Services and the Slow Economic Recovery

The Berkeley Economic History Laboratory (BEHL) launched a series of working papers earlier this year. The BEHL website notes that "These papers are preliminary works, and their circulation is intended to stimulate discussion and comment." To further that goal, as I mentioned in an earlier post, I'll be spotlighting these working papers on the blog. Three new papers are out; the one I'd like to write about today is called "Goods, Services, and the Pace of Economic Recovery," by Martha Olney and Aaron Pacitti.

The authors cite Lazear and Spletzer's argument that “the problem [with the U.S. economy now] is not that the labor market is underperforming; it is that the recovery has been very slow” (2012 pg. 35). Olney and Pacitti offer an explanation for the slow recovery based on a hypothesis that recoveries from downturns should be slower when services are a larger share of the economy. This comes from the simple idea that goods, and not services, can be produced ahead of an anticipated increase in demand, because only goods can be inventoried. Here is the abstract:

Do service-based economies experience slower economic recoveries than goods-based economies? We argue they do. An economy recovers from a downturn when businesses increase production. Both goods and services can be produced in response to actual demand. But only goods—and not services—can be produced in response to anticipated increases in demand, allowing optimistic forward-looking producers to inventory goods until anticipated buyers appear. Services can’t be inventoried. The more services an economy produces relative to goods, the more production is dependent upon only actual increases in demand, and the slower the recovery. We exploit variation across time and states in the share of services in output. Controlling for the depth of the downturn, the higher is the share of services, the longer is the recovery. Extending our results to the current downturn, given the depth of the downturn, the rise in services alone will make the post-2009 recovery last about 1 year longer than it would have a half-century ago.

The authors use national data for the 10 recessions in the United States from 1948 to 2001, and a panel of state data for 50 states and 5 recessions from 1969 to 2001. They use the depth of each recession as a control variable. Getting the state-level data on service sector shares and business cycles was not an easy feat, and is an important contribution of this research. They are able to document interesting, and changing, variation in the share of services by state. My home state, Kentucky, had the second lowest share of services (39%) in the nation in 1967-1969; the share has risen to 50%. Now oil-rich states Wyoming, Alaska, and Louisiana have the lowest share of services. (Take a look at figure 6 and very cool figure 7 in the paper.)

I am left wondering about the other side of the business cycle. The story in this paper is that businesses can anticipate an increase in demand and build up an inventory. What happens when a decrease in demand is anticipated? Wouldn't goods-producing businesses decrease production and start using up their inventory? This would lengthen the downturn part of the cycle by making it start sooner. If this is the case, service-oriented economies would have longer recoveries and shorter downturns. I don't know if the effect would be asymmetrical. For the state-level data, the authors measure recovery as the length of time from one peak to the next peak of the business cycle. This actually captures the length of the downturn plus recovery. I think it would be preferable to use trough-to-peak length instead of peak-to-peak length if the data allowed it, since share of services could plausibly effect peak-to-trough length and trough-to-peak length in different ways.


Overall, I think this working paper documents an intriguing empirical fact. Has anyone out there read (or written) a macro model with two firms with heterogeneous inventory costs? Please comment or send it my way if you have.Setting the inventory costs of one of the firms to infinity could represent the service sector. I think it would be useful to have a model to go along with this paper-- both to help think about my point in the last paragraph and because I am having trouble thinking about GE implications for relative prices and wages in the goods and services sectors and what role that could play. Any other comments or suggestions on the paper are of course welcome, and I will pass them along to the authors.

Trust and the Future of the Euro

Last week I attended the Future of the Euro conference at UC Berkeley. The conference was cosponsored by the Institute of European Studies, the EU Center of Excellence, the Austrian Marshall Plan Foundation, and the Austrian National Bank. The conference was structured around four panels on political, banking, fiscal, and monetary union. On each panel, several panelists--mostly economic historians-- gave brief presentations of about 20 minutes. In each case, I wished I could hear longer presentations to get more details. This was particularly true of the presentation by Lars Jonung from the monetary union panel, in part because he gave a critique of modern macro which I hadn't heard before.

Jonung is a senior professor in economics at Lund University, Chairman of the Swedish Fiscal Policy Council, and Research Adviser at DG ECFIN at the European Commission. Jonung says that when applying macroeconomic models, we need to keep in mind economic political culture, which he claims can be summarized as “trust.” The indirect cause of the euro crisis, he argues, was lack of trust by the public in the political system in certain parts of the Eurozone, especially Greece, Spain, and Cyprus. He describes the “vicious trust circle” in those areas, whereby weak performance leads to low trust, which leads to more weak performance, and so on. In other parts of the Eurozone, such as Germany and the Nordic countries, a “virtuous trust circle” is in place.

Jonung uses the Eurobarometer dataset as an indicator of trust. He says that the Eurobarometer ought to be a gold mine for researchers, but is rarely used because modern macro models include no role for trust. From his own analysis of the Eurobarometer, he finds that trust in national governments, the European Parliament, and the European Central Bank have fallen over the 1999-2012 period, but support for the euro has not. Jonung remarked, “People trust the euro, but they don’t trust the institution behind the euro.”

His proposed long-run cure for the euro area is to foster trust in national governments and the EU system via decentralized fiscal policy. For starters, this would entail fiscal policy councils in every member country, as well as Eurostat offices in every member country. (See a paper by Jenny E. Ligthart and Peter van Oudheusden on the role of fiscal decentralization on trust in government.) If the recovery continues to be slow, so that trust cannot be restored across the Eurozone, he thinks that one possibility is to have a “high trust monetary union” in the North and a “low trust monetary union” in the South, with flexible exchange rate between the two. Then, when trust is equalized, they could fix the exchange rate.

As I mentioned, I wished Jonung’s talk could have been longer, because it left a lot of missing details. First, I would have liked to hear more about his high trust and low trust monetary unions idea, particularly, how trust would eventually be equalized between the two unions. Much more fundamentally, I’m not sure exactly how Jonung interprets the concept of trust. The Eurobarometer survey asks respondents a large number of questions about their trust in, and support for, the euro and various institutions. But what do respondents mean when they say that they trust a currency or institution? Does trust in a government mean confidence that the government is not corrupt? Does it mean approval of government’s policies toward people in their situation, or in all situations? Does it mean optimism that the government will be successful in preventing hyperinflation or recession? Does it imply that the government is credible, or something else? What about trust in the euro? Does it simply measure the subjective probability that the euro will persist? Is it a sense of European identity? On the one hand, I am sympathetic to the argument that macroeconomic models do not incorporate political cultural factors like trust. On the other hand, depending on what exactly is meant by trust, it may be reflected in interest rates, exchange rates, and other features of the asset market which are to some degree built into macro models.

Jonung's recent working paper with Felix Roth and Felicitas Nowak-Lehmann D. notes that when respondents are asked about "trust" in the euro, "It seems reasonable to interpret 'trust' in the euro as `trust' in the purchasing power of this type of money," but this is not what the authors mean by trust. Instead they focus on the question about "support" for the euro, which "would then mean support for the idea of a single European currency while not necessarily meaning that the respondent expects the euro to deliver a stable purchasing power." This is more what the authors mean by trust. 

The first figure below comes from the Roth, Jonung, and Nowak-Lehmann's paper showing support for the euro in the EA-12 countries (where support is their indicator for trust.) I made the second figure at the Eurobarometer website (European Commission Public Opinion). It shows, for Greece only, the percent of respondents that tend to trust or not trust in the European Union. You can see trust in the EU fall drastically around crisis time. But I'm not sure exactly what this tells us, since respondents could interpret the question about trust in a variety of ways that would all show a decline in trust following a crisis. The fact that trust continues to fall, and hasn't leveled off, does seem interesting.

You can play around on the Eurobarometer site and see how trust in the EU and ECB changes in different countries with different country-specific or Europe-wide events. Roth, Jonung, and Nowak-Lehmann "interpret the fall in trust in the ECB to imply that citizens blame the ECB for not preventing the economic, financial and political turmoil during the crisis and suspect that the crisis measures taken by the ECB and other European institutions have had an inflationary effect," while at the same time, "respondents support the euro as their currency and...do not blame the euro for the crisis." 

When Economists Have an Auction

I just got back from the Berkeley Economics annual skit party. The skit party is combined with an auction to raise money for the Graduate Economics Association. Professor Yuriy Gorodnichenko contributed a very interesting auction item: a promise to pay $500 if Christina Romer or Janet Yellen becomes Fed chair at any time in the future.

The bidding started at $50, and quickly jumped up to $200. I was bidding against Gabriel Chodorow-Reich, a fellow macro student. I chickened out and went silent after he bid $220, so he won. Immediately after, I was kicking myself for not sticking in a little longer. I think Gabe got a heck of a deal-- plus I would just love to be able to say that I had bought this unique asset.

Professor Gorodnichenko (who also swept the awards ceremony tonight, winning the Best Professor and Best Adviser awards) donated another auction item-- a check with the amount drawn from a beta distribution with parameters alpha=3 and beta=2, multiplied by $100. The beta distribution is only nonzero on the unit interval, so the check will have value between $0 and $100. The mean of the beta distribution is alpha/(alpha+beta), so the expected value should be $100 (3/5)=$60. The item went for $50 -- so everyone in the audience must have been risk averse, loss averse, financially illiterate, or liquidity constrained (or some combination, like me.) A bottle of wine from Professor David Card's vineyard was the highest-priced item, going for $240.

The most creative item was donated by grad student Kaushik Krishnan. He collected and printed all of Brad DeLong's "Liveblogging World War II" blog posts and put them into a binder, which he promises to get signed by DeLong next time he's in Berkeley. If I remember right, that went for around $40.

Operationalizing the Dual Mandate

In January 2012, the Federal open Market Committee put out a principles statement describing its longer-run goals and policy strategy. On April 13, Narayana Kocherlakota, President Federal Reserve Bank of Minneapolis, gave a speech on the "operational implications" of the principles statement. He focused in particular on paragraph 5 of the statement, which says the following:

The Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

If the Fed's only mandate were to mitigate deviations of inflation from its longer- run goal, Kocherlakota explains, then the Fed would aim for the green line, rather than the red line, in the graph below (from his slides.) He is confident that monetary policy works in one to two years, so reaching the inflation target of 2% (indicated by pi* in the graph) in two years would be both feasible and consistent with the mandate concerning inflation, if that were the only mandate.

Since the Fed has not one but two mandates, Kocherlakota explains, they must "balance" the inflation objective and the employment objective. He uses the graphs below to explain how he interprets "balance."

He says that the red line is "not balanced" because unemployment returns too slowly to its objective level u* (he does not specify its value.) The green line, on the other hand, he calls "balanced." It is more accomodative, with inflation rising faster and unemployment falling faster. The key point he makes is that inflation is allowed to rise temporarily above target, for a time, to help bring unemployment down.

A word I kept waiting for him to use is "symmetric." Last year, Mark Thoma noted that "the projections from members of the FOMC looked more like a ceiling than a central point," and thought that comments made by some officials could indicate that the Fed viewed the costs of overshooting and undershooting its target as asymmetric. If the objective were treated as a ceiling, then policymakers would choose the red line. Kocherlakota's  preference for the green line in the graph indicates that he does not view 2% as an upper bound on inflation, but is willing to allow inflation to go above 2%.

Thoma also wrote a fake interview with Kocherlakota in September asking him about the symmetry of the inflation target, and whether there is in fact an upper threshold on inflation. This fake interview was based on Kocherlakota's speech "Planning for Liftoff" in which he said that "as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent." There is no scale on the graph to tell us whether that green line, at its maximum, is "allowed" to go above 2.25%. 

Though the speech is called "Operational Implications of the FOMC's Principles Statement," I'm not entirely sure how those green lines are intended to be operationalized. Until somewhere around quarter 7 on his graph, the two mandates are actually complementary; accommodative policy brings both inflation and unemployment closer to target. Then it looks like accommodation continues until around quarter 10-- inflation keeps rising, unemployment falling. But what does the Fed do from quarter 10 onward to get inflation to fall and keep unemployment moving steadily downward? The reason the two objectives are sometimes called "not complementary" is because in previous experience it has been hard to achieve the kind of outcome he plots starting in quarter 10. So if I were fake-interviewing Kocherlakota, that is what I would ask him about.

In the graphs below, I replicated Kocherlakota's "Dual Mandate Outlook" graphs using data from the U.S. Survey of Professional Forecasters. The red lines show the mean forecasts for inflation and unemployment made in 2013Q1 for various time horizons. The dashed lines are pi* and u*, where for u* I used the forecasters' latest mean "natural rate of unemployment." The forecasters do expect something qualitatively similar to Kocherlakota's green "balanced" lines at first: they expect inflation to exceed the 2% target in sometime sooner than 8 quarters, and for unemployment to continue falling. But while Kocherlakota hopes inflation will peak in 10 quarters, the forecasters expect inflation to peak in 12 quarters (at 2.27%). And while he hopes inflation will fall back to target by around 16 quarters from now, the forecasters expect it to still be up at 2.24% even  in 20 quarters. 

Finance and Morality

A few weeks ago I wrote about Ignazio Visco, Governor of the Bank of Italy, and his lecture on the Financial Sector After the Crisis. This week he gave the opening remarks at the Islamic Financial Services Board forum on "The European Challenge."

The main prescriptions relating to financial transactions in accordance with Islamic religious law are the ban on paying interest and the prohibition of excessive uncertainty and speculation in contractual arrangements. This is predicated on the principle that profits should be generated from fully sharing in the business risk of an investment (the so called “profit and loss sharing principle”). The asset-backing requirement complements these prescriptions, providing for the link between each financial transaction and an identifiable underlying asset. 

A few weeks ago I gave a lecture on the financial sector after the crisis. On that occasion, it occurred to me that the renowned economist and philosopher – and eventually Nobel laureate – Amartya Sen had given in these same rooms the first of our scholarly lectures entitled to the memory of our late governor Paolo Baffi. Sen’s lecture was on “Money and Value: on the Ethics and Economics of Finance”. It is of course an interesting and good read in these difficult days. But what I was most intrigued by was Sen’s question: “How is it possible that an activity that is so useful has been viewed as morally so dubious?” 

There are indeed a good finance and a bad finance. While we may have some differences in ideas and perceptions on the goods and the bads, I think that what is most important is really to focus on the link between financial transactions and underlying assets, to conclude, with Sen, that “finance plays an important part in the prosperity and well-being of nations”. Indeed, it is crucial for sharing and allocating risk, especially for poorer societies and people. It is crucial for transferring resources over time and removing liquidity constraints. It is very important for fostering innovation and promoting economic growth. 

But it has to be certainly “ethical” and certainly transparent.

Many religious traditions have long recognized the moral and ethical challenges of finance and provide at least some guidance to their followers on the issue of finance. Ignazio Visco is not himself Muslim (as far as I know), but he is sympathetic with some of the moral sentiment behind Islamic religious law about finance. What I think we are seeing recently, and will see more of, as a result of the financial crisis is a wider-spread emphasis on morality in finance.

Not that this is entirely new. Via Nathan Tankus, here's a quote from The Economist, November 2, 1907 (after a major banking panic):

The financial crisis in America is really a moral crisis, caused by the series of proofs which the American public has received that the leading financiers who control banks, trust companies, and industrial corporations are often imprudent, and not seldom dishonest. They have mismanaged trust funds, and used them freely for speculative purposes. Hence the alarm of depositors, and a general collapse of credit.

What can a secular society do about a moral crisis? Can regulatory reform (like Admati and Hellwig's proposals in "The Bankers' New Clothes," for example) make the financial system as a whole more "moral" seeming, even if individuals within the system are not moral? Can economists treat morality as something that can be incentivized? I need to keep this post brief today since I am preparing for a presentation tomorrow, but I'd love to hear readers' thoughts on these questions, or for people to post links to good readings on this topic.

Sex Ratios, Savings Rates, and Princeton Women

I'm sure by now just about everyone has read the letter to the editor in the Daily Princetonian, written by Susan Patton, called "Advice for the young women of Princeton: the daughters I never had." Her advice, in short, is to "Find a husband on campus before you graduate" because "you will never again have this concentration of men who are worthy of you." It is controversial advice, to say the least, and has sparked a veritable deluge of reactions by bloggers, journalists, and even Princeton alum economist Edward Glaeser.

By curious coincidence, a new NBER working paper appeared the same month as Patton's letter that takes her basic reasoning to more extreme implications. The paper, by Qingyuan Du and Shang-Jin Wei, is called "A Theory of Competitive Savings Motive." Patton, like the economists, has a model in her head of marriage as a two-sided market, in which both sides (males and females) act strategically to find an optimal match. The premise of Patton's advice, and of Du and Wei's paper, is that sex ratio imbalances in a pre-marital cohort affect the bargaining power of each gender, which in turn influences their optimal strategies.

In countries like China, where there are many more young men than young women, men (or households with sons) raise their savings rates to improve their relative standing in the marriage market. Du and Wei model this competitive savings motive and use simulations and cross-country data on savings rates, sex ratios, and other control variables to estimate its magnitude-- which they find to be very large. Not only does an imbalanced sex ratio cause a country's savings rate to be higher, it can also affect the global economy, since, given a world interest rate, a country with a more balanced ratio wants to save less than a country with an imbalanced ratio, so capital flows from the imbalanced-ratio country to the balanced-ratio country. As the authors explain:

When the country with an unbalanced sex ratio is large, this could have global ramifications. In particular, as the sex ratio rises, the world interest rate becomes lower. Other countries with a balanced sex ratio could be induced to run a current account deficit. Calibration results suggest that the sex ratio effect could potentially explain about half of China's current account surplus and the U.S. current account deficit.

In China, the sex ratio imbalance is a drastic and horrifying demographic fact, as Du and Wei explain:

In many economies, parents have a preference for a son over a daughter. This used to lead to large families, not necessarily an unbalanced sex ratio. However, in the last three decades, as the technology to detect the gender of a fetus (Ultrasound B) has become less expensive and more widely available, many more parents engage in selective abortions in favor of a son, resulting in an increasing relative surplus of men. The spread of technology started in the early 1980s and accelerated quickly afterwards...The strict family planning policy in China, introduced in the early 1980s, has induced Chinese parents to engage in sex-selective abortions more aggressively than their counterparts in other countries. The sex ratio at birth in China rose from 106 boys per hundred girls in 1980 to 122 boys per hundred girls in 1997.

Susan Patton, the Princeton mother, refers to a quite different sex ratio imbalance, one that afflicts Princeton women in particular:

Men regularly marry women who are younger, less intelligent, less educated. It’s amazing how forgiving men can be about a woman’s lack of erudition, if she is exceptionally pretty. Smart women can’t (shouldn’t) marry men who aren’t at least their intellectual equal. As Princeton women, we have almost priced ourselves out of the market. Simply put, there is a very limited population of men who are as smart or smarter than we are. And I say again — you will never again be surrounded by this concentration of men who are worthy of you... As freshman women, you have four classes of men to choose from. Every year, you lose the men in the senior class, and you become older than the class of incoming freshman men. So, by the time you are a senior, you basically have only the men in your own class to choose from, and frankly, they now have four classes of women to choose from. 

If smart women "can’t (shouldn’t) marry men who aren’t at least their intellectual equal" and also can't marry men who are younger than them, but smart men can marry younger, less educated women, then smart women find themselves up against an effective ratio that is not in their favor once they leave college. (As Hanna Rosin points out, for every two men who receive a B.A. in the United States, three women will do the same.) Young men and women in China cannot escape the imbalanced ratio, so they adjust their financial behavior to improve their marital outcome, taking the ratio as given. In other words, it's an exogenous variable in their optimization problem. Princeton women, in contrast, do not need to take an unfavorable sex ratio as given; it is a choice variable in their optimization problem. They can choose to benefit from a better ratio by marrying while they are still at Princeton, when vicinity and youth work in their favor. (Presumably they could also benefit from a better ratio by not getting so gosh-darned well educated that they "price themselves out of the market," is an unspoken implication--but I'm sure she does not intend to advise this.) (Also presumably they could enter PhD programs in economics and have a few more years of smart men in high concentration, but I'm sure she does not intend to advise this either.)


I'm not a Princeton woman, but I am smart, and a newly-wed, and an economist.  So I do more than my fair share of thinking about love and marriage and markets, though not (usually) simultaneously. I met my husband in my first year of graduate school (he was already out of school), but I don't think my newly-acquired optimization-problem-solving skills had anything to do with it. It certainly wasn't part of my plan. I think the marriage-as-market concept is useful on a macro level, because in the aggregate there are indeed consequences of imbalanced sex ratios, so papers like Du and Wei's are interesting and important. Demography is real, culture is real. They can be usefully incorporated, at least to some degree, into models. But I don't know how useful the marriage-as-market concept is on a personal advice level, from a mother to the "daughters she never had." It sounds funny and odd, just as it does when the economists try to factor love and emotions into the equation-- not their comparative advantage. Here's a gem from the paper:

Everyone is endowed with an ability to give his/her spouse some emotional utility (or "love" or "happiness"). This emotional utility is a random variable first period with a common and known distribution across all members of the same sex, and its value is realized and becomes public information when the individual enters the marriage market.

I would be more than happy to get advice from older female alumni from my college or grad school. But instead of life-optimization tips through an economist's lens, I'd much rather have the kind of advice that Patton thinks young women don't need. "For years (decades, really) we have been bombarded with advice on professional advancement, breaking through that glass ceiling and achieving work-life balance. We can figure that out," she claims. I have not been bombarded with that type of advice at all, (and don't expect to run across a model for optimizing work-life balance any time soon.) Those topics are precisely the areas where I think advice is still welcome and needed.

We didn't meet at Princeton.

Uncertainty as a Tool

At the Fed, uncertainty is frequently blamed for dragging down the economy. "There’s no question that slow growth, high unemployment, and significant uncertainty are challenges for monetary policy," John Williams of the San Francisco Fed remarked earlier this year. He added:

There’s pretty strong evidence that the rise in uncertainty is a significant factor holding back the pace of recovery now...More generally, research shows that heightened uncertainty slows economic growth, raises unemployment, and reduces inflationary pressures. This pattern has held over the past three decades, but the effects have been particularly notable in recent years. For example, capital spending has downshifted noticeably since early last year...  The job market also shows the effects of uncertainty...

Williams and other Fed officials have pointed to several sources of uncertainty. The fiscal cliff is an often-cited example, as is the European debt crisis. These sources of uncertainty are basically exogenous to monetary policy, but the Fed itself can also add or reduce uncertainty through its policies and communications. A handful of economists--George Shultz, Michael Boskin, John Cogan, Allan Meltzer, and John Taylor-- wrote in a Wall Street Journal editorial that "The Fed is adding to the uncertainty of current policy. Quantitative easing as a policy tool is very hard to manage. Traders speculate whether and when the Fed will intervene next."

If uncertainty really does have significant effects on the economy, and the Fed really can significantly influence the level of uncertainty, then a logical implication is that uncertainty management is a powerful policy tool. And yet, at least in most countries (with a notable exception that I will get to), this implication does not seem to be taken seriously. For all that policymakers bemoan the effects of uncertainty, they seem reluctant to seriously address it, which makes me wonder if it is simply a convenient scapegoat. Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, called for more accomodative monetary policy in a speech on April 2.

I think that there are several possible approaches available to the Committee. For example, the FOMC could reduce the public’s level of policy uncertainty by clarifying the nature of the economic conditions that would lead the Committee to reduce or stop its current asset purchases....However, [this] would require the FOMC to make relatively complex changes to the language of its current communications.

He ultimately rejected the notion of using uncertainty management as a policy tool, however, calling instead for a lower unemployment threshold.

The notable exception is Turkey, where the central bank deliberately increased uncertainty to address its policy goals. The iMFdirect blog describes the situation:

In mid 2010 the Turkish central bank decided to introduce a policy that increased uncertainty in interest rates hoping that would stop foreign investors who were pouring money into the country in search of a quick buck... The Turkish economy was overheating. Money poured into the country from foreign investors attracted by a strong economy and high yields. A lending boom resulted in excessive growth along with an appreciating exchange rate and widening current account deficit. While evidence of success, these kinds of capital inflows are a headache policymakers would rather avoid, as they expose a country to risks that affect the economy and financial system as a whole, while undermining the objective of controlling inflation... 

Although targeting inflation, in 2010 the Turkish central bank became increasingly vocal about dangers to financial stability. In the absence of a timely response from the banking supervisor, it started to employ less traditional tools with an explicit purpose of addressing both price and financial stability concerns. A cornerstone of the strategy was using policies that created uncertainty.

The uncertainty-generating strategy entailed widening the so-called interest rate corridor. The upper end of the corridor is the overnight lending rate, and the lower end is the overnight borrowing rate. The iMFdirect explains,

In October 2010, the central bank sharply lowered the overnight borrowing rate, at which banks deposit money at the central bank, while keeping the overnight lending rate, at which the central bank lends money to banks, unchanged. By varying the volume of liquidity provided to the markets through repo auctions, which are essentially short-term collateralized loans, it started to generate a lot of volatility in the overnight interbank rate within this widened interest rate corridor... 

Previously, the overnight interbank rates were kept close to the policy rate at which the central bank provides liquidity through quantity repo auctions, indicating the potential rate-of-return for a foreign investor. As the corridor widened, the volatility of the market rates increased. While on average the market rates continued to be close to the policy rate, now it was the “floor” of the corridor that signaled to investors a guaranteed rate-of-return. Lowering it, it was hoped, would deter speculative inflows.

The Turkish central bank also began to provide liquidity to the markets through different repo facilities. By varying the amounts of liquidity provided through these facilities, the central bank could change the cost of lending to banks on a daily basis which creates uncertainty for local banks. Turkish Central Bank Governor Erdem Basci "confounded economists" with his latest move a few days ago. Bloomberg reports that

Economists are split on whether Turkish monetary policy is looser or tighter...BNP Paribas SA, Goldman Sachs Group Inc., Oyak Securities and Ata Invest interpreted the move as loosening policy to focus on boosting growth, while BGC Securities said it was contractionary. Morgan Stanley described it as “neither here nor there” and Finansbank called it “confusing.”

The iMFdirect post writes that it is too early to judge the benefits and drawbacks of Turkey's approach. They point out, and I agree, that the banking supervisor could have employed macroprudential measures sooner to address some of the concerns about excessive growth and capital inflows without the need for the central bank to use uncertainty to address these concerns. Still, it is interesting to see uncertainty added to the toolbox.