Raghuram Rajan is Not Paul Volcker

Raghuram Rajan will take over leadership of the Reserve Bank of India (RBI) on September 4. The BBC lists some of the challenges facing the Indian economy, including a large current account deficit, weak rupee, the slowest growth in a decade (around 5%), and inequality, adding, "Many believe that the single biggest failure of the government's economic policies in recent years has been the inability to control inflation in general and food prices in particular."

It's clear that Rajan will have his work cut out for him, but what kind of work will that be? 

"The monetary situation is such that he may be forced to act as India’s Paul Volcker, hiking up rates and perhaps even orchestrating a recession to get the currency and inflation under control," writes Dylan Matthews. Matthews notes that "By law, India’s central bank doesn’t have much political independence, as Rajan serves at the pleasure of the government and can be sacked at any time. That could deter him from making tough moves against inflation that could have unpopular implications for growth. But Subramanian thinks he’ll have a great deal of flexibility in practice, even if the opposition Bharatiya Janata Party comes to power again."

There is a tendency to want to frame the challenges of the Indian economy in terms of a power struggle between monetary and fiscal authorities-- an "unseemly battle of wits over interest rates," according to Rajrishi Singhal at Bloomberg.  Singhal describes how the Finance Ministry has piled pressure on Rajan's predecessor, RBI Governor Duvvuri Subbarao, to keep rates low. The idea is that, if only the new Governor can stand up to "bullying" and raise rates, then inflation and the rupee can be stabilized. But India in 2013 is not the U.S. in 1979, and Raghuram Rajan need not imitate Paul Volcker.

A central banker's role in India is much different than a central banker's role in the United States or Europe. Monetary policy, remember, is ultimately based on frictions. Prices and inflation are nominal variables. In a frictionless economy, there is no role for monetary policy. It is because of certain frictions that monetary policy can have short-run effects, and these frictions provide the justification for using monetary policy to stabilize economic fluctuations over the business cycle. The optimal monetary policy depends on the nature and magnitude of these frictions. Sticky prices and sticky information are the two categories of frictions most used in the analysis of monetary policy. Both have similar implications for how monetary policy should generally work.

The theory behind the Taylor rule is based on the sticky price friction. The rule recommends a relatively high interest rate or “tight” policy when inflation or employment is relatively high, and a relatively low interest rate in the opposite scenario. According to the Taylor rule, India's policy rates are currently too low. As Ashok Rao writes (in a very excellent post), "A healthy Taylor rule requires an accurate estimate of the output gap which is founded on long-run trend growth. “Trend” growth is a useless concept in countries like India and China, whose growth rates have both a high mean and variance."

But there may be a more fundamental reason why the Taylor rule is not suitable for India. The Taylor rule is based on the sticky price friction, which may not be the dominant friction. Amartya Lahiri suggests that the dominant friction is asset market segmentation (emphasis added).

A well-known feature of the Indian economy is that access to asset markets and instruments is extremely limited. About 140 million households in India do not have access to any formal banking at all. Consequently, less than half of all individuals have access to any formal financial services...It is thus abundantly clear that there is endemic and widespread segmentation in asset markets in India with only a small subset of India having access to formal asset markets. But curiously, discussions about monetary policy in India are completely divorced from this asset market segmentation."

How does asset market segmentation impact the monetary policy calculus? In this case the central bank needs to use monetary policy to provide insurance to those that are absent from these markets. This policy imperative can naturally imply very different monetary policy responses relative to when prices are sticky.

Rajesh Singh, Amartya Lahiri, and Carlos Vegh study optimal monetary policy in environments with segmented asset markets. As Lahiri summarizes,

Intuitively, the role of policy under this friction is to protect households that are excluded from asset markets from excessive fluctuations in their consumption levels. When output is high, consumption of these households tends to rise due to (a) higher income; and (b) higher real money balances as the exchange rate tends to appreciate. By expanding money supply, the central bank can inflate away some of the increase in real balances and thereby moderate the rise in consumption. This procyclicality of the optimal monetary policy is clearly at odds with the Taylor rule prescription that monetary policy should be countercyclical.

The authors also find that asset market segmentation has surprising effects on optimal exchange rate regimes (effectively the opposite of the Mudellian model). They come down in favor of targeting monetary aggregates instead of targeting the exchange rate. The model of Singh et al. is admittedly very stylized and I have found no existing tests of its empirical implications. So I am certainly not actually recommending that Rajan rush to lower interest rates. Nor am I suggesting that Rao's proposal of a rule-based exchange rate policy should be off the table.

Rather, I just intend to highlight the topsy-turvy theoretical results that can arise when we alter the foundations of our models; in particular, when we acknowledge lack of financial inclusion as a significant friction. I also believe that an important role for Rajan, perhaps more important than any decision about interest rates, will be in reforming the financial system and promoting financial inclusion. I am very optimistic on this front. The Financial Times reports that "economists who know Mr Rajan well say helping hundreds of millions of Indians get access to efficient financial services is close to his heart." In 2008, he wrote "A Hundred Small Steps," a report on financial sector reforms. I am most impressed by his inclusion in Chapter 3, "Broadening Access to Finance," of this chart, which shows the interest rates actually paid by people in each income quartile.

It appears that he is quite sensitive to the severity of asset market segmentation in India and to the fact that interest rate movements are not evenly transmitted across all segments of the population.

Three Thought-Provoking Central Banking Reads

I have three recommendations for readers interested in central banks and monetary policy. First, my classmate Jeremie Cohen-Setton has started a new blog (together with Tishani Dorfmeister) called ECB Watchers. This blog is great for anyone who watches the Fed too, because the comparative analyses of ECB and Fed policies are quite illuminating. In particular, they have good insights into why the ECB and the Fed will each face serious but different challenges with forward guidance. They explain how the differences stem in part from the Trichet doctrine, which basically holds that non-standard monetary policy measures can “be determined largely independently” from conventional measures. They add:

The intellectual case for such a separation became more fragile, however, as the ECB introduced another set of non-standard measures (LTROs, covered bond programme, Securities Markets Programme and, should it be implemented, the Outright Markets Transactions), which implicitly addressed the second category of problems. By and large, the ECB has remained very shy with measures affecting the structure and risk premia problems (which it consistently saw as bordering fiscal policy) in comparison to the Fed and other central banks.

This relative timidity for touching the risk and term premia can be understood in a multi-country context where monetary policy would inevitably have important distributional consequences. But ECB officials often overplay this aspect. The ECB has eventually been forced to venture in this field and is nervously attempting to rationalize and justify these interventions ex post by explaining that the specific set up of the euro area and in particular the risks of financial fragmentation justified such an approach (see speech by Benoit Coeure at the Banque de France). But this argument is anachronic, because the ECB’s non-standard measures largely predates the financial fragmentation along national boundaries or redenomination risks (covered bond programme, SMP) and because the institutional set up cannot be a sufficiently good reason for the ECB not to undertake what its mandate and its fiduciary duty towards European citizens call for.

My second recommendation is a speech by Fed Governor Sarah Bloom Raskin called "Beyond Capital: The Case for a Harmonized Response to Asset Bubbles." Unfortunately, since she gave the speech on the same day as Chairman Ben Bernanke's testimony on July 17, the speech was under-covered. The bit of coverage that the speech has had mostly just notes that she thinks regulation can stem asset bubbles. But it actually has quite a bit more content. The mechanics of asset bubbles-- why and how they form and grow-- is not clearly understood. But Governor Raskin provides a much clearer and more coherent discussion than I have seen in any previous central banker speech (and I have read quite a lot of them!) Here's a long excerpt-- I'm thrilled to see a central banker actually putting this many words into explaining precisely what they mean by an asset bubble before saying what they want to do about it.

It used to be believed that asset bubbles emerged spontaneously, or perhaps came from sunspots or other mysterious causes. Now we know more and we know better, and, while we may not be able to predict bubbles, we understand them to be a product of particular actions and choices by financial institutions and their regulators.

Here is one way a bubble might start. And, to approximate current economic conditions, we'll assume an environment of interest rates that have been low, and continue to be low, for a long time. To start, retail investors may become dissatisfied with their low yields and begin to seek higher yields by purchasing some specific higher-yielding asset. If investors have access to credit, they might try to raise the return on their money by funding a greater portion of their purchases with debt. The asset purchased could serve to collateralize their loan. If many investors employ this strategy and they borrow to invest in the same asset, the price of that asset, and perhaps the prices of closely related assets as well, will increase noticeably faster than the historical trend.

At the same time, increased demand for credit to finance these asset purchases could lead lenders to increase their reliance on less expensive, unstable short-term funding, such as uninsured deposits, commercial paper, or repo transactions, in order to fund the loans.

Besides meeting customers' growing demands for credit, financial intermediaries may themselves decide to "reach for yield" and take on additional risk in a low interest-rate environment. Banks suffering compressed net interest margins because of low long-term interest rates, money market funds facing an earnings squeeze, insurance companies that had promised minimum rates of return on their products, and others may all begin to take on higher interest rate risk, market risk, liquidity risk, or credit risk in search of higher returns.

If these conditions seem likely to continue, an initial rise in the asset's price leads to expectations of further increases, which adds to investor demand, spurring further borrowing and credit growth and increased household and financial sector leverage, which, in turn, could drive asset prices still higher. Rising asset prices, in turn, would increase the value of borrowers' collateral, allowing still further borrowing.

For loans collateralized by an asset whose price is rising, lenders believe they can rely for repayment more on the appreciation of the asset and collateral and less on the borrower's repayment ability. Lenders relax their underwriting standards, such as minimum requirements for borrower down payments, credit scores and credit history, or required maximum debt-to-income ratios. To compete for loans to buy or to hold the appreciating asset, or financial assets related to it, financial institutions could also decrease the margins and haircuts that usually protect them from asset price declines.

Financial institution decisions to relax underwriting and impose less-stringent margins and haircuts will further increase the pool of potential borrowers and their borrowing capacity, further increasing credit growth and supporting still higher asset prices, but, at the same time, will also increase lenders' credit risks and exposure--as secured creditors--to a decline in the asset's price. Ultimately, the asset becomes severely overvalued, with its price untethered from economic fundamentals. We would then have on our hands a full-blown, credit-fueled asset bubble.

And, as we experienced in the financial crisis, when a bubble involving a widely-held asset bursts, the consequent plunge in asset prices can seriously impair the balance sheets of households and firms. Indeed, a dramatic decline in the price of a significant asset can reduce household wealth, spending, and aggregate demand. When such effects on wealth, credit availability, and aggregate demand are large enough, the real economy can suffer a significant recession. And, of course, lower employment and incomes further depress asset prices and borrowers' ability to repay loans, with further adverse effects on financial institutions and their ability to extend credit.

At this point, some financial institutions may have become nearly insolvent. And this, coupled with their increased reliance on potentially unstable short-term funding, could make them more vulnerable to sudden losses of public confidence.

Such a loss of confidence, in turn, makes it impossible for affected institutions to roll over existing debts or extend new credit, and may force deleveraging that requires selling illiquid assets quickly and cheaply in asset fire sales, resulting in further declines in asset prices. Such developments further threaten the solvency of financial institutions and intensify credit contraction, depriving households and businesses of financing. A loss of confidence that is institution-specific could spread, causing other institutions to experience their own heightened solvency risks, liquidity problems, and need to de-lever through asset sales.

My third recommendation is an old (in blogosphere terms) post by Nick Rowe called "Is money a liability?" I came across it because I'm teaching undergrads about the central bank balance sheet this week (as Rowe was too when he wrote the post.)

Chronicles of a Reverse Helicopter Drop

Ben Bernanke's nickname, "Helicopter Ben," refers to a famous "thought experiment" in economics. What would happen if the government were to rain money down upon us from a helicopter? Milton Friedman pondered this question in "The Optimum Quantity of Money" in 1969. The helicopter drop thought experiment is increasingly mentioned in discussions of unconventional monetary policy possibilities for the Fed, Bank of England, and ECB. Helicopter money was the subject of a speech given by David Miles, External Member of the Monetary Policy Committee of the Bank of England. Forbes calls QE4 "Another Step Towards Helicopter Money."

An earlier version of the helicopter drop thought experiment did not involve helicopters, because they were not invented yet. David Hume, in 1752, asks us to "suppose that,by miracle, every man in Britain shou’d have five pounds slipt into his pocket in one night." (Robert Lucas later criticizes the "magical" quality of this scenario.) Hume reasons that it should have no effect:

Where coin is in greater plenty; as a greater quantity of it is then requir’d to represent the same quantity of goods; it can have no effect, either good or bad, taking a nation within itself: no more than it wou’d make any alteration on a merchant’s books, if instead of the Arabian method of notation, which requires few characters, he shou’d make use of the Roman, which requires a great many.

Yet, Hume notices that in practice, his conclusion doesn't seem to hold. “Tho’ the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease, but some time is requir’d before the money circulate thro’ the whole state, and make its effects be felt on all ranks of people." His observation is based on the experience of France in the 1720s, an experience almost as magical as the five pound miracle.

In a paper with one of my all-time favorite titles, "Chronicles of a Deflation Unforetold," Francois Velde describes and analyzes the French monetary experiment of the 1720s. French currency at the time was gold and silver coins with nominal value set by government decree. The monarch could raise the legal tender value of the coins (augmentation) or lower their value (diminution). Over a seven-month period in 1724, the nominal value of the coins was reduced by 50% through a sequence of diminutions. On one instance, coins lost 20% of their nominal value overnight. This episode served as an experiment testing the neutrality of money. Here is Velde's abstract:

Suppose the nominal money supply could be cut literally overnight by, say, 20%. What would happen to prices, wages, output? The answer can be found in 1720s France, where just such an experiment was carried out, repeatedly. Prices adjusted instantaneously and fully on one market only, that for foreign exchange. Prices on other markets (such as commodities) as well as prices of manufactured goods and industrial wages fell slowly, over many months, and not by the full amount of the nominal reduction. Coincidentally or not, the industrial sector (as represented by manufacturing of woolen cloths) experienced a contraction of 30%. When the government changed course and increased the nominal money supply overnight by 20%, prices responded much more, and the woolen industry rebounded.

By the spring of 1724, the diminutions had cumulatively reduced the value of coins by one third, but without a matching reduction in prices. In other words, money was non-neutral. This of course caused economic troubles including industrial contraction. Policymakers clearly recognized that public expectations were a cause of monetary non-neutrality and a channel of monetary transmission. Following a diminution on April 4, 1724, the finance minister Dodun wrote a letter to be made public (cited in Velde).

The minister explained that the cumulative reduction in coin value had by now reached a third, and the public ought to see the benefit of this reduction in lower prices. This had not yet happened “because merchants and workers, foreseeing that other reductions might happen, used this pretext to increase prices rather than reduce them.” But coins were now at a rate destined to remain “for a long time if not forever, the public has no reason to fear further reductions for now.”

Dodun's letter served as an attempt of "forward guidance," but was not credible; another diminution ocurred on September 22. Today, monetary policymakers still attempt to make use of the power of public expectations. Forward guidance has been especially emphasized since 2011.

On another occasion, Dodun remarked that

...experience has shown us that the prices of commodities and goods is influenced less by the value of coins than by the fear of an impending reduction on coins and uncertainty over their future value, and this same fear and uncertainty would persist and prevent the previous reductions from having their effect...

Dodun's remark sounds familiar. The choice criticism of Fed policy even now is the accusation that it causes uncertainty. John Taylor, for example, argues that the Fed's quantitative easing announcements amplify uncertainty. In a speech I discussed in a previous post, Cleveland Fed President Sandra Pianalto lists "managing uncertainty" as a primary responsibility of the Fed. The American Enterprise Institute cautions that "Economic policymakers must focus not on experimental policy responses, but rather on reducing the high level of economic policy uncertainty by simplifying the tax system and avoiding new initiatives like the Federal Reserve’s QE3."

Dodun mentions not only uncertainty, but also fear. It is the combination of fear and uncertainty that he finds disruptive. Fear, I would argue, has the potential to do more harm than uncertainty, but the two tend to be confused. Unconventional monetary policy, to the extent that it is poorly understood and sometimes unprecedented, may cause uncertainty but it need not cause fear. The Fed can take some steps to address uncertainty through communication, provided they don't toss credibility out the window like Dodun. In a crisis, doing nothing would cause more fear than trying something new. "Avoiding new initiatives" is not the way to reduce fear and uncertainty.

Overheating and the Fed

This article is cross-posted at the Berkeley Blog.

Governor Jeremy Stein of the St. Louis Federal Reserve gave a speech on February 7 called "Overheating in Credit Markets: Origins, Measurement, and Policy Responses." Overheating is a term he uses to describe a credit market with low interest rates, lax lending standards, and high risk-taking by investors "reaching for yield." The problem with overheating is that it can contribute to financial instability. A boom followed by a bust can create harmful spillovers for the economy.

Both monetary policy and regulatory policy can potentially address overheating. In the speech, Stein describes an approach called decoupling, which holds that monetary policy should restrict its attention to the goals of price stability and maximum employment, while supervisory and regulatory tools should be used to safeguard financial stability.  Stein does not completely buy this decoupling approach. He recognizes that low interest rates are a cause of overheating, and that the Fed, by its power to control interest rates, can address overheating in ways that regulators cannot.

I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly... I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability...Supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns...While monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot.

In the New York Times, Binyamin Applebaum writes that Stein's speech "underscored that the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth." In fact, the Fed's concern about bubbles is not so new. After the Great Depression, it was widely believed that the stock market overheated in the 1920s, leading to the Great Crash in 1929 and the onset of the Depression. In those days, the word for bubbles or overheating was speculation, and it became a dirty word indeed. After the Great Depression, speculation remained a major concern of the Fed. The Fed very explicitly regarded bubbles as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth.

For example, the United States economy was in a recession in 1953-54. In 1955, as the economy was recovering, the minutes from the Federal Open Market Committee refer multiple times to concerns about "speculative developments" or "speculative excesses." The March 2 minutes note:

The critical problem for credit and monetary policy in the United States, the review [from the Board's Division  of Research  and  Statistics  and  Division  of  International  Finance] said,  was how to thread its way along the narrow ledge that encourages sound economic growth and high employment and, at the same  time, limits speculative developments and discourages financial over commitments by businesses and consumers.

Minutes from May 10, 1955 say:

Business,  financial,  and  consumer  confidence  is  extraordinarily  high--possibly  too  high  for sound  growth.  At  this  stage,  the task  of monetary  and  credit  policy  is  to foster  stable  growth  in  line  with expanding  manpower  and  industrial  resources,  at  the  same  time  restraining financial  over-commitments  and  dampening  speculative  excesses.

In 1958, William Phillips published "The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom." This really kicked off the now-common idea that inflation is the most likely negative consequence of the Fed's efforts to reduce unemployment. If the Fed is now starting to regard bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment, this is not a new trend. It is history of thought repeating itself.

Quantity Theory in Chinese History

Yesterday Yaohua Li of the Shanghai University of Economics and Finance presented her research on "The Goal of Private Pensions" at the Berkeley Economic History Lunch. After her presentation, I have a new-found tremendous admiration for anyone brave enough to study Chinese economic history. The data challenges are huge-- and so are the potential rewards for anyone diligent and resourceful enough to confront them.

Li is studying the differences in the private pension systems that arose in the United States and China in the 1920s and 30s and trying to understand why the systems developed the way they did. It is not too hard to find data about pension plans in the U.S. in that era, but for China, due to political constraints, no one has been able to collect such data before. Li is doing it totally from scratch. (As someone who has always been able to download my data straight from the Internet, I am blown away!) Her research is too preliminary for me to share results here, but she did bring up an interesting episode in monetary history that I would like to discuss.

In 1934, the United States passed the Silver Purchase Act and as a result began importing significant volumes of silver from abroad, particularly from China. China was on a silver standard, so as its silver flowed abroad, its money supply shrank. Exactly as Anna Schwarz describes, the shrinking money supply caused interest rates to rise. China was relatively unaffected by the Great Depression in 1929-- that depression rampaged the countries shackled by "golden fetters," which transmitted a monetary contraction in the United States and France around the world. But depression hit China in 1934, concurrent with the decline in its silver money supply. Just as the gold standard countries were forced off of gold in the late stages of the Great Depression, China left its silver standard in 1935.

I wanted to know more about what happened next with China's money. Research is substantially limited because of data restrictions, exacerbated by the Pacific War beginning in 1937. There is a 1954 paper by Colin Campbell and Gordon Tullock which includes as its first footnote, "The personal observations of Mr. Tullock have provided the principal data for this study. He was in Tientsin as a Foreign Service Officer from 1948 to 1950." They describe how the Nationalist, Communist, and Japanese governments in China all issued their own currencies and engaged in "monetary warfare," each prohibiting the use of the others' currency beginning around 1938.

In Free China, with the Japanese invasion in 1937, the government increased bank credit as a means of war finance. Campbell and Tullock were up on their quantity theory. From 1937 to 1938, the government was able to expand the money supply faster than prices rose. But in 1938, "people evidently began to realize that prices would rise continuously. As soon as they tried to hold smaller cash balances because they expected inflation, velocity increased sharply...In 1938-44 and in 1946-47 wholesale prices rose more rapidly than the money supply." This is a textbook-example-worthy case of Milton Friedman's distinction between the short run and long run.

In 1988, the Chinese authorities were worried about double-digit inflation and remembered how perfectly Friedman's theories described their own history before 1949. They sought Friedman's advice and apparently followed it, bringing inflation down to acceptable levels.

Real Estate Monetary Standard: the New Wildcat Banking?

Michael Sankowski at Monetary Realism suggests that we may be on a "real estate monetary standard." He writes:

Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.
Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.

He makes the comparison to a gold standard, but I suggest another analogy: the Free Banking Era. The Free Banking Era refers to the period from 1837 to 1863. Prior to free banking, opening a bank was a difficult process that involved obtaining a charter from a state legislature, and the Second Bank of the United States required state banks to keep an adequate supply of specie on hand, thereby limiting the amount of notes that they could issue. When the Second Bank closed, states needed to make bank entry easier to fill the void in banking services. New York and Michigan were early adopters of free banking laws, which allowed anyone to operate a bank as long as notes were redeemable on demand and backed by state bonds held at the state auditor's office. Eventually, 18 states adopted free banking laws. I would like to compare the state bond-backed monetary system to what Sankowski calls our real estate monetary standard.

With the passage of the free banking laws, many new banks opened and a plethora of different kinds of banknotes circulated as currency. An expansion of the banking sector in that era has its analogue in the expansion of mortgage lending, including subprime lending, from around 2003-2007, when there was also large growth in non-bank independent mortgage originators. (See Joshua Wojnilower's post on how tax policies created a real estate monetary standard.)

The Free Banking Era is notorious for a large number of bank failures, which often resulted in losses to noteholders. The conventional explanation for the problems of free banking is also a common explanation for the bank failures of recent years: fraud and greed. The evil bankers of those days were called “wildcat bankers." In a well known 1974 paper, Hugh Rockoff explains the link between wildcat banking and free banking laws. Some states allowed banks to issue notes equal to the face value, instead of the market value, of the bonds backing. So wildcat bankers could buy state bonds that had depreciated, deposit them with the state auditor, and issue currency amounting to the face value, rather than the depreciated value, of the bonds. They could then circulate these notes to the public, in exchange for specie and investments worth more than what they paid for the state bonds, forfeit the bonds and run off with the bank’s assets. Sound familiar? Consider Felix Salmon's description of the "enormous mortgage bond scandal."

This is where things get positively evil. The investment banks didn't mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren't going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker. In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors. 

However, as the Economist notes, there has been "a lot of debate over whether blame [for the recent financial crisis] should be assigned to deliberate fraud by financial-industry actors, or whether the whole phenomenon was simply an unfortunate catastrophe based on systemic miscalculations. General opinion settled on the unfortunate-catastrophe thesis." Likewise regarding the free banking era, later authors such as Gerald Dwyer and Arthur Rolnick and Warren Weber argue that most bank closings and noteholder losses were not caused by fraudulent wildcat banks, but rather by capital losses due to drops in state bond prices. There were systemic miscalculations concerning state bonds like there were with mortgage-backed securities. And in fact, they were eerily similar.

State governments at the time were in the business of building roads and canals, running up big debts to do so. It seemed like a great investment, given New York's success with the Erie Canal. States expected to be able to service debt with the revenue proceeds of an expanding tax base; the land boom of the 1830s seemed to promise growing property tax revenues. Plus, the roads and canals that they were borrowing to build were expected to bring in even more revenue. So state bonds were presumably extremely safe assets. It was very similar to the subprime loans made during the housing bubble: even though borrowers didn't have the income they would need to pay their mortgages, they were allowed to borrow because home values were expected to keep rising. But just as AAA-rated subprime-mortgage-backed securities were downgraded to junk status when borrowers started defaulting, the state bonds also sunk in value when many states went into default.

Then as now, leverage mattered. Nine of the ten states with the highest per capita debts defaulted; none of the states with below median per capita debts defaulted. The defaults of course caused financial turmoil and also adversely impacted the real economy. And although the pros and cons of free banking were not well understood until well over a century later, policymakers were fairly quick to impose new regulations. The Free Banking Era came to an end with the passage of the National Bank Acts of 1863 and 1864, which set up a national system of banking with federally issued charters and a uniform national currency backed by Treasury securities. The Comptroller of the Currency was established as a supervisor in 1863; the Federal Housing Finance Agency was established in 2008 to supervise secondary mortgage market components. The parallels are so interesting--this is why I love economic history!

Japan and the Formation of Inflation Expectations

With the Bank of Japan's adoption of a 2% inflation target making headline news, it seems like a good time to discuss some recent research on the psychology of inflation expecations by Berkeley Professor Ulrike Malmendier, who was recently awarded the 2013 Fischer Black Prize from the American Finance Association. This biennial prize honors the top finance scholar under the age of 40 years old. Malmendier works in the intersection between finance and behavioral economics and is known for her incredible creativity.

Here is the abstract of Malmendier's paper with Steven Nagel titled "Learning from Inflation Experiences":

How do individuals form expectations about future inflation? We propose that past inflation experiences are an important determinant absent from existing models. Individuals overweigh inflation rates experienced during their life-times so far, relative to other historical data on inflation. Differently from adaptive-learning models, experience-based learning implies that young individuals place more weight on recently experienced inflation than older individuals since recent experiences make up a larger part of their life-times so far. Averaged across cohorts, expectations resemble those obtained from constant-gain learning algorithms common in macroeconomics, but the speed of learning differs between cohorts.
Using 54 years of microdata on inflation expectations from the Reuters/Michigan Survey of Consumers, we show that differences in life-time experiences strongly predict differences in subjective inflation expectations. As implied by the model, young individuals place more weight on recently experienced inflation than older individuals. We find substantial disagreement between young and old individuals about future inflation rates in periods of high surprise inflation, such as the 1970s. The experience effect also helps to predict the time-series of forecast errors in the Reuters/Michigan survey and the Survey of Professional Forecasters, as well as the excess returns on nominal long-term bonds.

Malmendier and Nagel's paper over a time period covering several monetary policy regimes, which differ markedly from that of Japan. But a related paper by David Blanchflower and Conall Mac Coille focuses on the UK, which practices inflation targeting.  "The Formation of Inflation Expectations: an Empirical Analysis for the UK" (2009) includes a summary of why inflation expectations matter for monetary policy, and how this is relevant to inflation targeting: 

In the neo-Keynesian model (see, for example, Clarida et al. 2000), sticky prices result in forward looking behaviour; inflation today is a function of expected future inflation as well as the pressure of demand, captured in an output gap term. Thus, expectations are deemed to be an important link in the monetary transmission mechanism. Monetary policy can be more successful when long-term inflation expectations are well anchored. Hence, many studies have focused on the question of how to assess the response of inflation expectations to macroeconomic shocks, and whether this is likely to be lower in inflation targeting regimes. 

Blanchflower and Mac Coille also summarize three paths through which inflation expectations matter:

Wages are set on an infrequent basis, thus wage setters have to form a view on future inflation.  If inflation is expected to be persistently higher in the future, employees may seek higher nominal wages in order to maintain their purchasing power.  This in turn could lead to upward pressure on companies’ output prices, and hence higher consumer prices.  Additionally, if companies expect general inflation to be higher in the future, they may be more inclined to raise prices, believing that they can do so without suffering a drop in demand for their output.  A third path by which inflation expectations could potentially impact inflation is through their influence on consumption and investment decisions.  For a given path of nominal market interest rates, if households and companies expect higher inflation, this implies lower expected real interest rates, making spending more attractive relative to saving. 

In Japan, the third path may be most important. The higher inflation target is intended to lower real interest rates and boost consumption and investment. But there is a fourth reason, not listed by Blanchflower and Mac Coille, of particular relevance to Japan. Foreigners' expectations of future inflation affect the value of the currency. the Japanese Ministry of Finance recently revealed a 222.4 billion yen ($2.5 billion) current account deficit-- a measure of how much imports exceed exports. When people expect Japanese inflation to be higher in the future, the yen gets less valuable now, because it won't be able to buy as much stuff later; the yen weakens. But in this case, weakness is not necessarily bad. A weaker yen means that Japanese people will find it more expensive to import stuff, so they will import less. Likewise, people outside of Japan will find it cheaper to buy Japanese stuff, so Japan will export more. This helps shrink the current account deficit. And depending on the sizes of the income and substitution effects, Japanese consumers may buy more Japanese products.

Under inflation targeting in the UK, even though inflation expectations are reasonably well anchored, and median expectations are around the inflation target, there is substantial heterogeneity across agents in their inflation expectations. Malmendier and Nagel's paper provides a behavioral theory to explain part of this heterogeneity based on agents' heterogeneous past experiences of inflation. Heterogeneous inflation expectations have the potential to affect the workings of all the paths through which inflation expectations matter. We need to understand not only how Japan's inflation target will influence median inflation expectations, but also how it will affect expectations of price setters, wage setters, borrowers, savers, exporters, trade partners, etc. More than likely, these groups differ significantly in their demographics, have had different experiences, and thus form different expectations of inflation. (For reference, the graph below displays Japanese inflation, interest rates, real GDP per capita growth rate, and M2 growth rate. Japan has not seen 2% inflation since 1997.) Extensions of Malmendier's research to other countries and monetary regimes will be very useful in understanding the effects of monetary policy.

Monetary Policy and Inequality

Technical statistical details don't usually make headlines, but in Britain they have, and for good reason. The Office for National Statistics (ONS) announced that they would not change the way they calculate the Retail Prices Index (RPI), the country's oldest measure of inflation. A change to the RPI was expected because the formula used to calculate it is widely recognized as flawed.

The Consumer Price Index (CPI) is the price index used for inflation targeting and other macroeconomic purposes. It was introduced in the 1990s and is calculated in a similar fashion across countries. Compared to the CPI, the RPI tends to be higher by around 1.3 percentage points. Why does this upward bias matter? The RPI is used as the price index for inflation-linked government bonds and for many company pension payments. If the ONS had changed the formula, pensioners and holders of these bonds would have received lower future payments. Pensioners tend to be older, so some groups representing older people lobbied against the change. Of course, other people would have benefited from the change, namely some companies and taxpayers who are financing these pensions and bonds.

This actually brings up a broader point about monetary policy. Protection against inflation varies significantly across the population, so monetary policy is redistributive. People don't all experience inflation in the same way. It depends on the share of their income that comes from labor income versus financial income and also on the proportion of their assets indexed to inflation. Moreover, some people's wages are indexed to inflation or at least respond quickly to inflation, while other wages are "stickier." And as illustrated by the RPI situation, even inflation-linked assets may not perfectly track inflation dynamics. Age, income, employment status, and asset holdings all play a role in determining how monetary policy affects a person.

My adviser Yuriy Gorodnichenko and several coauthors have a recent paper called "Innocent Bystanders? Monetary Policy and Inequality in the U.S." They note that there are several theoretical channels through which monetary policy can affect income inequality. For example, if low-income households tend to hold relatively more currency than high-income households, then increased inflation would create a transfer from low-income households toward high-income households. Some of the channels predict that monetary policy will increase inequality, while other channels predict that monetary policy will decrease inequality. So a priori, the effect of monetary policy on inequality is ambiguous. Through careful empirical work, they are able to determine which channels are strongest. They find that monetary policy accounts for about 10-20% of the increase in inequality since the 1980s. In particular, contractionary monetary policy shocks "have effects on labor earnings which vary systematically across the income distribution: labor income rises at the upper end of the distribution and falls at the lower end." (Their empirical results apply to the United States, not to Britain, where the relative strength of the various channels could be different.)  Considering the redistributive impacts of monetary policy, not just its overall impact on GDP, is an important challenge.

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