which purports to show the problems with the monetary system we use today, and how it can be solved. I wouldn't recommend reading the book - it's a polemical tract that had me choking with laughter at some of its attempts at “analysis”. Nevertheless, despite the flaws Brown's book does point out some of the essential problems with the fractional reserve system.
If you're not familiar with the term, or how money is created under the modern monetary system, here's a short narrative. Let's say we have person A, B and C. A owns a bank, B has $100 in cash, and C has nothing. B puts his money with A, who now has $100 in assets (the cash from B), and $100 in liabilities (B has a claim on A's assets). That $100 is now the sum total of the money supply.
Now assume that the central bank places a 5% reserve ratio on the banking system and this reserve has to be placed at the central bank- in other words, A is required to hold only 5% of any liabilities in cash, and can lend out the remaining 95%. C then approaches A for a loan which is granted, the maximum of which is $95 (95% of $100). A gives a $95 loan to C who promptly deposits the cash with A, thus creating on A's books a $95 asset (the loan), and a $95 liability (the cash owing to C). A's balance sheet, and thus the money supply, has been inflated to $195. Assuming B and C are irrational and don't mind paying A a whole bunch of interest, this round-robin of borrowing and depositing can be carried out ad nauseum to the point where the money supply has now increased by a factor of:
m = 1/r = 1/0.05 = 20
...where m is the money multiplier, and r is the reserve ratio. Using our $100 initial cash position, the total amount of money at the end has grown to $2,000, with B and C owing A $1,900 in loans, but A owing B and C $2000 in cash, which from our example doesn't actually exist - only the original $100 cash is available.
Money is thus created or destroyed as if by "magic" - because all money under the current system is fiat money, there is no intrinsic value to money save for its functions as a medium of exchange and (with qualifications) a store of value. The fractional reserve system evolved over the centuries from a behavioral characteristic that bankers and money lenders have observed - people don't really use all their cash at once, even under the metallic system. Under normal circumstances, it was thus profitable to lend out the excess cash.
From the example, we can see how such a system contributes to instability:
1. If B or C default on any of their loans, that will reduce A's assets but not his liabilities. This is a solvency problem.
2. If either B or C withdraw the cash due to them from their deposits in excess of $100, then A doesn't actually have sufficient cash on hand. A corollary is that, if either B or C suspect that A may not be able to meet his cash obligations both will attempt to withdraw the total cash owing to them, which leads to a bank run. This is a liquidity problem.
In either case, A is in deep trouble, and has to run to the central bank for help. I think you can see the relevance of the two scenarios above to the situation in the global banking system today. To be fair, central banks now regulate fractional reserve money creation through the liabilities side of the balance sheet, rather than the reserve or asset side. Based on Basle I risk-weighted capital requirement of 8%, the maximum money multiplier (irrespective of reserve ratios) is about 12. In accounting terms, this is analogous to the gearing ratio.
In addition, there are some systemic issues that are intrinsic to fractional reserve banking:
1. There is no doubt that the fractional reserve banking system actively encourages taking on debt. In my example, from a zero debt and $100 asset position, the system creates $1900 in debt with the same $100 in assets. If any of the debts are not honored, the system has a solvency problem.
2. Then there is the issue of inflation and deflation, where money supply and real output are not in equilibrium with each other. If money supply is greater than real output, then you have the phenomenon of inflation (assuming money velocity is constant). If money supply is lower than real output, you get deflation. Both change the relative value of money with respect to real goods and services, making money less trustworthy under a fiat money system. Under the fractional reserve system central banks can at best influence the supply of money to support economic growth, but not directly control it. On the other hand, it is very easy for central banks to trigger inflation or deflation, by supplying too much or too little cash into the banking system.
Further, there are some philosophical and religious objections to fractional reserve banking:
1. Banks get essentially a free ride through the money creation process. Profits through lending are gained not through the production of real goods or services, but through recycling (non-existent) cash. This issue is disputable - the intermediation process does require performing a service, which is vetting borrowers for credit risk. There's understandably more angst over this issue in light of the origination-securitization model now prevalent, where the performance of this service has been passed on through the securitization process to rating agencies and investment banks, who obviously dropped the ball.
2. Relating to the above, since money held in deposits is a claim on cash which doesn't exist, fractional reserve banking can be likened to fraud perpetrated by banks on the public.
3. An additional claim of fraud can also be attached to central banks and governments. The money supply can be raised to cause inflation, which has two effects: reduce the claims of monetary units on real goods and services, as well as reduce the future real value of debts (including that of the government). Since fiat money represents an obligation of the government which guarantees its convertibility, inflation can be construed as an act of fraud by monetary authorities.
Both Christians and Muslims thus have serious problems with the modern banking system as it stands. From an economics point of view however, the only opposition to fractional reserve banking comes from the Austrian School. These disparate groups prefer full-reserve banking (or alternatively free banking as argued by some in the Austrian School), as well as tying money to some object of intrinsic worth such as gold. This would have the following effects:
1. Full reserves means bank runs would be avoided, as there is no issue of liquidity. However, potential solvency problems will remain.
2. Tying money to gold removes government interference from the money supply. Since the Austrian School sees inflation as purely a monetary phenomenon, inflation (and deflation) would not be possible.
From my point of view however, to paraphrase Winston Churchill, fractional reserve banking is the worse form of banking, except all the others.
Let’s contrast the two systems:
1. Solvency is and remains an issue whatever the system of banking, so I will not touch on it here.
2. Liquidity problems are resolved in the fractional reserve system in two ways: first is recourse to the interbank market; and secondly the function of lender of last resort that central banks typically take on. Banks who are short of liquidity can borrow liquid assets from banks with excess reserves. If this is not possible, banks can borrow directly from the central bank, but typically under sanctions such as penal interest rates. If the liquidity problem is really severe, central banks can in extremis take over the bank concerned. Under the full reserve banking system, of course, liquidity is never an issue.
3. In terms of debt creation, because of the requirement for full reserve backing money can only be lent out if depositors agree to it, i.e. waive their claim to their money for a certain period. This is analogous to today’s time or fixed deposits. Since money available for loans is limited, debt creation never exceeds the total amount of available reserves.
4. Under a full reserve system, the money supply is independent of real output and it follows therefore that inflation and deflation cannot be artificially created. Which sounds good until you realize that counter-cyclical monetary policy is also impossible – in fact monetary policy of any kind is impossible. I’ll expand on this point later.
5. The banking business model is quite different. Whereas under fractional reserve systems interest is paid to depositors and charged to borrowers, under the full reserve system banks act more like custodians so depositors pay banks for keeping their money in the system, except where deposits are allowed to be lent out. Interest (or profit, if you prefer), continues to be charged to borrowers.
Now, going through the above it would appear as if full reserve banking is a viable replacement for fractional reserve banking. It reduces the level of debt possible, takes care of liquidity problems, and removes the temptation for government to inflate their debts away.
Here’s the gotcha…full reserve banking also definitely removes support for economic growth. It is no accident, in my view, that fractional reserve banking (and by extension fiat money) has facilitated the explosion in real economic growth and the substantial increase in human welfare over the past two centuries.
Since money can be created and destroyed on demand, the fractional reserve system fully accommodates economic activity. In other words, money supply and money demand will always adjust to equilibrium. The process can be helped along and smoothed out by application of monetary policy, i.e. influence through the creation or destruction of high-powered money, or through changing the price of money (the interest rate). It is therefore possible for monetary authorities to apply counter-cyclical policies to reduce the impact of booms and busts in the economic cycle, although this is predicated on how much trust you can place in monetary authorities (for counter-examples refer to the Weimar Republic and the current government of Zimbabwe).
This adjustment isn’t possible under a full reserve system, as money demand must adjust to a relatively fixed money supply. If the Fisher identity holds, then assuming the velocity of money is constant real output growth must always converge to the rate of growth of the money supply. While the velocity of money is never a constant as I demonstrated before, it does vary within a range. For excess economic growth to persist and be supported by a full reserve system, the velocity of money must always be ever increasing, which is not plausible. I won’t repeat here the arguments for limited resources (i.e. the supply of gold will run out), but the rate of increase in gold supplies has historically been very low (evidence to come in a future post). A further implication is that under the full reserve banking system deflation and depressions are not only possible but probable, since there is no scope for using counter-cyclical monetary policy. The argument that inflation and deflation are not possible at all under a full reserve system is complete bunk as far as I’m concerned. This is borne out by the historical record, as the discovery of the New World in the 15th century along with its gold and silver mines, caused a long period of inflation in Europe.
More dangerously, tying money to gold or any other object of intrinsic value can give rise to the conflation that money=wealth. If that sounds innocuous to you, look up mercantilism. I think that there is no doubt that free trade (or at least, freer trade) has had a positive impact on global prosperity. Just as important, removing the link between money and wealth (and thus the applicability of mercantilist theory) reduces the impetus towards war, colonialism, and imperialism. If real output growth on a global basis is restricted to the rate of growth in money (i.e. gold), then the only way an individual country can raise the welfare of its own citizens is through appropriation (i.e. steal wealth from others) or annexation (i.e. take over and oppress others). Despite the fact that two massive world wars were fought in the last 100 years, the latter half of the 20th century has been amongst the most peaceful periods in recorded human history – yes, even with the conflicts in the Middle East, Asia, Africa and the Balkans. Incidentally, this ties in rather nicely with the shift from the Gold standard to a full fiat money system – you can draw your own conclusions.
The only way I see a full reserve banking system being even remotely attractive is if the monetary base is convertible into an asset which has a higher rate of growth than real potential output. This will of course apply a moderate amount of inflation, which is not necessarily bad as it allows for a low real interest rate as well as providing the correct incentives to borrowers and producers. But that still doesn’t allow for discretionary monetary policy, or remove the logic of mercantilism.
In short, at the present time, I see no real alternative to the fractional reserve banking system despite its many flaws. There is no doubt that the current global financial crisis represents a failure of the system on a wide scale, but I believe there is a case to be made that the fundamentals of the system has been short-circuited over the past ten years by the origination-securitization model, as well as the rise of the shadow-banking system. On the whole, I would rather have a system that generally supports increases in human welfare rather than one that restricts it, even if it means lots of bumps along the way.
As far as an Islamic financial system goes, I don't believe a debt-based banking system is the best way to intermediate between savers and entrepreneurs - but that's a post for another day.
If you're not familiar with the term, or how money is created under the modern monetary system, here's a short narrative. Let's say we have person A, B and C. A owns a bank, B has $100 in cash, and C has nothing. B puts his money with A, who now has $100 in assets (the cash from B), and $100 in liabilities (B has a claim on A's assets). That $100 is now the sum total of the money supply.
Now assume that the central bank places a 5% reserve ratio on the banking system and this reserve has to be placed at the central bank- in other words, A is required to hold only 5% of any liabilities in cash, and can lend out the remaining 95%. C then approaches A for a loan which is granted, the maximum of which is $95 (95% of $100). A gives a $95 loan to C who promptly deposits the cash with A, thus creating on A's books a $95 asset (the loan), and a $95 liability (the cash owing to C). A's balance sheet, and thus the money supply, has been inflated to $195. Assuming B and C are irrational and don't mind paying A a whole bunch of interest, this round-robin of borrowing and depositing can be carried out ad nauseum to the point where the money supply has now increased by a factor of:
m = 1/r = 1/0.05 = 20
...where m is the money multiplier, and r is the reserve ratio. Using our $100 initial cash position, the total amount of money at the end has grown to $2,000, with B and C owing A $1,900 in loans, but A owing B and C $2000 in cash, which from our example doesn't actually exist - only the original $100 cash is available.
Money is thus created or destroyed as if by "magic" - because all money under the current system is fiat money, there is no intrinsic value to money save for its functions as a medium of exchange and (with qualifications) a store of value. The fractional reserve system evolved over the centuries from a behavioral characteristic that bankers and money lenders have observed - people don't really use all their cash at once, even under the metallic system. Under normal circumstances, it was thus profitable to lend out the excess cash.
From the example, we can see how such a system contributes to instability:
1. If B or C default on any of their loans, that will reduce A's assets but not his liabilities. This is a solvency problem.
2. If either B or C withdraw the cash due to them from their deposits in excess of $100, then A doesn't actually have sufficient cash on hand. A corollary is that, if either B or C suspect that A may not be able to meet his cash obligations both will attempt to withdraw the total cash owing to them, which leads to a bank run. This is a liquidity problem.
In either case, A is in deep trouble, and has to run to the central bank for help. I think you can see the relevance of the two scenarios above to the situation in the global banking system today. To be fair, central banks now regulate fractional reserve money creation through the liabilities side of the balance sheet, rather than the reserve or asset side. Based on Basle I risk-weighted capital requirement of 8%, the maximum money multiplier (irrespective of reserve ratios) is about 12. In accounting terms, this is analogous to the gearing ratio.
In addition, there are some systemic issues that are intrinsic to fractional reserve banking:
1. There is no doubt that the fractional reserve banking system actively encourages taking on debt. In my example, from a zero debt and $100 asset position, the system creates $1900 in debt with the same $100 in assets. If any of the debts are not honored, the system has a solvency problem.
2. Then there is the issue of inflation and deflation, where money supply and real output are not in equilibrium with each other. If money supply is greater than real output, then you have the phenomenon of inflation (assuming money velocity is constant). If money supply is lower than real output, you get deflation. Both change the relative value of money with respect to real goods and services, making money less trustworthy under a fiat money system. Under the fractional reserve system central banks can at best influence the supply of money to support economic growth, but not directly control it. On the other hand, it is very easy for central banks to trigger inflation or deflation, by supplying too much or too little cash into the banking system.
Further, there are some philosophical and religious objections to fractional reserve banking:
1. Banks get essentially a free ride through the money creation process. Profits through lending are gained not through the production of real goods or services, but through recycling (non-existent) cash. This issue is disputable - the intermediation process does require performing a service, which is vetting borrowers for credit risk. There's understandably more angst over this issue in light of the origination-securitization model now prevalent, where the performance of this service has been passed on through the securitization process to rating agencies and investment banks, who obviously dropped the ball.
2. Relating to the above, since money held in deposits is a claim on cash which doesn't exist, fractional reserve banking can be likened to fraud perpetrated by banks on the public.
3. An additional claim of fraud can also be attached to central banks and governments. The money supply can be raised to cause inflation, which has two effects: reduce the claims of monetary units on real goods and services, as well as reduce the future real value of debts (including that of the government). Since fiat money represents an obligation of the government which guarantees its convertibility, inflation can be construed as an act of fraud by monetary authorities.
Both Christians and Muslims thus have serious problems with the modern banking system as it stands. From an economics point of view however, the only opposition to fractional reserve banking comes from the Austrian School. These disparate groups prefer full-reserve banking (or alternatively free banking as argued by some in the Austrian School), as well as tying money to some object of intrinsic worth such as gold. This would have the following effects:
1. Full reserves means bank runs would be avoided, as there is no issue of liquidity. However, potential solvency problems will remain.
2. Tying money to gold removes government interference from the money supply. Since the Austrian School sees inflation as purely a monetary phenomenon, inflation (and deflation) would not be possible.
From my point of view however, to paraphrase Winston Churchill, fractional reserve banking is the worse form of banking, except all the others.
Let’s contrast the two systems:
1. Solvency is and remains an issue whatever the system of banking, so I will not touch on it here.
2. Liquidity problems are resolved in the fractional reserve system in two ways: first is recourse to the interbank market; and secondly the function of lender of last resort that central banks typically take on. Banks who are short of liquidity can borrow liquid assets from banks with excess reserves. If this is not possible, banks can borrow directly from the central bank, but typically under sanctions such as penal interest rates. If the liquidity problem is really severe, central banks can in extremis take over the bank concerned. Under the full reserve banking system, of course, liquidity is never an issue.
3. In terms of debt creation, because of the requirement for full reserve backing money can only be lent out if depositors agree to it, i.e. waive their claim to their money for a certain period. This is analogous to today’s time or fixed deposits. Since money available for loans is limited, debt creation never exceeds the total amount of available reserves.
4. Under a full reserve system, the money supply is independent of real output and it follows therefore that inflation and deflation cannot be artificially created. Which sounds good until you realize that counter-cyclical monetary policy is also impossible – in fact monetary policy of any kind is impossible. I’ll expand on this point later.
5. The banking business model is quite different. Whereas under fractional reserve systems interest is paid to depositors and charged to borrowers, under the full reserve system banks act more like custodians so depositors pay banks for keeping their money in the system, except where deposits are allowed to be lent out. Interest (or profit, if you prefer), continues to be charged to borrowers.
Now, going through the above it would appear as if full reserve banking is a viable replacement for fractional reserve banking. It reduces the level of debt possible, takes care of liquidity problems, and removes the temptation for government to inflate their debts away.
Here’s the gotcha…full reserve banking also definitely removes support for economic growth. It is no accident, in my view, that fractional reserve banking (and by extension fiat money) has facilitated the explosion in real economic growth and the substantial increase in human welfare over the past two centuries.
Since money can be created and destroyed on demand, the fractional reserve system fully accommodates economic activity. In other words, money supply and money demand will always adjust to equilibrium. The process can be helped along and smoothed out by application of monetary policy, i.e. influence through the creation or destruction of high-powered money, or through changing the price of money (the interest rate). It is therefore possible for monetary authorities to apply counter-cyclical policies to reduce the impact of booms and busts in the economic cycle, although this is predicated on how much trust you can place in monetary authorities (for counter-examples refer to the Weimar Republic and the current government of Zimbabwe).
This adjustment isn’t possible under a full reserve system, as money demand must adjust to a relatively fixed money supply. If the Fisher identity holds, then assuming the velocity of money is constant real output growth must always converge to the rate of growth of the money supply. While the velocity of money is never a constant as I demonstrated before, it does vary within a range. For excess economic growth to persist and be supported by a full reserve system, the velocity of money must always be ever increasing, which is not plausible. I won’t repeat here the arguments for limited resources (i.e. the supply of gold will run out), but the rate of increase in gold supplies has historically been very low (evidence to come in a future post). A further implication is that under the full reserve banking system deflation and depressions are not only possible but probable, since there is no scope for using counter-cyclical monetary policy. The argument that inflation and deflation are not possible at all under a full reserve system is complete bunk as far as I’m concerned. This is borne out by the historical record, as the discovery of the New World in the 15th century along with its gold and silver mines, caused a long period of inflation in Europe.
More dangerously, tying money to gold or any other object of intrinsic value can give rise to the conflation that money=wealth. If that sounds innocuous to you, look up mercantilism. I think that there is no doubt that free trade (or at least, freer trade) has had a positive impact on global prosperity. Just as important, removing the link between money and wealth (and thus the applicability of mercantilist theory) reduces the impetus towards war, colonialism, and imperialism. If real output growth on a global basis is restricted to the rate of growth in money (i.e. gold), then the only way an individual country can raise the welfare of its own citizens is through appropriation (i.e. steal wealth from others) or annexation (i.e. take over and oppress others). Despite the fact that two massive world wars were fought in the last 100 years, the latter half of the 20th century has been amongst the most peaceful periods in recorded human history – yes, even with the conflicts in the Middle East, Asia, Africa and the Balkans. Incidentally, this ties in rather nicely with the shift from the Gold standard to a full fiat money system – you can draw your own conclusions.
The only way I see a full reserve banking system being even remotely attractive is if the monetary base is convertible into an asset which has a higher rate of growth than real potential output. This will of course apply a moderate amount of inflation, which is not necessarily bad as it allows for a low real interest rate as well as providing the correct incentives to borrowers and producers. But that still doesn’t allow for discretionary monetary policy, or remove the logic of mercantilism.
In short, at the present time, I see no real alternative to the fractional reserve banking system despite its many flaws. There is no doubt that the current global financial crisis represents a failure of the system on a wide scale, but I believe there is a case to be made that the fundamentals of the system has been short-circuited over the past ten years by the origination-securitization model, as well as the rise of the shadow-banking system. On the whole, I would rather have a system that generally supports increases in human welfare rather than one that restricts it, even if it means lots of bumps along the way.
As far as an Islamic financial system goes, I don't believe a debt-based banking system is the best way to intermediate between savers and entrepreneurs - but that's a post for another day.
Friday, March 13, 2009
Links of the Day
Dani Rodrik starts a debate against global financial regulation:
"Mr Rodrik identifies a number of problems with the idea of global regulation. Would the major economic powers of the world surrender their financial sovereignty to international regulators? No, he says. But if they were willing, could the nations of the world agree on the right set of regulations? They may not, he argues, pointing to the Basel process. Is there even a one-siz-fits-all solution? No, he concludes, citing the fundamental problem with the idea of global regulation."
Check out Richard Baldwin's post for a useful roundup of proposals for reform. I also like this little tidbit from Baldwin as well:
"My friends who are experts in financial regulation tell me that the whole Basle II exercise was subject to ‘regulatory capture’ by the big international banks, so I take Buiter’s point seriously."
"Mr Rodrik identifies a number of problems with the idea of global regulation. Would the major economic powers of the world surrender their financial sovereignty to international regulators? No, he says. But if they were willing, could the nations of the world agree on the right set of regulations? They may not, he argues, pointing to the Basel process. Is there even a one-siz-fits-all solution? No, he concludes, citing the fundamental problem with the idea of global regulation."
Check out Richard Baldwin's post for a useful roundup of proposals for reform. I also like this little tidbit from Baldwin as well:
"My friends who are experts in financial regulation tell me that the whole Basle II exercise was subject to ‘regulatory capture’ by the big international banks, so I take Buiter’s point seriously."
Thursday, March 12, 2009
Down The Slippery Slope: January IPI
A picture is worth a thousand words (log changes in IPI over the same period last year):
and here's the month on month (log changes in IPI over the previous month):
Unfortunately, DOS have changed the base of the index to 2005 starting this month, which precludes any deeper analysis until I get my hands on the complete time series and splice it into the old one. It's clear however that the carnage is largely in manufacturing.
and here's the month on month (log changes in IPI over the previous month):
Unfortunately, DOS have changed the base of the index to 2005 starting this month, which precludes any deeper analysis until I get my hands on the complete time series and splice it into the old one. It's clear however that the carnage is largely in manufacturing.
Maxis, iPhone and competitive markets
I'm going slightly off topic with this post, but since it's something I feel strongly about, I think it's justified.
The Star reports that the Apple iPhone will be launched on March 17, and only available with 6 month/24 month contracts through Maxis. I have nothing against the iPhone per se - it's a nice piece of hardware and engineering - but I truly deplore the idea of lock-in contracts, subsidised hardware, and exclusivity. The cheapest plan requires a monthly commitment of RM100 for 24 months, on top of the phone price of RM1900/RM2290 (8GB and 16GB models), and this comes with 333 minutes talk time and 500MB of data (full details of rate plans here). If you are already a Value Plan subscriber the phone costs RM2,540 for the 8GB model and RM2,960 for the 16GB model.
My opposition to this is that the way this is structured constitutes monopoly behaviour and restricts consumer choice. All the telcos have shifted to this model for wireless broadband modems, so the business model itself is nothing new. But putting it into practice with handphones is in my view a dangerous precedent, because that takes the business model mass-market. Here's my take:
1. Lock-in contracts means customers can't leave a telco without paying a hefty penalty.
2. Subsidised hardware distorts the price signals for handsets. Check out the difference between the new customer prices and old customer prices.
3. Exclusivity is market distortionary as well - want the iPhone? You have to be a Maxis customer, and never mind their service level. I can't confirm the exclusivity aspect, but I suspect it's there as that has been Apple's standard practice in every market they've tried to enter.
4. As a result of all the above, both Maxis and Apple will gain monopoly profits.
5. The incentive for maintaining after-sales customer service is substantially reduced.
6. The pressure to compete on price and service as far as voice and data are concerned, is also substantially reduced.
My biggest fear is that the iPhone deal will force other handset makers to follow suit - want a Samsung Omnia? Go to this telco. Want a HTC Touch Pro 2? Go to this telco. Want the latest, greatest Nokia? Go to this telco. The market becomes defined not by who has the best or cheapest service, but rather who has the best subsidy and hardware. If consumers were fully rational in the economic sense and take into account the total cost of a contract, this business model would never get off the ground. But the lower upfront costs relative to unsubsidised hardware seriously colours consumer perceptions, and we contribute to reducing competitive pressures in the market.
This business practice is one American import I truly wish we didn't get. Look at the structure of the US telco market - choice of handsets are far more restricted; services and features are defined by what telcos want to offer, not what the hardware can handle; and the pace of innovation is slow. France did the right thing in forcing Orange to supply iPhones unlocked and unsubsidised - I wish we had done the same.
Update:
Hah! Someone agrees with me:
"I think American cellular customers, businesses especially but also individuals, are not well served by linking handsets and carriers so tightly. Is it going to change? Not likely. Unless consumers speak up, Americans will probably continue to get second-rate cellular forever."
and:
" I do not know how we end these subsidies. I do not expect the government to intervene, though I do wish the FCC would take a deep breath and show some gumption for a change...Hardware subsidies by wireless carriers are anti-customer and need to stop. Wireless hardware and services should be purchased separately, which will lead to enhanced competition in both areas and wider choice/lower prices for customers."
And this link goes to a study of the American cellular industry that supports the contentions in this post.
The Star reports that the Apple iPhone will be launched on March 17, and only available with 6 month/24 month contracts through Maxis. I have nothing against the iPhone per se - it's a nice piece of hardware and engineering - but I truly deplore the idea of lock-in contracts, subsidised hardware, and exclusivity. The cheapest plan requires a monthly commitment of RM100 for 24 months, on top of the phone price of RM1900/RM2290 (8GB and 16GB models), and this comes with 333 minutes talk time and 500MB of data (full details of rate plans here). If you are already a Value Plan subscriber the phone costs RM2,540 for the 8GB model and RM2,960 for the 16GB model.
My opposition to this is that the way this is structured constitutes monopoly behaviour and restricts consumer choice. All the telcos have shifted to this model for wireless broadband modems, so the business model itself is nothing new. But putting it into practice with handphones is in my view a dangerous precedent, because that takes the business model mass-market. Here's my take:
1. Lock-in contracts means customers can't leave a telco without paying a hefty penalty.
2. Subsidised hardware distorts the price signals for handsets. Check out the difference between the new customer prices and old customer prices.
3. Exclusivity is market distortionary as well - want the iPhone? You have to be a Maxis customer, and never mind their service level. I can't confirm the exclusivity aspect, but I suspect it's there as that has been Apple's standard practice in every market they've tried to enter.
4. As a result of all the above, both Maxis and Apple will gain monopoly profits.
5. The incentive for maintaining after-sales customer service is substantially reduced.
6. The pressure to compete on price and service as far as voice and data are concerned, is also substantially reduced.
My biggest fear is that the iPhone deal will force other handset makers to follow suit - want a Samsung Omnia? Go to this telco. Want a HTC Touch Pro 2? Go to this telco. Want the latest, greatest Nokia? Go to this telco. The market becomes defined not by who has the best or cheapest service, but rather who has the best subsidy and hardware. If consumers were fully rational in the economic sense and take into account the total cost of a contract, this business model would never get off the ground. But the lower upfront costs relative to unsubsidised hardware seriously colours consumer perceptions, and we contribute to reducing competitive pressures in the market.
This business practice is one American import I truly wish we didn't get. Look at the structure of the US telco market - choice of handsets are far more restricted; services and features are defined by what telcos want to offer, not what the hardware can handle; and the pace of innovation is slow. France did the right thing in forcing Orange to supply iPhones unlocked and unsubsidised - I wish we had done the same.
Update:
Hah! Someone agrees with me:
"I think American cellular customers, businesses especially but also individuals, are not well served by linking handsets and carriers so tightly. Is it going to change? Not likely. Unless consumers speak up, Americans will probably continue to get second-rate cellular forever."
and:
" I do not know how we end these subsidies. I do not expect the government to intervene, though I do wish the FCC would take a deep breath and show some gumption for a change...Hardware subsidies by wireless carriers are anti-customer and need to stop. Wireless hardware and services should be purchased separately, which will lead to enhanced competition in both areas and wider choice/lower prices for customers."
And this link goes to a study of the American cellular industry that supports the contentions in this post.
Wednesday, March 11, 2009
Malaysian Mini-Budget and National Debt Implications
I won't make any commentary on the mini-budget - there's been enough in the blogosphere today, both for and against. But here's some of the implications for the national debt that I covered yesterday. Only RM35 billion out of the RM60 billion total package will be direct spending, and a further RM7 billion will be PFIs or off-balance sheet expenditure which won't be financed by the government.
That leaves a net increase of RM28 billion additional borrowing required, on top of the original RM21.8 billion projected budget deficit plus last year's RM7 billion stimulus package. Assuming next year's (2010) deficit is around the same ballpark figure as this year's (I'm leaving aside for now potential revenue shortfalls), we're looking at an increase of the national debt to about RM365 billion by the end of 2010 (net of the new Savings Bond scheme), or just under 50% of 2008 nominal GDP. In per capita terms, the increase is approximately RM3,000 per person.
As far as the increase in gross debt is concerned, there's really no historical precedent. However, in terms of the debt to GDP ratio, the two year increase is on par with the increase in debt after the severe 1981 recession. Let's hope we don't follow the same trajectory this time - debt to GDP peaked at 69.7% in 1987.
Funding the borrowing shouldn't be too much of a problem, as there is enough excess liquidity in the banking system to take the whole lot. But at this scale we're now in crowding-out territory where considerably less funds will be available for the private sector, not to mention the impact on monetary policy. RM80 billion of MGS, even spread as it is over two years, is going to significantly contract the money supply - in fact, yields on MGS have already increased in anticipation (thanks satD!) - unless BNM monetizes the debt i.e. print money.
At this stage, I don't think we have much choice in either fiscal spending or quantitative easing to cushion the downturn, but interest rates and MGS yields will bear close watch from now on - yields on 5 year MGS has already jumped 20 basis points yesterday, and are over 100 basis points above January levels.
That leaves a net increase of RM28 billion additional borrowing required, on top of the original RM21.8 billion projected budget deficit plus last year's RM7 billion stimulus package. Assuming next year's (2010) deficit is around the same ballpark figure as this year's (I'm leaving aside for now potential revenue shortfalls), we're looking at an increase of the national debt to about RM365 billion by the end of 2010 (net of the new Savings Bond scheme), or just under 50% of 2008 nominal GDP. In per capita terms, the increase is approximately RM3,000 per person.
As far as the increase in gross debt is concerned, there's really no historical precedent. However, in terms of the debt to GDP ratio, the two year increase is on par with the increase in debt after the severe 1981 recession. Let's hope we don't follow the same trajectory this time - debt to GDP peaked at 69.7% in 1987.
Funding the borrowing shouldn't be too much of a problem, as there is enough excess liquidity in the banking system to take the whole lot. But at this scale we're now in crowding-out territory where considerably less funds will be available for the private sector, not to mention the impact on monetary policy. RM80 billion of MGS, even spread as it is over two years, is going to significantly contract the money supply - in fact, yields on MGS have already increased in anticipation (thanks satD!) - unless BNM monetizes the debt i.e. print money.
At this stage, I don't think we have much choice in either fiscal spending or quantitative easing to cushion the downturn, but interest rates and MGS yields will bear close watch from now on - yields on 5 year MGS has already jumped 20 basis points yesterday, and are over 100 basis points above January levels.
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