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September 20, 2009

Economist's View - 6 new articles

Toxic Assets in the 18th Century

An example of a "toxic asset" from the past, the inconvertible bank note, that shows the need for the government to identify financial sector risks, and then provide the regulation necessary to keep the financial sector functioning normally:

Toxic assets in the 18th century, by Oren Levintal and Joseph Zeira, Vox EU: The global financial crisis has revived the old debate on optimal regulation in the money and credit markets. The current debate is centred on how to regulate highly sophisticated financial markets, yet the pros and cons are similar to those observed a few centuries ago, when paper money emerged and became the state of the art in the money market. Actually, problems of regulation appear whenever financial innovations change the ways capital markets operate. Looking at this history, e.g. the study of Davis (1896) on banking in Massachusetts, can help us understand the turbulent recent developments. In recent work, we touch on these issues by studying the evolution of paper money and its influence on economic efficiency and financial stability (Levintal and Zeira 2009).
Financial innovation in the 18th century
The evolution of money is, in some sense, a story of the development of financial technology. In the pre-banking era, gold and silver coins were the main media of exchange. Transactions were made with coins because purchases on credit were very risky (and barter was almost always impossible). When banks emerged during the medieval ages, they started to lend silver and gold. It was much cheaper to borrow money from a bank, which could exploit economies of scale to diversify the risk of default, than borrowing from a single risk-averse lender. Hence, the introduction of money lending by bankers reduced borrowing costs and facilitated trade.
The problem with lending silver or gold coins is the burden of reserves. Since lending and trade occur in different locations and different times, the bank must hold large reserves for loans. To see this, consider a simple model with a buyer, a seller, and a bank. At first, the buyer borrows silver from the bank. Then, he goes to the market to buy goods and pays the seller with his silver coins. The seller receives the silver and decides whether to hold it, deposit in the bank, or repay his bank loans. Note that silver flows into the bank only after the trade is executed (through deposits or loan repayments by sellers). Since the bank lends silver to buyers before trade, it faces a liquidity problem that imposes a reserve constraint on its lending. Namely, in order to be able to lend each morning, the bank has to carry silver reserves from the previous day, which is costly.
A better instrument of lending would be an asset that is available right at the moment of lending, without the need to hold it in advance. This type of asset emerged in the form of convertible notes or paper money. Convertible notes were issued by private banks and could be converted into silver or gold on demand. From the bank's point of view, lending notes was cheaper than lending silver, because silver had to be held in advance while notes could be issued by the bank at no cost. Actually, the bank still had to hold some reserves because the notes were not perfect substitutes for silver. Some note-holders continued to demand silver for various reasons. However, most of the notes were not converted because agents used them as a medium of exchange.
Convertible bank notes spread through the economy, as they enabled easier lending. This phenomenon happened toward the end of the middle ages and the beginning of the modern period. But that was not the end of the story. Banks realised that they could further reduce their lending costs by issuing inconvertible notes. If the notes were not convertible on demand, the bank did not have to hold reserves at all. We show in our paper that inconvertible banknotes emerge endogenously in a model of money and banking. The value of these notes is stable as long as there is competition with other forms of money, such as silver or notes issued by other banks. Competition imposes discipline on the issuing banks, because agents can always move to other forms of money. However, if some bank becomes the dominant issuer of notes (as was the case many times) and if silver is scarce, these notes face little competition. Thus, the issuing bank has incentive to over-issue notes, which might lead to inflation. This happened in several episodes of free banking and ultimately led to government intervention.
Inconvertible note crises
A very interesting example of inconvertible bank notes happened in Boston in 1740. In those days, the economy suffered from a chronic shortage of specie and a lack of appropriate substitutes. Several attempts were made to establish a bank that would supply an alternative medium of exchange. All of these schemes, described in detail by Davis (1896), proposed to issue notes that were not convertible into silver on demand, contradicting the practice of convertible notes prevailing in Europe. The intense debate and the greater scarcity of specie led to the establishment of two private corporations, the Land Bank and the Silver Bank. These banks issued notes that were not convertible on demand. The notes of the Land Bank could be redeemed only after twenty years into certain "manufactures" whose quality and value remained vague. The Silver Bank promised to redeem its notes within fifteen years into silver. The structure of the notes enabled the banks to operate without large reserves, because they were not obliged to convert on a daily basis. The notes circulated for less than two years. Many opposed their circulation, especially the Land Bank notes, but others favoured them. The operation of the banks was outlawed in 1741 by an Act of Parliament.
Another example of inconvertible notes was the famous "optional clause" in Scotland. The Scottish banking system in the 18th century comprised many private banks that issued convertible notes with an optional clause. The clause allowed the issuing bank to suspend payments of specie for six months and pay an additional interest of 2.5%. The exercise of the clause culminated in the years 1762-1765 where convertibility was practically abandoned, even beyond the six-month suspension. At some point, banks refrained from paying specie altogether, "confirming Scottish dependence upon paper" (Checkland 1975). The period was characterised by chronic inflation, exchange crises, and specie shortage. The public strongly protested against the option clause and the inability to receive specie, calling for government intervention. Eventually, in 1765, the option clause was outlawed and all the notes were required to be convertible on demand.
These examples demonstrate the endogenous development of inconvertible money issued by private banks, which served as a tool to minimise the stock of bank reserves. They also clarify why and how the government had to intervene. Evidently, all the free-banking episodes terminated with government regulation. Indeed, free and competitive money markets motivated the invention of new forms of money. Yet it also led to the emergence of a "toxic" asset (the inconvertible banknote) that had adverse effects on the economy and required government regulation. This story should sound familiar to the current observer, with banknotes replaced by asset-backed securities and toxic mortgages playing the role of the villain. The lesson is the same – free financial markets enhance financial innovation but can also have a somewhat shady side. The role of the government is to identify the risks and provide adequate regulation keeping the market on track.
Checkland, S. G. (1975), Scottish Banking: A History, 1695-1973, Glasgow: Collins, 1975.
Davis, A.M. (1896), "Currency Discussion in Massachusetts in the Eighteenth Century" The Quarterly Journal of Economics, Vol. 11, No. 1. (Oct., 1896), pp. 70-91.
Levintal, O. and J. Zeira (2009), "The Evolution of Paper Money", CEPR Discussion Paper 7362, July.

"What the Economy Needs Now"

Lawrence Mishel of the Economic Policy Institute (link)

The Response to Climate Change "Can Be Gradual—and Affordable"

When the topic of climate change legislation comes up, Republicans predictably respond with "but what about small business?," though the concerns generally extend to big business as well. Again and again we hear that any attempt to reduce carbon emissions will significantly reduce economic growth. For example, tomorrow's Wall Street Journal asks "Can Countries Cut Carbon Emissions Without Hurting Economic Growth?"

Taking the no we can't side of the debate, a side I disagree with, is Steven Hayward of the American Enterprise Institute. Taking the yes we can side is Robert Stavins of Harvard (see here too). He argues, persuasively in my opinion, that objections to climate change legislation based upon what it will do to business, small or large, and what it will do to the economic growth rate suffer from "basic errors":

Yes: The Transition Can Be Gradual—and Affordable, by Robert Stavins, WSJ [podcast of debate]: ...Critics argue that the legislation passed earlier this year by the U.S. House of Representatives—to cut U.S. emissions 80% below 2005 levels by 2050—will mean big, disruptive changes to our infrastructure and untold economic damage. But they make a couple of basic errors. For one thing, they seem to think we'd have to replace the entire infrastructure quickly, paying trillions of dollars to shift to cleaner power. They also seem to assume that we have to choose between much more expensive energy and no energy at all.
The move to greener power doesn't have to be completed immediately, and it doesn't have to be painful. ... How would this work? One way is via a combination of national and multinational cap-and-trade systems. ... The effect would be to send price signals through the market—making use of less carbon-intensive fuels more cost-competitive, providing incentives for energy efficiency and stimulating climate-friendly technological change, such as methods of capturing and storing carbon.
More Efficient
True, in the short term changing the energy mix will come at some cost, but this will hardly stop economic growth. ... Consider this: From 1990 to 2007, while world emissions rose 38%, world economic growth soared 75%—emissions per unit of economic activity fell by more than 20%. Critics argue we can't possibly increase efficiency enough to hit the 80% goal. In a very limited sense, that's true. Efficiency improvements alone ... won't get us where we need to go by 2050. But this plan doesn't rely solely on boosting efficiency. It brings together a host of other changes,... What's more, making gradual changes means we don't have to scrap still-productive power plants...
As for how much this will cost, the best economic analyses—including studies from the U.S. Congressional Budget Office and the U.S. Energy Information Administration—say such a policy in the U.S. would cost considerably less than 1% of gross domestic product per year in the long term, or up to $175 per household in 2020. (That's the cost of one postage stamp per household per day.)
In the end, we would be delaying 2050's expected economic output by no more than a few months. And bear in mind that previous environmental actions, such as attacking smog-forming air pollution and cutting acid rain, have consistently turned out to be much cheaper than predicted.
Critics ... challenge the price estimates the experts have set out. ... In particular, they say, developing nations won't sign onto plans for curbing emissions, for fear of losing their economic momentum. Indeed, we do need a sensible international arrangement in place..., and the economic pain will be much greater if we don't set up an international carbon market. But it can be done. ...
Road to Cooperation
For instance, the U.S. and China have been involved in intense talks about climate policy. If the two nations come together in a bilateral agreement—a real possibility—they would have much more leverage to persuade other major nations to join. From there, developing nations could be brought on board by giving them targets that reduce emissions without stifling growth. Advanced nations might agree to more-severe emissions cuts and allow developing nations to make gradual cuts in the early decades as they rise toward the world's average per-capita emissions. With the right incentives, developing countries can and will move onto less carbon-intensive growth paths.
The longer we put off serious action, the more aggressive our future efforts will need to be... For every year of delay before moving to a sustainable emissions path, the global cost of taking necessary actions increases by hundreds of billions of dollars. ... [A]cting sooner ... will lower the ultimate costs of achieving the target, because there will be more time allowed for gradual transition—which is what keeps costs down. Perhaps most important, the costs of failing to take action—the damages of climate change—would be substantially greater. ...

"New Models for a New Challenge"

Stephen Cecchetti, Piti Disyatat and Marion Kohler on "whether our macroeconomic models are still relevant," and if not, what needs to change:

Integrating financial stability: new models for a new challenge, by Stephen G Cecchetti, Piti Disyatat and Marion Kohler, September 2009: Introduction Reflecting on the financial crisis that is not yet over, it is natural to ask whether our macroeconomic models are still relevant. For all of their elegance and beauty, with their microeconomic foundations and complex endogenous dynamics, they provided the basis for monetary policy that delivered a quarter of a century of stability. The Great Moderation was great - inflation was low, growth was high, and both were stable. At least, that's what we thought. In retrospect, signs of smugness abounded. Academic journals are filled with papers explaining that this stability was, in large part, a result of good policy. And policymakers listened. The economy was inherently stable, with strong self-correcting forces. The financial crashes that were so common before the mid-20th century were banished by our deep and profound understanding that had been translated into mathematical models.

What a difference a year makes!

The models neither stopped the crisis from happening nor provided guidance on how policies could cushion its impact. They failed utterly in guiding our construction of an institutional framework capable of preventing systemic financial failure. Yes, there were warnings.1 And yes, there were models that hinted at the sources of the difficulties we now face. And yes, the economic reasoning provides the lens through which we can start to understand what happened and why. But, in the end, we ignored the risks.

In this essay, we begin with a brief review of the pre-crisis consensus that provided the basis for stabilization policy as it has been conducted since around 1980. Our main conclusion is obvious: we need to build economic models that integrate the financial sector in a serious way, accounting for the role of intermediaries with all of their linkages, both with each other and with the real economy. And, most importantly, these models must be capable of endogenously creating financial stress that can build up until the pressure leads to a crisis - that is, models in which booms and busts are normal. ...

... 4. Conclusion For macroeconomics, the biggest lesson of the financial crisis is that our models need to find a more meaningful role for finance. Episodes of financial stress are too frequent, and seem too costly, to be treated just as events that are "bad luck" and therefore of little consequence to forward-looking stabilization policy, as suggested by Lucas (2009). Rather, we should ask whether policy can and should intervene to make financial stress less likely and less damaging when it inevitably comes.
While the New Keynesian workhorse models are built around a role for stabilization policies, they appear to have stopped too soon. Understanding how to deliver economic stability must include an understanding of how to avoid financial instability.
Modeling financial booms and busts requires a model where financial imbalances matter for the real economy. As we have suggested in this essay, this means questioning a number of fundamental assumptions of the current workhorse macroeconomic models, including whether capital markets function properly, whether individuals behave rationally, whether we can really rely on the fiction of a representative agent, and whether markets clear.
As daunting a task as this may seem, prospects for progress are encouraging. Not only is there a clear awareness of the challenge (Bean (2009)), but work is already under way: heterogeneous agent models are being solved, bounded-rationality and learning are being actively explored, agent-based models are being simulated, and incomplete financial markets as well as substantive financial frictions are being introduced.
It is our hope and expectation that successfully integrating financial imbalances into models of real fluctuations will yield a toolkit for policymakers. It will guide us in the creation of new stabilization tools as well in the improved use of old ones. It will help us understand how to measure financial stress in real time and allow for transparency and accountability of policymaking in the same way that price measurement is essential for holding inflation targeting central banks accountable. Getting there will not be easy, but then, the challenge to conventional monetary policymaking 50 years ago surely appeared daunting as well. Hopefully, this time it will not take as long to get things worked out.

"The Essential Pillars of a New Climate Pact"

Sheila Olmstead and Robert Stavins argue that three essential elements must be present in the successor to the 1997 Kyoto Protocol:

The essential pillars of a new climate pact, by Sheila M. Olmstead and Robert N. Stavins, Commentary, Boston Globe: The climate change summit at the United Nations on Tuesday is aimed to build momentum for ... a successor to the 1997 Kyoto Protocol, which expires in 2012. To be successful, any feasible successor agreement must contain three essential elements: meaningful involvement by a broad set of key industrialized and developing nations; an emphasis on an extended time path of emissions targets; and ... policy approaches that work through the market, rather than against it.
Consider the need for broad participation. Industrialized countries have emitted most of the ... man-made carbon dioxide in our atmosphere, so shouldn't they reduce emissions before developing countries are asked to contribute? While this seems to make sense, here are four reasons why the new climate agreement must engage all major emitting countries - both industrialized and developing.
First, emissions from developing countries are significant and growing rapidly. ... Second, developing countries provide the best opportunities for low-cost emissions reduction... Third,... industrialized countries may not commit to significant emissions reductions without developing country participation. Fourth, if developing countries are excluded, up to one-third of carbon emissions reductions ... may migrate to non-participating economies through international trade, reducing environmental gains...
The second pillar of a successful post-2012 climate policy is an emphasis on the long run..., and major technological change is needed to bring down the costs of reducing CO2 emissions. The economically efficient solution will involve firm but moderate short-term targets to avoid rendering large parts of the capital stock prematurely obsolete, and flexible but more stringent long-term targets.
Third, a post-2012 global climate policy must work through the market rather than against it. ... One market-based approach, known as cap-and-trade, is emerging as the preferred approach ... among industrialized countries. ...
Cap-and-trade systems can be linked directly, which requires harmonization, or indirectly by linking with a common emissions-reduction credit system; indeed, this is what appears to be emerging... Kyoto's Clean Development Mechanism allows parties in wealthy countries to purchase emissions-reduction credits in developing countries by investing in emissions-reduction projects. These credits can be used to meet emissions commitments...
A new international climate agreement missing any of these three pillars may be too costly, and provide too little benefit, to represent a meaningful attempt to address the threat of global climate change.

links for 2009-09-19

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