I'm going to put forward two perspectives on why bad banks might be important in understanding the recession: an orthodox perspective; and a heterodox perspective.
Banks are financial intermediaries. A financial intermediary is a firm whose (primary) business is borrowing and lending. (They intermediate between the ultimate borrowers and the ultimate [...]
Today I taught basic finance to my first year economics class. We don't have time to cover all the micro chapters, so have to skip some. In the past we skipped the finance chapter. This year we decided to include the basic finance chapter, and skipped consumer choice (indifference curves [...]
Most macroeconomists take a Ricardian regime as their unspoken assumption; and, if pressed, would recommend a [...]
Similarities:
S1. Both do general equilibrium analysis, trying to understand the interaction between parts of a whole system, with lots of positive and/or negative feedback loops.
S2. Both have got time-series data that show how different variables are correlated. We try to explain those correlations by building models. Sometimes we can use [...]
To paraphrase Churchill, accountants and economists are divided by a common language. We seem to be using the same words to talk about the same things, but we don't understand what the other is saying. This is my attempt to provide an economist's perspective on the relation between accounting and [...]
Last night I was chatting with someone who works for a think-tank. I work for Carleton University. We both work for charities. Like households, firms, and governments, charities have income and expenses, and a net worth. Consumer choice theory tells us, at least in principle, how much people should save, [...]
We always knew that interest rate targeting could never work in theory, because it left the price level indeterminate. But it seemed to work well in practice, and kept inflation close to target, so we eventually learned to overcome our theoretical squeamishness and embrace it as part of the reality [...]
Cuban blogger Yoani Sanchez reports being beaten up and abducted by Cuban...quasi-authorities, for being a "counter-revolutionary" (i.e. having an independent blog). Check out her blog Generation Y.
I normally stick to economics, but have decided to make a rare exception here. I follow Yoani's blog, to help keep me in [...]
Scott Sumner argues that nominal interest rates are near zero because monetary policy (specifically expected future monetary policy) is too tight. He argues that tight (expected future) monetary policy makes expected inflation low, which makes nominal rates low. He also argues that tight (expected future) monetary policy makes real [...]
I am going to start with an orthodox monetarist approach, make one trivial semantic change, and see how far I can get in deriving Neo-Chartalist results. The semantic change is to change what I mean by "fiscal policy". It's an unconventional definition of fiscal policy, from a monetarist [...]
If a social scientist wanted to understand what happens in church, he could ask the churchgoers themselves for an account of what they do in church. But the social scientist's account of what happens in church need not be the same as the churchgoers' account.
If an economist wanted to understand [...]
If you look at the balance sheet of a central bank, you will see it has liabilities (mostly currency) and assets (normally mostly government bonds/bills). Why do central banks have assets? Do they need them?
The wrong answer is that central banks need assets to "back" the value of the [...]
Both central banks and commercial banks issue liabilities that function as media of exchange. Why do we say that it is central banks, rather than commercial banks, that determine monetary policy; setting interest rates in the short run, and inflation in the long run? What makes a bank a central [...]
Notes for a panel discussion in Ottawa on Tuesday evening (details below).
200 years ago, economists made a prediction, and we got it wrong. "Big deal" you might say. But it was a big deal; a much bigger deal than some piddling mistake like failing to predict a global financial crisis. [...]
The title really says it all. And it's not a rhetorical question; I don't know the answer. But if the US is really concerned (H/T Mark Thoma) about the US dollar being too high against China's yuan, and it believes China is "artificially" preventing the yuan from appreciating [...]
Why does the Loonie appreciate when the Bank of Canada tightens monetary policy (relative to what was expected)? And depreciate when the Bank loosens monetary policy (relative to what was expected)?
Before you conclude I've lost it, by asking such an easy question, consider the following weird thought-experiment.
Suppose that one night, [...]
Doug Peters and Arthur Donner (names I remember from the 1970s debate over inflation in Canada) have an opinion piece in the Toronto Star on the role of the Bank of Canada in reducing the budget deficit. It starts out fine, but ends in a non-sequitur.
It really does start [...]
Paul Krugman has a flow chart showing flows of savings from ultimate lenders to ultimate borrowers. One arrow goes via the banks. Paul labels it "traditional banking"; that's fine. People deposit their savings in banks, and the banks lend those savings to other people or firms. But a second [...]
Brad De Long thinks very highly of Greg Ip, even when Brad thinks Greg gets something wrong. Brad thinks Greg is very sharp. So do I. But the other reason why Greg Ip is such a good economic journalist is that he was thoroughly trained in both Journalism and [...]
There is a perfectly sensible theory that says that rent controls reduce labour mobility and can therefore worsen structural unemployment. I'm going to ignore that sensible theory and put forward a silly theory -- one I believe is wrong. But I'm putting forward a silly theory to make (what I [...]
The textbooks say that money serves as: store of value; medium of account; and medium of exchange. Arnold Kling seems to miss the importance of the fact that money is a medium of exchange. Worse, he misunderstands me, thinking that I am one of those economists who makes a [...]
Arnold Kling asks: why are mackerels different from money? Why should the M in MV=PY stand for money, and not mackerels?
Why can't an excess demand for mackerel cause a recession? Why can't an excess supply of other goods be matched by an excess demand for mackerel?
Keynesians don't know the [...]
This post is more of a bleg; because I'm sure someone reading this knows more about the answer than I do.
An insurance company doesn't need reserves if it is insuring a large number of short term uncorrelated risks. The Law of Large Numbers ensures that its annual claims will equal [...]
Mike Moffatt asks the right question; and it's the economist's question.
In economics, if we think the price of x is too high, we don't just say "we should lower the price of x". We look for the underlying causes of the price of x being too high. "Where's the [...]
(Or maybe the title should be: "Notes from the Phelps/Lucas Administration"; or "Notes to supplement our fading memories of the late 1970's".)
Is this a Dark Age in macroeconomics? In other words, have we collectively forgotten some (important) stuff that we used to understand?
I want to approach this [...]
My own memories are similar to Paul Krugman's, but with one important difference. This is the bit I remember differently:
"The Lucas view took the economics profession by storm – not because there was any solid evidence for it, but because it was so clever, because it led to nice math, because [...]
It's not just John Cochrane; it's not just (modern) Chicago; it's (nearly) all of us.
Which economist has not written, said, thought, taught, or learned, the following:
"Let there be n goods (including money, if it exists). Max U(X1,X2,..Xn) subject to SUM over n[P(X-E)]=0. Aggregate over all people. Therefore the sum of [...]
For a whole economy, does planned expenditure on newly-produced goods necessarily equal planned income from the sale of newly-produced goods? That's what I mean by "Say's Law" in this context.
Say's Law is wrong, and the fact that it is wrong is really important for macroeconomics. But it's not obvious why [...]
That's the question we ought to be asking right now, but I haven't seen anyone ask it, let alone answer it. I don't know the answer, but I do know it's the right question to ask.
For every dollar borrowed there's a dollar lent, by definition. If there are debtors, who [...]
There are signs of economic recovery. Suppose a year from now it is clear that the economy has indeed recovered. What caused it? Was it: monetary policy; fiscal policy; or did the economy recover by itself?
I don't know the answer to that question; nor does anyone else. If you have [...]
I saw an example of the Junker Fallacy recently (it doesn't matter where). You have probably seen it too somewhere.
"Investment is low because people (or firms) spend all their savings on speculation rather than investment -- bidding up the price of houses, shares, land, or in corporate takeovers; there is [...]
"You and I can only lend money if we've got some to lend; but banks can create money and debt simultaneously at the stroke of a pen". Might commercial banks be the cause of the increase in debt over the last few years?
Maybe partly, but basically no. You can't just [...]
Who owns the Fed? Is the Fed really privately owned?
I don't know, and I don't really care (except perhaps out of idle curiosity). Learning who has really owned the Fed all these years would make little or no difference to how I view the Fed.
I expect someone determined enough to [...]
Could monetary policy have caused the recent rise in levels of debt?
The obvious answer is that loose monetary policy lowers interest rates, which causes people to want to borrow and spend more, and so go deeper into debt. That answer is both obvious and wrong, as I explained in a [...]
The Loonie has been appreciating recently. This has a number of people, including me, a bit worried. What can/should the Bank of Canada do about it?
So it's easier for me to tell the story simply, assume:
1. The world = Canada + US
2. The Loonie is initially at par with [...]
Updated below.
I have heard the argument so many times: "Low interest rates caused people to want to borrow and spend, and that's what caused debt to increase". It's such a simple and obvious explanation; only someone with a PhD in economics could fail to understand it. Unfortunately it's also an [...]
I first heard about this growth model back in the 1980's, applied to management consulting firms. Only the expletive wasn't "Cripes!".
It's a 2-stage growth model:
Stage 1: "Cripes! We've got all these consultants on the payroll! How are we ever going to pay for them all? Better get some more contracts."
Stage [...]
I think our minds (brains, whatever) are like a multi-product firm. We have to decide how many things to think about -- how many different products to produce. We don't think about just one thing all the time; but we don't think about an infinite number of things either. There [...]
I have been checking almost daily for the Teranet-National Bank May house price data, and now it's out. Their national composite price index increased 0.72% from April to May. This confirms the less accurate and more anecdotal data we've been hearing about the Canadian housing market improving this Summer.
The [...]
Nothing new here. Just another kick at the debt can. And basic national income accounting.
Income = expenditure is almost always false at the level of the individual. How can it be true for a whole economy, which is just a collection of individuals?
Income = expenditure [in any given year, or [...]
The Bank of Canada says it believes the recession has ended. Maybe they are right; I haven't checked, but I get the impression that their forecasting has been better than most over the last year. This doesn't mean that output and employment will immediately return to normal, of course. But [...]
Felix Salmon has a lovely metaphor that helps me articulate something I've been wanting to say about the risk of buying a house:
"In that sense buying a house isn’t an investment, so much as it’s a way of permanently covering your built-in short position when it comes to the shelter market."
If [...]
I don't want tighter monetary policy; I want looser. I don't want the Bank of Canada to raise interest rates, but I do want the Bank to do something that would cause it to want interest rates to rise. I want it to buy real assets.
We have become so accustomed [...]
Paul Krugman has bravely and commendably been trying to understand intuitively the underlying reasons for the big differences between fiscal policy multipliers in a couple of New Keynesian models. Someone needs to do this job. (Take as read a general rant against economists who write down fancy mathematical models [...]
I learn via Mark Thoma that there is a distinct chance that California will allow taxes to be paid in the new scrip it issued when it ran out of funds. I have no idea whether this will happen, or whether the Federal government will stop it. Let me [...]
Suppose one big bank makes a mistake, and that big bank is 50% of the market? You have a problem.
Suppose lots of little banks make the same mistake, and those little banks are 50% of the market? You have a problem. The same problem.
If banks' mistakes were independent, having lots [...]
This isn't a very focused post. There are two sets of thoughts bubbling through my mind this morning. The first is about Canadian house prices; the second is about global savings gluts. But the two topics are very definitely related.
There is a lot of anecdotal evidence of a pick-up in [...]
"Tight money causes unemployment to rise, and loose money causes unemployment to fall. Therefore, if monetary policy had a 20% inflation target rather than a 2% inflation target, monetary policy would be looser, and unemployment would be lower". Wrong, and now obviously wrong. But 40 years ago most economists thought [...]
We have learned, after long and painful lessons, that there are some good things we wish that monetary policy could do that monetary policy in fact cannot do.
But we don't seem to have learned the corollary to that lesson: by exactly the same argument, there are also some bad things [...]
His critics blame Alan Greenspan for setting interest rates too low, which caused the house-price bubble, which then burst and caused the financial crisis. As I argued back in February, the critics are typically confused between interest rates that are low, and interest rates that are low relative to [...]
I want to compare and contrast the pursuit of monetary stability with the pursuit of financial stability. I am talking mainly about Canada, though much of what I say applies to other countries as well.
1. Ask n monetary economists, and you will get at least n different definitions of what [...]
One of the standard arguments against the Ricardian Equivalence Proposition is that some households are borrowing-constrained. They want to borrow and spend against their future income, but can't find anyone to lend them money. So when the government gives them a tax cut, financed by higher future taxes, the [...]
We normally think of monetary and fiscal policy as alternative methods of stabilising fluctuations in aggregate demand. It is only in abnormal times, like the present, when central banks' interest rate instruments are at or near the zero lower bound, that we might want to use both monetary and fiscal [...]
Seeing the path on the rocks worn by millions of passing feet on an old portage just upstream of Ottawa reminds you that what is now a short detour off a recreational walking trail was once the trans-Canada highway. Canoes once had a very large economic impact in Canada. Now [...]
We are just curious to know who is reading this blog, and would love to know a little bit more about you, including those who don't usually comment.
1. What is your nationality or country of residence? (What proportion of our readers are Canadian?).
2. What is your profession/occupation? Private/government/education sector?
3. How [...]
As far as I can tell, the Bank of Canada's Financial System Review (pdf) has basically got it right. At least in the way it is looking at household debt. Provided you ignore the aggregate numbers that make the headlines, and focus on the disaggregated numbers instead.
The eye-catching headline [...]
I used to think that the Equation of Exchange, MV=PY, was just a different way of writing the Cambridge Equation, M=kPY, with V=1/k. And of the two I preferred the M=kPY formulation, because it looked more like a money supply=money demand condition, and reminded us that V=1/k must be interpreted [...]
While "financial conservatives" have been complaining about too much financial innovation, my complaint is that there's been too little. Why can't I use my house as an ATM, as long as I have sufficient remaining equity? Why can't I make positive, zero, or negative monthly payments on my mortgage, whenever [...]
There is nothing new in the substance of this post; it is an exposition of standard monetary theory. (Though some might find the exposition interesting.)
It is an open invitation for people to tell me where standard monetary theory of the effects of inflation might be wrong.
It's an invitation open to [...]
The lag in the effect of monetary policy on output employment and inflation may or may not be a problem. It depends on the nature of the shock: whether the shock has a shorter or longer lag than monetary policy. It should not have been a problem in the current [...]
The Loonie (Canadian dollar) has appreciated against the US dollar recently. The Bank of Canada expressed its concern in Thursday's Announcement.
"In recent weeks, financial conditions and commodity prices have improved significantly, and consumer and business confidence have recovered modestly. If the unprecedentedly rapid rise in the Canadian dollar (which reflects a combination [...]
Talking about "investment" in housing is guaranteed to provoke a reaction. It's a way of talking about houses that sounds so reminiscent of the bubble mentality. It's yesterday's way of thinking. "A house is not an investment; it's a place to live!" is today's way of thinking.
I decided to [...]
I was on CPAC Sunday evening, on a roundtable with two other economists: David MacDonald (who coordinated the alternative budget for the Canadian Centre for Policy Alternatives); and Glen Hodgson (Chief Economist for the Conference Board). [You can watch it here - SG.]
The topic was Canada's projected $50 billion [...]
If the government runs a deficit, it means you have to increase taxes or cut government spending sometime in the future, right? Well no, that's not exactly right.
If there's 2% inflation, you can let the debt grow at 2% per year and it still stays the same in real terms. [...]
I just finished reading John Cochrane's paper, where he applies the fiscal theory of the price level to the current crisis. (Thanks Adam P!). OK, I admit I didn't really read it thoroughly; I skimmed it. It's full of good insights, and also bad mistakes. The best thing to [...]
I've been reading through the Annex of the Bank of Canada's most recent Monetary Policy Report (pdf), the "Framework for conducting monetary policy at low interest rates", and reading Deputy Governor John Murray's speech on unconventional monetary policy.
I can't quite put my finger on the right metaphor. "Atheists [...]
You might think you understand the IS curve. You probably don't. And your failure to understand it properly means you don't understand how an excess demand for money is an integral part of the theory of the IS curve, underlying any state of deficient-demand unemployment. And you don't understand the [...]
I am opening a contest. Let's see who can come up with the most plausible (or least implausible) model in which fiscal policy would not work in present circumstances.
This is not an entirely frivolous exercise. David Andolfatto (who runs another excellent Canadian economics blog) has made a number of [...]
Would the current financial crisis matter as much in a world without money?
Let me be more specific. Imagine we lived in a world where we still had money as a medium of account, so prices were measured in money. But people did not use any medium of exchange; they used [...]
{Update: Preface: Is it possible that an economy could find itself in an absolute liquidity trap because the natural rate of interest went negative? Or is it only possible if mistakes in monetary policy caused expected inflation to go negative?]
We argue that the nominal rate of interest cannot be negative. [...]
This Bloomberg story reports the Fed saying that rising bond yields are a good sign. They don't precisely say that monetary easing is what caused the rise in interest rates; they are perhaps too modest to claim credit? But I will say it for them: by buying bonds, and [...]
This was supposed to be a review of Joseph Heath's new book "Filthy Lucre: Economics for People who hate Capitalism". But I'm not used to doing book reviews, so it's going to turn into a ramble on the teaching of economics, and economics in the political spectrum.
I got the [...]
It all depends on what you hold constant when you draw the AD curve in {price level,real output} space.
See Paul Krugman, Bryan Caplan (h/t), and David Henderson.
If you hold the nominal interest rate constant, and let the nominal money supply contract endogenously when the price level falls, [...]
I'm still not sure I fully understand this, but I'm going to post it anyway. That's what blogs are for.
[Updated, see halfway down the post.]
The basic idea is that one of the ways quantitative easing may work (there are others) is that it allows the central bank to buy stuff [...]
Suppose there were an excess demand for antique furniture. Antique furniture is not part of GDP. By Walras Law, if there were an excess demand for antique furniture, there must be an equal and offsetting excess supply of something else, like newly-produced goods for example. Could an excess demand for [...]
I'm going to take another crack at this topic. Do bad banks (and a bad financial system) reduce the effectiveness of fiscal and monetary policies in shifting the Aggregate Demand curve to the right? The answer matters, because if they do reduce the effectiveness of fiscal and monetary policy (a [...]
What happened in the first quarter of 2001 that would cause BOTH:
1. A US house price bubble?
AND
2. A structural change in relative prices between high-end and low-end US houses?
It's hard to date precisely the beginning of the US house price bubble. House prices rose gradually at first. But looking at [...]
Mark Carney, Governor of the Bank of Canada, spoke yesterday about short run "speed limits" to economic recovery. This is a concept you don't hear very often, so I thought I would briefly discuss it. It's easily confused with the much more familiar long run "speed limits" to economic [...]
What is the relation between banks, aggregate demand, and aggregate supply? Do bad banks shift the AD curve or the AS curve? Do bad banks make it harder for fiscal or monetary policy to shift the AD curve?
Some economists argue that you need to fix the banks (and the financial [...]
This is a topic I do not understand at all well, but I am confident that some of our readers will. But I do hear that the myth that Canadian banks are more strictly regulated is largely...well, a myth. One colleague who used to work in banking told me he [...]
This is a post for people who find mechanical metaphors useful. And remember, any theory that can be translated into math and put on a computer (even if it doesn't need to be) has a mechanical counterpart, because a computer is a machine.
I am going to use mechanical metaphors to [...]
So, the Bank of Canada has finally cut the overnight rate target to 0.25%, which is as low as it feels technically able to go, so is effectively zero, by its reckoning. I'm not going to discuss those technical issues on the problems with 0.00% vs. 0.25%, because it's not [...]
Imagine you are a monetary economist, working in a central bank, and you wake up one morning and find yourself in an alternative universe. You don't realise it's an alternative universe at first, because everything looks the same. But when you get into work and go to the meeting of [...]
There used to be a debate over interest rate control vs. base control of monetary policy. We always knew (at least some of us always knew) that interest rate control couldn't work in theory, but it seemed to work in practice, so eventually even the die-hard defenders of base control [...]
"Deficiencies of aggregate demand are always and everywhere a monetary phenomenon". There's an excess supply of newly-produced goods, and an excess demand for money. But what exactly does an excess demand for money mean? And what does it mean for the effectiveness of monetary policy?
Aggregate demand for goods is a [...]
Two weeks and 8,000 km (5,000 miles) later, I'm back home from a US road trip. Here are some random thoughts FWIW. Nothing very important, insightful, or authoritative here.
Itinerary: south from Ottawa to Lewes, Delaware; continuing along the Atlantic coast to Ocracoke Island, North Carolina; Savannah, Georgia; then west across [...]
This will be my last post for a couple of weeks. I'm off on a US road trip!
My last big US road trip was Summer 1976. Berkeley to New York, by a very circuitous route. This one will be shorter, down the Atlantic coast, across to the Gulf of Mexico [...]
Suppose an increased supply of government bonds to finance deficit spending were met with an increased demand for government bonds from the private sector, so that interest rates stayed the same, and the bond issue were fully subscribed. That is exactly what would happen for a bond-financed tax cut under [...]
Are we seeing the first signs of recovery, or just a temporary bear-market rally?
What caused it? Fiscal policy? Monetary Policy? Financial policy? Or did it just happen by itself?
As I said, I don't have the answers, but while the rest of the economics blogosphere seems to be concentrating on AIG [...]
Is this a risk crisis or a liquidity crisis? What's the difference?
We can define "risk" and "liquidity" any way we like, but some definitions are more useful than others. A useful definition would explain why "risky" assets need high yields to make people willing to hold them, and why "illiquid" [...]
This question has been bugging me for the last few months. I see the financial crisis as largely a liquidity crisis. People only want to hold the most liquid assets, and shun the illiquid. So liquid assets have high prices and low yields; and illiquid assets have low prices and [...]
Some extra money from the last Federal budget went to fund new projects at universities. As part of its application for funds, each university must say how it plans to spend the money, and also do an "Economic Impact Assessment". I have been called in to help. I know little [...]
The Bank of England has switched to quantitative easing. It is buying long bonds (gilts). What would count as a signal of success? We could argue that falling yields would signal success, because it is trying to reduce long interest rates to stimulate investment. But we could equally argue that [...]
