Monetary policy

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Zombie Arguments Against Fiscal Stimulus

Published by Anonymous (not verified) on Wed, 20/01/2021 - 10:58pm in

Busy days. I just want to drop a quick note on a piece just published on the Financial Times that is puzzling on many levels. Ruchir Sharma pleads against Joe Biden’s stimulus on the ground that it risks “exacerbating inequality and low productivity growth”. The bulk of the argument is in this paragraph:

Mr Biden captured this elite view perfectly when he said, in announcing his spending plan: “With interest rates at historic lows, we cannot afford inaction.”

This view overlooks the corrosive effects that ever higher deficits and debt have already had on the global economy. These effects, unlike roaring inflation or the dollar’s demise, are not speculative warnings of a future crisis. There is increasing evidence, from the Bank for International Settlements, the OECD and Wall Street that four straight decades of growing government intervention in the economy have led to slowing productivity growth — shrinking the overall pie — and rising wealth inequality.

If one reads the two papers cited by Sharma, they say, in a nutshell, (a) that expansionary monetary policies have deepened income inequality via an increase in asset prices (while for low interest rates and bond prices there is no clear link); (b) that the increasing share of zombie firms drags down the performance of more productive firms thus slowing down overall productivity growth.

So far so good. So where is the problem? Linking these results to excessive debt and deficit, to the “constant stimulus”, is stretched (and I am being kind). A clear case of Zombie Economics.

Let’s start with monetary policy and its impact on inequality (side note: the effect is not so clear-cut). One may see expansionary monetary policies as the consequence of fiscal dominance, excessive deficit and debt that force central banks to finance the government. But, they can also be seen as the consequence of stagnant aggregate demand that is not properly addressed by excessively restrictive fiscal policies, forcing central banks to step in. Many have argued in the past decade that especially in the Eurozone one of the causes of central bank activism was the inertia of fiscal policies. Don’t take my word. Read former ECB President Mario Draghi’s Farewell speech, in October 2019:

Today, we are in a situation where low interest rates are not delivering the same degree of stimulus as in the past, because the rate of return on investment in the economy has fallen. Monetary policy can still achieve its objective, but it can do so faster and with fewer side effects if fiscal policies are aligned with it. This is why, since 2014, the ECB has gradually placed more emphasis on the macroeconomic policy mix in the euro area.

A more active fiscal policy in the euro area would make it possible to adjust our policies more quickly and lead to higher interest rates.

This is as straightforward as a central banker can be: in order to go back to standard monetary policy making, fiscal policy needs to step up its game. Notice that Draghi also hints to another source of problems: the causality does not go from expansionary policies to low interest rates, but the other way round. We have been living in a a long period of secular stagnation, excess savings, low interest rates and chronic demand deficiency which monetary policy expansion can accommodate by keeping its rates close to “the natural” rate, but not address. Once again, fiscal policy should do the job.

Regarding zombie firms, it is unclear, barring the current and very special situation created by the pandemics, why this would prove that stimulus is unwarranted. The paper describes a secular trend whose roots are in insufficient business investment and a drop in potential growth rate (that in turn the authors link to a drop in multi-factor productivity). The debate on the role of fiscal policy in these matters is as old as macroeconomics. In the past ten years, nevertheless, the cursor has moved against the Sharma’s priors and an increasing body of literature points to crowding-in effects: especially when the stock of public capital is too low (as is the case in most advanced countries), an increase of public investment — “constant stimulus”– has a positive impact on private investment and potential growth (see for reference the most recent IMF fiscal monitor and the chapter by EIB economists of the European Public Investment Outlook). Lack of public investment is also widely believed to be one of the factors keeping our economies stuck in secular stagnation.

Fifteen years ago one could have read Sharma’s case against fiscal policy on many (more or less prestigious) outlets. Even then, it would have been easy to argue that it was flawed and fundamentally built on an ideological prior. Today, it seems simply written by somebody living in another galaxy.

The International Spillover of U.S. Monetary Policy via Global Production Linkages

Published by Anonymous (not verified) on Wed, 06/01/2021 - 11:00pm in

Julian di Giovanni

The International Spillover of U.S. Monetary Policy via Global Production Linkages

The recent era of globalization has witnessed growing cross-country trade integration as firms’ production chains have spread across the world, and with stock market returns becoming more correlated across countries. While research has predominantly focused on how financial integration impacts the propagation of shocks across international financial markets, trade also influences these cross-border spillovers. In particular, one important aspect, highlighted by the recent work of di Giovanni and Hale (2020), is how the global production network influences the transmission of U.S. monetary policy to world stock markets.

World Production Linkages and Stock Market Correlations

The production process of a good or a service may spread across several borders before creating a final good. This global production process (often referred to as the “global value chain”) can be measured by the strength of connections between industry sectors across countries. This is a key first step to analyze international spillovers, since customer-supplier linkages are not equal in size. For example, there might be one key producer of an electronic component that is sourced by many customer firms, which use the component to produce their own goods. Such an asymmetry in the network then implies that shocks to a given firm, sector, or country will have different consequences across economies (Acemoglu et al. [2012]).

The figure below shows that the distribution of production linkages across and within countries, where the unit of observation is the country-sector level (for example, the Chinese textiles sector). The figure uses data from the World Input-Output Database (WIOD) to plot the counter cumulative distribution function (the CCDF) of the weighted cross-country connections (outdegree) of a given country-sector. (Technically, the CCDF captures the probability of observing a given value of a variable within a data set. That is, if all observations in a data set are either equal to or between zero and one, the CCDF for the value zero would equal one, while the CCDF of observing a value of two would be zero.) This measure quantifies the importance of a country-sector as a supplier to other sectors across the world. Crucially, this measure not only captures direct linkages, such as the degree to which Chinese textiles are used in production by Vietnam’s clothing sector, but indirect linkages such as the subsequent use of Vietnam’s clothing by the Spanish fashion sector in its production of a final garment.

The International Spillover of U.S. Monetary Policy via Global Production Linkages

The figure’s construction is designed to line up the dots of country‑sector groups according to how important their connections are to the rest of the world. Moving to the right, it is clear that only a small fraction of the country-sector observations has strong global production linkages (outdegree greater than 1), while the vast majority of country-sector dots have small production linkages (outdegree of 0.01 or below). For example, the largest outdegree value belongs to manufacturing of food products, beverages, and tobacco products in the United States, while at the other extreme, sectors such as Australia’s repair and installation of machinery and equipment have zero cross-sector input-output linkages.

The next figure shows that country-sector pairs that have the strongest production linkages also have more correlated stock market returns. The x-axis plots a measure of how close two country-sector pairs are along the global production network, where the larger the number, the weaker the linkages. The y-axis plots the correlation of sector-specific stock market returns of the corresponding country-sector pairs. As can be seen, the larger the trade (production) connection, the greater the pairs’ stock returns correlation.

The International Spillover of U.S. Monetary Policy via Global Production Linkages

How Monetary Policy Shocks Are Transmitted across Countries via Production Linkages

The evidence presented in the figures above suggests that economic or financial developments may propagate along world production linkages and impact global stock market returns. However, several unanswered questions remain, such as how do shocks propagate along the global production network, and how important is the network’s contribution to the overall impact of the shock on stock market returns?

The recent paper by di Giovanni and Hale (2020) begins to answer such questions by focusing on the transmission of one important shock: unexpected changes in U.S. monetary policy. The authors present a conceptual framework that lays out necessary conditions for monetary policy to be transmitted across countries via the global production network. In their setting, changes in demand induced by changes in monetary policy propagate upstream from customers to suppliers. Using a newly constructed data set, the authors use their empirical framework to quantify the role of the global production network in transmitting U.S. monetary policy across international stock markets. Crucially, the empirical estimation also controls for financial variables that have been shown to explain cross-country asset returns (Miranda-Agrippino and Rey [2020]). Further, the framework allows for the decomposition of the estimated impact of a monetary policy shock on stock market returns into contributions from a “direct effect” and a “network effect,” with the latter effect capturing the importance of global production linkages in shock transmission.

Using monthly stock return data at the country-sector level, the estimation finds that the propagation of a U.S. monetary policy shock through the global production network is statistically significant and accounts for most of the total impact. Specifically, average monthly stock returns increase by 0.12 percentage point in response to a one percentage point expansionary surprise in the U.S. monetary policy rate, with nearly 80 percent of this stock return increase due to the spillovers via global production linkages. U.S. monetary policy’s directly impacts the domestic sectors and then spills over from the United States to foreign markets most prominently as the impact on U.S. sectors’ demand propagates upstream to those sectors’ foreign suppliers. This finding is robust to controlling for other variables that may drive a common financial cycle across markets, such as the VIX, the 2-year Treasury rate, and the broad U.S. dollar index. It is also robust to different time periods, different definitions of stock returns and monetary policy shocks, and to controlling for monetary policy shocks in the United Kingdom and the euro area.

Implications

The sizeable role of production linkages in transmission of U.S. monetary policy has a number of important implications. First, if international trade in intermediate goods continues to grow and global supply chains become longer and more complex, the impact of U.S. monetary policy on other countries is likely to increase as well. To the extent that this transmission channel is independent of capital flows and related policies, the results present one of the mechanisms by which capital controls may not be effective in insulating economies from foreign monetary policy actions.

Julian di Giovanni

Julian di Giovanni is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

How to cite this post:

Julian di Giovanni, “The International Spillover of U.S. Monetary Policy via Global Production Linkages,” Federal Reserve Bank of New York Liberty Street Economics, January 6, 2021, https://libertystreeteconomics.newyorkfed.org/2021/01/the-international-....




Disclaimer

The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

Reconciling IS-LM and endogenous money

Published by Anonymous (not verified) on Wed, 06/01/2021 - 4:52am in

This post was sparked by conversations with people who have opposing views of how money creation works. Some people think that classical models such as IS-LM don't work with endogenous money theory, therefore the models need to be discarded: others think that there's nothing wrong with the model and the problem is endogenous money theory. Personally I think that simple models like IS-LM can be powerful tools to explain aspects of the working of a market economy, and it behooves us therefore to find ways of adapting them to work with an endogenous fiat money system. So this is my attempt to reconcile IS-LM with endogenous money. I don't claim that it is anything like the final word on the subject, so comments are welcome. 

The IS-LM model looks like this:

:

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where M is the quantity of money in circulation, L is the "liquidity preference" (the degree to which investors prefer to hold interest-bearing, less liquid assets rather than to zero-interest, highly liquid money), I is investment and S is saving. The real interest rate i is on the y axis and real output Y on the x axis. IS-LM is a short-run model, so it ignores inflation: all variables are real.

In the IS-LM model, M is assumed to be fixed: the supply curve for M from which the LM curve is derived is a vertical line. This is hardly surprising, since the IS-LM model is a short-run model dating from a gold standard era.

At this point, of course, endogenous money types say "But M is not fixed - the quantity of money is determined by bank lending", and other sensible people say "But M is not fixed - the quantity of money is determined by the central bank". These are actually both correct in different ways, but that doesn't necessarily invalidate the model.

I had a long argument with Scott Sumner about the definition of M, the details of which I won't repeat here. Suffice it to say that for the purposes of this post, he wins. On this occasion I'm defining M as the monetary base M0, not the total amount of "money" (broadly defined) in circulation. Defining M in this way neatly avoids the "moneyness" problem and actually enables the IS-LM model to work with endogenous money theory, as I shall show. Liquidity preference L simply becomes the private sector's preference for "outside money" (physical currency and bank reserves) versus all other assets including bank "credit" money ("inside money").

The IS curve shows the equilibrium between saving and investment that holds at all times: S = I. At this point endogenous money types remind us that banks don't need deposits in order to lend, so saving doesn't precede investment. Indeed it doesn't. The S=I identity says nothing about the direction of causation. The prevalent belief that "you need saving in order for there to be investment" is a misinterpretation of this identity. It would be equally accurate to say that investment drives saving, and in an endogenous money system this is closer to how it works in practice. Either way, the S=I identity holds. The IS curve is therefore as relevant in an endogenous money system as it is in a "loanable funds" system.

Indeed, endogenous money types really need to understand the importance of the IS curve. In the IS-LM model, demand for M is inversely proportional to demand for credit. The intersection of the IS curve with the LM curve tells us the relative demand for credit versus M for a given combination of interest rate and GDP. 

Of course, the IS curve does not simply represent bank lending: after all, investment does not have to involve borrowing. But almost all the "money" circulating in the economy, and all of the money held in bank deposit accounts, is created when banks lend. Therefore even if an asset is purchased from existing savings, bank lending is still involved. The savings themselves are the result of an earlier lending transaction: one person's debt is another person's savings. So we can regard the position of the IS curve as an indicator of "credit money" supply - or credit demand, if you prefer: it's the same thing. 

The IS curve shifts in response to changes in demand for credit relative to M. I visualise this as the IS curve "sliding" up and down the fixed LM curve:

Main article image

(an interactive graphic that did this would be REALLY neat!)

In endogenous money language, when the IS curve shifts leftward and the intersection with the LM curve moves downward, demand for loans has reduced and therefore "inside money" has fallen relative to "outside money": when the IS curve shifts rightward, demand for loans increases and "inside money" rises relative to "outside money". Classical monetary economics would say that the money multiplier (ratio of credit money to monetary base) increases as credit demand rises and decreases as credit demand falls.*. It's the same thing. 

The IS-LM model shows us that real interest rates and output rise as demand for M falls and credit money increases, and fall as demand for M rises and credit money is destroyed. It's an excellent depictor of the procyclicality of bank credit creation. The ultimate "slide down the LM curve" is the classic bank run, when depositors reject credit money in favour of M (physical cash). It is hardly surprising therefore that bank runs are associated with sudden disastrous falls in Y. 

I've implicitly assumed here (in accordance with endogenous money theory) that changes in credit demand (or supply, if you are a "bash-the-banks" supporter) drive changes in interest rates and GDP. But the model actually doesn't say this. Endogenous money theory says changes in demand for credit are causative. Scott Sumner says changes in interest rates are causative. Supply-side shocks to output would also be causative. In fact any or all of these would cause the IS curve to shift. The IS-LM model doesn't tell us the cause: all it does is model the relationship.

It is very easy to misunderstand the IS-LM model. For example, it shows that falling interest rates are deflationary. Therefore, some will say, we should raise interest rates in order to increase investment and output. No, absolutely not. The model does not imply that. The interest rate in IS-LM is the equilibrium rate, not the policy rate. If the central bank responded to falling output by raising the policy rate, that would reduce M (because central banks raise policy rates by draining reserves), which would shift the LM curve to the left. If the LM curve shifted to the left, the equilibrium interest rate would rise, but Y would fall even more. Raising interest rates is not the best medicine for a stagnant, fragile economy. 

And this brings me to how the IS-LM model works when M is not fixed. Prior to 2008, M responded to credit demand. This is the reason why endogenous money types say the money multiplier is a myth. If M responds to credit demand, the IS curve remains at the same position and the LM curve shifts as M changes. The money multiplier is still present, but it is a more-or-less constant ratio and therefore not much use as an indicator of the relationship between the money supply and the price level.

Main article image

M also is not fixed if IS-LM is used as anything other than a very short-run model, because then inflation must be taken into account. Real M = nominal M/price level P. Of course an inflation-targeting central bank doesn't allow P to change much, does it? Umm.....

I can't leave this subject without considering the thorny problem of excess reserves, though. In most developed countries, M is currently increasing rapidly due to exogenous actions of the central bank, not credit demand. Does this model still work when M far exceeds the amount needed to intermediate payments?

Well yes, the model itself still does. Increasing M is gradually shifting the LM curve to the right, which raises Y. This suggests that low though it is, output would be even lower without the increase in M. But exactly how this works is an open question. How many articles, academic papers and even books have there been now on the effects of unconventional monetary policy? 

The question is not whether the model works with excess reserves, but whether it tells us anything useful. What it shows is that Y would be much lower if it were not for the increase in the monetary base due to unconventional policy. This supports the argument of those who claim QE and its relatives prevent1930s style depressions. What it does not support, though, is the argument of those who claim that QE and its relatives can neutralise the effects of inadequate deliberately contractionary fiscal policy. IS-LM cannot tell us where Y would have been had fiscal policy not been inadequate or contractionary. Nor does it suggest that expansionary monetary policy alone can engineer recovery. To establish that, we need far more than one simple model.

IS-LM is only a model: although it helps us understand the relationship between money and economic activity, it doesn't tell us how things work in reality, and it doesn't model the uncertainties and complexities of a modern market economy. And it can't be used to predict a future path. It's a powerful tool, but we should respect its limitations.

Related reading:

Interest rates and deflation, and Scott Sumner's response

IS-LMentary - Krugman (paywall)

Money creation in the modern economy - Bank of England

IS-LM vs. Minsky - Lars P. Syll

Dare to be Silly - Krugman (paywall)

Keynes and the Quantity Theory of Money

No, please don't show me your model

This article was originally posted on Pieriaview on 29th March 2014. It has been slightly updated to reflect developments since. The original post can be found here, and comments on it here.  

 *The money multiplier has been widely misinterpreted as an ex ante determinant of the amount of money that banks are "allowed" to create, when it is actually an ex post descriptor of the amount of money banks HAVE created in relation to base money - i.e. the demand for credit, which is an important driver of nominal GDP.

How Did Market Perceptions of the FOMC’s Reaction Function Change after the Fed’s Framework Review?

Published by Anonymous (not verified) on Fri, 18/12/2020 - 11:00pm in

Ryan Bush, Haitham Jendoubi, Matthew Raskin, and Giorgio Topa

LSE_2020_market-perceptions_topa_460

In late August, as part of the Federal Reserve’s review of Monetary Policy Strategy, Tools, and Communications, the Federal Open Market Committee (FOMC) published a revised Statement on Longer-Run Goals and Monetary Policy Strategy. As observers have noted, the revised statement incorporated important changes to the Federal Reserve’s approach to monetary policy. This includes emphasizing maximum employment as a broad-based and inclusive goal and focusing on “shortfalls” rather than “deviations” of employment from its maximum level. The statement also noted that, in order to anchor longer-term inflation expectations at the FOMC’s longer-run goal, the Committee would seek to achieve inflation that averages 2 percent over time. In this post, we investigate the possible impact of these changes on financial market participants’ expectations for policy rate outcomes, based on responses to the Survey of Primary Dealers (SPD) and Survey of Market Participants (SMP) conducted by the New York Fed’s Open Market Trading Desk both shortly before and after the conclusion of the framework review. We find that the conclusion of the framework review coincided with a notable shift in market participants’ perceptions of the FOMC’s policy rate “reaction function,” in the direction of higher expected inflation and lower expected unemployment at the time of the next increase in the federal funds target range (or “liftoff”).

Recent Desk survey data show shifts in expectations for inflation and unemployment rate at liftoff

One can think of the reaction function as a description of how monetary policy settings are adjusted in response to evolving conditions and expectations. Gauging market perceptions of the reaction function can help in interpreting signals from financial markets and assist policymakers in understanding the extent to which market perceptions align with their policy intentions. However, survey questions that only elicit expectations for the path of the federal funds target range reflect both perceptions of the policy rate reaction function as well as expectations for future economic conditions. For example, two respondents may have different views on the likely path of the target range because of differing economic outlooks but nevertheless have similar views on how the FOMC would set the target range in response to given levels of inflation, unemployment, or other variables.

When the target range is at the effective lower bound (ELB), a useful way to try to isolate respondents’ views on the reaction function is to directly ask for their estimates of the values of various economic indicators that will prevail at the time of liftoff. Recent iterations of the SPD and SMP have included just this type of question; respondents have been asked for the most likely level of the unemployment rate, headline twelve-month personal consumption expenditures (PCE) inflation, the labor force participation rate, and the level of real GDP at the time of the next increase in the target range.

Examining changes in responses to these questions before and after the conclusion of the framework review provides compelling evidence of a shift in perceptions of the Committee’s reaction function. As the chart below shows, among market participants, the median expectation for headline twelve-month PCE inflation at liftoff increased from 2.0 percent in the July survey to 2.3 percent in the September survey, while the median expectation for the unemployment rate at liftoff fell from 4.5 percent to 4.0 percent in the respective surveys. Similarly, among primary dealers, the median expectation for headline twelve-month PCE inflation at liftoff increased from 2.2 percent in the July survey to 2.3 percent in the September survey, while the median expectation for the unemployment rate at liftoff fell from 4.5 percent to 4.0 percent. Across both surveys, the interquartile ranges of respondents’ expectations moved in similar directions as the medians.

While various other developments could have influenced perceptions of the FOMC’s reaction function, market commentary and qualitative responses to other questions in the surveys suggest that these shifts were primarily in response to the outcome of the framework review.

How Did Market Perceptions of the FOMC’s Reaction Function Change after the Fed’s Framework Review?

Recent responses imply higher inflation, lower unemployment rate at liftoff compared to pre-2015

To put the levels and changes shown above into historical context, we compare recent SPD data with responses to similar questions asked in the SPD from 2011 to 2015, during the prior period in which the target range was set at the ELB. (We focus on SPD data because the SMP was launched in 2014, limiting historical comparisons.)

As shown in the chart below, we find that responses from recent surveys indicate higher expected inflation and a lower expected unemployment rate at liftoff than in the previous ELB episode, and that the recent changes in these expectations are notable by historical standards. Specifically, during the earlier period, the median estimate for headline twelve-month PCE inflation at liftoff averaged about 2 percent until mid-2014 and then declined sharply as expectations persisted for the Committee to raise the target range at a time when energy prices had depressed headline inflation. In light of the impact of energy prices on headline inflation at that time, it is helpful to also compare recent results to estimates for core twelve-month PCE inflation at liftoff during the previous ELB episode, given it should be less impacted than headline inflation by transitory shocks to energy prices. Although only a subset of questions near the end of that period asked for estimates of core PCE inflation at liftoff, median responses for that indicator were less volatile and averaged around 1.4 percent—considerably below the median of 2.3 percent in the September 2020 SPD following the outcome of the framework review. Meanwhile, the median estimate for the unemployment rate at liftoff gradually declined from 8 percent in 2011 to 5 percent just before the 2015 liftoff—higher than the median estimate of 4 percent in the September 2020 survey.

How Did Market Perceptions of the FOMC’s Reaction Function Change after the Fed’s Framework Review?

Expectations may continue to evolve following changes to forward guidance

In sum, responses to the SPD and SMP suggest that the Fed’s announcement of the outcome of the monetary policy framework review induced a notable shift in market participants’ perceptions of the FOMC’s reaction function. On the whole, this shift appears large when compared to prior historical experience at the ELB, when a similar survey question was also asked of SPD respondents.

It is important to note that soon after the conclusion of the framework review and after the September surveys, the FOMC introduced changes to the guidance in its post-meeting statement on the overall stance of monetary policy and path of the target range, including the conditions the Committee expects to prevail at the time of liftoff. These changes, which (as the Chair explained in his September press conference) were guided by the outcome of the framework review, may have further shaped market perceptions of the policy reaction function. Indeed, though changes in views were dispersed, the median across combined responses from the November SPD and SMP indicated a slight further increase in the median expectation for the level of inflation at the time of liftoff, while the median expected unemployment rate was unchanged. Going forward, data on perceptions and expectations such as those contained in the Desk’s surveys are likely to prove useful in judging how views about the reaction function evolve.

Ryan BushRyan Bush is a manager for policy and market analysis in the Federal Reserve Bank of New York’s Markets Group.

Haitham JendoubiHaitham Jendoubi is a senior associate for policy and market analysis in the Bank’s Markets Group.

Matthew RaskinMatthew Raskin is a vice president for policy and market analysis in the Bank’s Markets Group.

Giorgio TopaGiorgio Topa is a vice president in the Bank’s Research and Statistics Group.

How to cite this post:

Ryan Bush, Haitham Jendoubi, Matthew Raskin, and Giorgio Topa, “How Did Market Perceptions of the FOMC’s Reaction Function Change after the Fed’s Framework Review?,” Federal Reserve Bank of New York Liberty Street Economics, December 18, 2020, https://libertystreeteconomics.newyorkfed.org/2020/12/how-did-market-per....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

When it Comes to Market Liquidity, what if Private Dealing System is Not “The Only Game in Town” Anymore? (Part 1)

Published by Anonymous (not verified) on Wed, 25/11/2020 - 6:57am in

A Tribute to Value Investing

“Investors persist in trading despite their dismal long-run trading record partly because the argument seduces them that because prices are as likely to go up as down (or as likely to go down as up), trading based on purely random selection rules will produce neutral performance… Apparently, this idea is alluring; nonetheless, it is wrong. The key to understanding the fallacy is the market-maker.”

–Jack Treynor (using Walter Bagehot as his Pseudonym) in The Only Game In Town.

By Elham Saeidinezhad | Value investing, or alternatively called “value-based dealing,” is suffering its worst run in at least two centuries. The COVID-19 pandemic intensified a decade of struggles for this popular strategy to buy cheap stocks in often unpopular enterprises and sell them when the stock price reverts to “fundamental value.” Such a statement might be a nuisance for the followers of the Capital Asset Pricing Model (CAPM). However, for liquidity whisperers, such as “Money Viewers,” such a development flags a structural shift in the financial market. In the capital market, the market structure moves away from being a private dealing system towards becoming a public one. In this future, the Fed- a government agency- would be the market liquidity provider of the first resort, even in the absence of systemic risk. As soon as there is a security sell-off or a hike in the funding rate, it will be the Fed, rather than Berkshire Hathaway, who uses its balance sheet and increases monetary base to purchase cheap securities from the dealers and absorb the trade imbalances. The resulting expansion in the Fed’s balance sheet, and monetary liabilities, would also alter the money market. The excessive reserve floating around could transform the money market, and the payment system, from being a credit system into a money-centric market. In part 1, I lay out the theoretical reasons blinding CAPM disciples from envisioning such a brave new future. In part 2, I will explain why the value investors are singing their farewell song in the market.

Jack Treynor, initially under the pseudo name Walter Bagehot, developed a model to show that security dealers rely on value investing funds to provide continuous market liquidity. Security dealers are willing to supply market liquidity at any time because they expect value-based dealers’ support during a market sell-off or upon hitting their finance limit. A sell-off occurs when a large volume of securities are sold and absorbed in the balance sheet of security dealers in a short period of time. A finance limit is a situation when a security dealer’s access to funding liquidity is curtailed. In these circumstances, security dealers expect value investors to act as market liquidity providers of near last resort by purchasing dealers excess inventories. It is such interdependence that makes a private dealing system the pillar of market-liquidity provision.

In CAPM, however, such interconnectedness is neither required nor recognized. Instead, CAPM asserts that risk-return tradeoff determines asset prices. However, this seemingly pure intuition has generated actual confusion. The “type” of risk that produces return has been the subject of intense debates, even among the model’s founders. Sharpe and Schlaifer argued that the market risk (the covariance) is recognizably the essential insight of CAPM for stock pricing. They reasoned that all investors have the same information and the same risk preferences. As long as portfolios are diversified enough, there is no need to value security-specific risks as the market has already reached equilibrium. The prices are already the reflection of the assets’ fundamental value. For John Lintern, on the other hand, it was more natural to abstract from business cycle fluctuations (or market risk) and focused on firm-specific risk (the variance) instead. His stated rationale for doing so was to abstract from the noise introduced by speculation. The empirical evidence’s inconsistency on the equilibrium and acknowledging the speculators’ role was probably why Sharpe later shifted away from his equilibrium argument. In his latest works, Sharpe derived his asset pricing formula from the relationship between the return on individual security and the return on any efficient portfolio containing that security.

CAPM might be confused about the kind of risk that matters the most for asset pricing. But its punchline is clear- liquidity does not matter. The model’s central assumption is that all investors can borrow and lend at a risk-free rate, regardless of the amount borrowed or lent. In other words, liquidity provision is given, continuous, and free. By assuming free liquidity, CAPM disregards any “finance limit” for security dealers and downplays the importance of value investing, as a matter of logic. In the CAPM, security dealers have constant and free access to funding liquidity. Therefore, there is no need for value investors to backstop asset prices when dealers reach their finance limit, a situation that would never occur in CAPM’s world.

Jack Treynor and Fischer Black partnered to emphasize value-based dealers’ importance in asset pricing. In this area, both men continued to write for the Financial Analysts Journal (FAJ). Treynor, writing under the pseudonym Walter Bagehot, thinks about the economics of the dealer function in his “The Only Game in Town” paper, and Black responds with his visionary “Toward a Fully Automated Stock Exchange.” At the root of this lifelong dialogue lies a desire to clarify a dichotomy inside CAPM.

Fischer, despite his belief in CAPM, argued that the “noise,” a notion that market prices deviate from the fundamental value, is a reality that the CAPM, built on the market efficiency idea, should reconcile with. He offered a now-famous opinion that we should consider stock prices to be informative if they are between “one-half” and “twice” their fundamental values. Mathematician Benoit Mandelbrot supported such an observation. He showed that individual asset prices fluctuate more widely than a normal distribution. Mandelbrot used this finding, later known as the problem of “fat tails” or too many outliers, to call for “a radically new approach to the problem of price variation.”  

From Money View’s perspective, both the efficient market hypothesis and Manderbrot’s “fat tails” hypothesis capture parts of the data’s empirical characterization. CAPM, rooted in the efficient market hypothesis, captures the arbitrage trading, which is partially responsible for asset price changes. Similarly, fat tails, or fluctuations in asset prices, are just as permanent a feature of the data. In other words, in the world of Money View, arbitrage trading and constant deviations from fundamental value go together as a package and as a matter of theoretical logic. Arbitrageurs connect different markets and transfer market liquidity from one market to another. Simultaneously, despite what CAPM claims, their operation is not “risk-free” and exposes them to certain risks, including liquidity risk. As a result, when arbitrageurs face risks that are too great to ignore, they reduce their activities and generate trade imbalances in different markets.

Security dealers who are making markets in those securities are the entities
that should absorb these trade imbalances in their balance sheets. At some
point, if this process continues, their long position pushes them to their
finance limit-a point at which it becomes too expensive for security dealers to
finance their inventories. To compensate for the risk of reaching this point
and deter potential sellers, dealers reduce their prices dramatically. This is
what Mandelbrot called the “fat tails” hypothesis. At this point,
dealers stop making the market unless value investors intervene to support the
private dealing system by purchasing a large number of securities or block
trades. In doing so, they become market liquidity providers of last resort. For
decades, value-based dealers used their balance sheets and capital to purchase
these securities at a discounted price. The idea was to hold them for a long
time and sell them in the market when prices return to fundamental
value. The problem is that the value investing business, which is the
private dealing system’s pillar of stability, is collapsing. In recent decades,
value-oriented stocks have underperformed growth stocks and the S&P 500.

The approach of favoring bargains — typically judged by comparing a stock
price to the value of the firm’s assets — has a long history. But in the
financial market, nothing lasts forever. In the equilibrium world,
imagined by CAPM, any deviation from fundamental value must offer an
opportunity for “risk-free” profit somewhere. It might be hard to
exploit, but profit-seeking arbitrageurs will always be “able” and
“willing” to do it as a matter of logic. Fisher Black-Jack Treynor
dialogue, and their admission of dealers’ function, is a crucial step away from
pure CAPM and reveals an important fallacy at the heart of this framework. Like
any model based on the efficient market hypothesis, CAPM abstracts from
liquidity risk that both dealers and arbitragers face.

Money View pushes this dialogue even further and asserts that at any moment,
security prices depend on the dealers’ inventories and their daily
access to funding liquidity, rather than security-specific risk or market risk.
If Fischer Black was a futurist, Perry Mehrling, the founder of “Money
View,” lives in the “present.” For Fischer Black, CAPM will
become true in the “future,” and he decided to devote his life to
realizing this ideal future. Perry Mehrling, on the other hand, considers the
overnight funding liquidity that enables the private dealing system to provide
continuous market liquidity as an ideal system already. As value investing is
declining, Money View scholars should start reimagining the prospect of the
market liquidity and asset pricing outside the sphere of the private dealing
system even though, sadly, it is the future that neither Fischer nor Perry was
looking forward to.

Elham Saeidinezhad is Term Assistant Professor of Economics  at Barnard College, Columbia University. Previously, Elham taught at UCLA, and served as a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

The post When it Comes to Market Liquidity, what if Private Dealing System is Not “The Only Game in Town” Anymore? (Part 1) appeared first on Economic Questions.

Sustaining and creating employment now and post Covid

Published by Anonymous (not verified) on Wed, 18/11/2020 - 6:59am in
  1. THE CHALLENGE

1.      The focus of economic policy should be on maintaining a high, sustainable level of employment. This is correct theoretically, practically, and socially. It counterbalances the capitalist market system’s tendency not to create a high level of employment; it largely pays for itself in generating revenue: it is socially right because it avoids the waste of human resources entailed by involuntary unemployment, crowding in activity that would otherwise be crowded out.  

Sustainability is a key requirement for any policy of high employment today. The workforce must be employable in work for which there is both demand, and which, by respecting nature, also secures the future of the planet.

These are general propositions for policy valid for most advanced economies, but they have a special application to our country at this particular moment in time.

2.       The consensus of forecasts is that the British economy will be more than 10% smaller this year than in 2019, with only a moderate recovery in 2021.  Unemployment is set to rise to at least 8 per cent (2.5m), with underemployment almost double this. The 16-25 age group is projected to take a disproportionate hit, shouldering up two fifths of the rise of unemployment to a million despite representing only a fifth of the workforce.

The roll out of the new vaccines and extension of the furlough scheme to March may postpone the worst effects of the predicted downturn but they offer no basis for sustained economic recovery: little or  nothing is in place to stop the gradual haemorrhaging of  businesses and their supply chains.  This means that job retention, which aims to preserve many jobs which two lockdowns have made obsolete, must urgently give way to job creation.

In conclusion the economy has to afford more employment opportunities, especially for the young. British capitalism – currently biased to short term value creation and rent extraction (rentier capitalism) – has to be repurposed to long-term, environmentally sustainable value creation. The international trade and financial framework must be as accommodative to these aims as possible. If these are the medium and long term aims, then the foundations must  be incorporated in any short term programme.  

B.            SHORT-RUN RECOVERY

  1. There are two urgent things the government should do now.

It must establish a tripartite Economic Recovery Board, incorporating a Taskforce on work. The Board’s task would be to identify those economic sectors, nationally and regionally, which could be a major source of future employment.  These are likely to be, indeed should be:

the green economy

the rural economy

the digital economy

the caring economy

the mentoring economy

The Task Force on work should be charged with identifying work and educational opportunities now available and linking them to these potentially expanding sectors. This would give short-term work and training schemes the focus and purpose which is largely lacking from emergency programmes – a bridge between the Job Retention phase of Covid-19 and the Job Creation phase which has to follow it. 

Initiatives deserving urgent consideration are:

  1. The government should build on its own Kickstart programme, the experience of the Future Jobs Fund and the model of  Roosevelt’s Civilian Conservation Corps  by ensuring  all  unemployed  18-25 year olds  are offered work and training  in urban conservation, rural regeneration and  digital skills. Kickstart is supposedly to generate 300,000 placements for the young people, largely from the private sector. No one now expects hard-pressed businesses to offer employment on anything like this scale in the coming months.  So the public sector will need to become “employer of last resort”. There should be a youth guarantee of work and/or training. The Roosevelt scheme provided  millions of jobs for young people in

“the prevention of forest fires…plant, pest and disease control, the construction, maintenance and repair of paths, trails and fire-lanes in the national parks and national forests and such other work…as the President may determine to be desirable”. 

A youth led National Youth Corps (NYC) should be created in the same Rooseveltian spirit ( one contemporary model is the Austrian Zivildienst) as the umbrella organisation in which volunteers, paid the minimum wage for a year and combining at least 3 months training, are able to work in a range of exciting and socially valuable projects across the country – giving them a vital role  and stake in stimulating recovery. The NYC should go beyond Kickstart to stimulate  local and central government, the private and third sectors to develop and create work-rich projects (see below), connecting volunteers to opportunities via a dedicated App, offering mentoring and crucially the chance of working away from home. With sufficient urgency such programmes could be up and running within the next six months.

  • All regional and local authorities should be asked to bring forward plans for work which needs to be done in their areas  for strengthening local economic resilience and  improving local amenities and  which now languish for lack of money. Examples would be the widening of the Manchester Ship Canal and retrofitting local properties to create thousands of new jobs as well as scaling up local training programmes.

The government should allocate a quantum of money to regional and local authorities for at least one year leaving it the authorities themselves, together with private businesses, to decide what jobs and training schemes they want to create.

  • These initiatives should be supported by measures to sustain demand, given a savings ratio approaching 30 per cent, the imposition of a second lockdown and the likelihood of a thin Brexit deal (or No Deal).  There should be an acceleration and expansion of its national infrastructure programmes, along with a 12 month temporary cut in VAT for all goods and services which in 2008 proved a very effective stimulus in response to the financial crisis.

The government advanced a £8bn infrastructure spending earlier this summer. It should be expanded. The 3 year Comprehensive Spending Review should not be deferred, but instead brought forward to be announced in March 2021 at the latest. In particular the £40bn five year infrastructure plan should be front-loaded into the next two years, with priority given to big environmental projects, social housing and NHS/social care.  In doing so it would simply be following the advice of respected organisations like the International Monetary Fund. It writes

Empirical estimates based on a cross-country data set and a sample of 400,000 firms    show that public investment can have a powerful impact on GDP growth and employment during periods of high uncertainty—which is a defining feature of the current crisis. For advanced and emerging market economies, the fiscal multiplier peaks at over 2 in two years. Increasing public investment by 1 percent of GDP in these economies would create 7 million jobs directly, and between 20 million and 33 million jobs overall when considering the indirect macroeconomic effects.

FOLLOW THROUGH – REFORM TO UNDERPIN RECOVERY

  • Launch the investment covenant. A newly created bank ( either an arm of the National Investment Bank or  specially created “ bad” or refinancing bank) will buy corporate debt of distressed companies, partially underwrite the first tranche with a credit guarantee and package up the loans into single tradeable “ reconstruction” or “build-back-better” bonds. Banks and Insurance Companies will be required to hold these bonds as up to 10 per cent of their balance sheet assets. Companies accepting this debt relief will be contractually required to bring forward a proportional increase in investment spending – and accept reciprocal obligations (see below).
  • Roll over and extend all existing loan schemes but with reciprocal obligations (executive pay, commitment to train, participation in Kickstart and NYC, union recognition, adherence to Social Value Act, sign up to Corporate Governance Code, Sustainable development goals). These obligations should also be incurred by all companies being relieved of debt.
  • Transform the British Business Bank into a National Investment Bank, properly capitalised and with power to lend.
  • Banks to publish term structure of lending as part of drive for more long termism. A comply or explain regime to be created to explain why lending remains short term.
  • Corporate Governance Code to be toughened and adherence made mandatory
  • Pilot a perpetual bond

        INTERNATIONAL

  • Follow through any EU trade deal with negotiations on service sector access, improved access for goods and mutual recognition. Either leading to  eventual full membership of single market and customs union or a unique European Economic Area plus 

C.    THE MEDIUM AND LONG TERM

British capitalism and financial system must be restructured around the pursuit of social purpose. Only thus can it take full advantage of digitalisation and protect natural resources and habitats in such a way as satisfies the demand for social fairness and equity between human demands and the logic of nature. Without such an economic and social settlement, the risk is ongoing degeneracy ultimately provoking civil unrest.

  1. Macro Policy
  • Establish a new Macroeconomic Policy Framework which integrates Fiscal and Monetary Policy in pursuit of the single objective of a non-inflationary level of high employment. This recognises that monetary policy on its own cannot shield the economy against shocks to supply or demand or restore full activity level following a shock. The Bank of should be given a dual employment/inflation mandate  like the Fed. It should aim to keep down borrowing costs for the government; with forward guidance in the form of a promise not to raise Bank Rate till unemployment has fallen below a certain percentage. We cannot afford a macro-policy just based on an inflation target and a passive fiscal policy except in emergencies.
  • Fiscal policy framework. Borrow for capital spending but balance current revenues and spending. Accept debt service limit (10 % of tax revenues?)
  • Increases in capital gains, corporation, inheritance taxes. Introduce environmental taxes.
  • Set in train the reorganisation of tax system around the Mirrlees report (proper taxation of capital and wealth, environmental taxes, reform of council tax, try to avoid high marginal rates for low earners)
  • Build in green targets for all public capital projects (Green New deal)
  • Up to 600,000 public sector jobs could be created, with more than half in the NHS and adult social care, as part of rebuilding of public capacity and reversing hollowed out civil service.
  • Stakeholder Capitalism
  • The objective is to create a capitalism that is driven by purpose, long term value creation and sustainability – balancing the needs of all stakeholders and in partnership with an agile, capable, well-resourced public sector.
  • Legislate for the multi- stakeholder company. A new Companies Act incorporating hardened up Corporate Governance and  Stewardship Codes.
  • Encouragement of varying ownership forms – co-operatives, mutuals, public benefit companies, new forms of collective ownership.
  • Towards the digital trade union. Trade unions to use IT to ballot members etc as part of digital enablement of participatory trade unionism and 21st century collective bargaining.
  • Consolidate National investment bank with scaled up regional branches
  • Organise a regional industrial strategy. Key components to include a “scale-up” ecosystem around Catapult network, creating regional growth hubs focused on key sectors – space, robotics, new pharma. AI applications etc
  • Overhaul CMA
  • Support with roll out of British style Fachhochschule ( universities of applied science)
  • Overhaul educational curriculum with wider range of skills – emotional intelligence, digital, ethics etc
  • The social settlement
  • The guiding principles must be universality of provision and fairness.
  • All forms of work – whether part time, flexible or full time – to carry the same employment rights, creating a British system of flexi-security.
  • Fully fledged National Youth Corps as part of a Work Corps for all with training arm
  • Universal basic income for children up to 18 – child benefit etc
  • Universal basic services
  • Restructure care sector into NHS as part of drive for public health resilience.
  • Properly funded universal national tutoring service 
  • Pursue Devolution Agenda ,  including  tax raising powers (eg local income tax) for regional authorities.   
  • International
  • The system needs to be more resilient and sustainable
  • Procurement policy for essential services, particularly health and food not to be dependent on global supply chains.
  • Movement of capital and labour should also be aligned with national purposes
  • Work with EU and Biden’s US to reinvigorate WTO
  • Joint action on tax havens and tax abuse by High Tech
  • Intense commitment to UN Sustainable Development and climate change goals
  • Have a referendum on re-joining the EU in 10 years time

Photo credit flickr : IFA teched

The post Sustaining and creating employment now and post Covid appeared first on The Progressive Economy Forum.

Covid-19 briefing: monetary policy strategy post-Covid

Published by Anonymous (not verified) on Mon, 16/11/2020 - 8:00pm in

Richard Harrison, Kate Reinold and Rana Sajedi

The Covid shock has created substantial and unprecedented challenges for monetary policymakers. This post summarises the key literature on the immediate monetary policy response to the shock, including both tools and short to medium-term strategy issues (but leaving aside the longer-term question of fiscal-monetary interactions).

Demand vs supply shocks

An early literature looked at modelling how the sectoral Covid shock affects the balance of demand and supply. Subsequently, the empirical literature has attempted to determine which channel dominates, and found that the answer differs across sectors and at different horizons. In general, the evidence suggests that, at least in the near term, deflationary demand shocks are larger, although a minority of papers argue supply is more important (Brinca, Duarte and Castro (2020) and del Rio-Chanona et al (2020)). Using forecast revisions in US survey data, Bekaert, Engstrom and Ermolov (2020) find a decline in inflation driven by a negative demand shock. Alvarez and Lein (2020) and Balleer et al (2020) use debit-card transaction data in Switzerland, and firm-survey data in Germany, respectively, and also find evidence of a decline in inflation during the first months of the pandemic.

Alternative economic mechanisms

The unprecedented nature of the Covid shock has also increased interest in other potential mechanisms at play. Caballero and Simsek (2020) highlight a novel role of financial markets in the transmission of the Covid shock, which they call the ‘Wall Street/Main Street disconnect’. US asset prices reacted quickly to news about the pandemic, and then recovered sharply following the Fed’s monetary expansion. Unemployment increased gradually and remained high. They rationalise the Fed’s policy in a model in which aggregate demand is sluggish, responding to asset prices with a lag. Optimal policy requires a sharp initial overshoot of asset prices to offset future contractionary forces on aggregate demand, given the stickiness of spending decisions.

Covid has also led to heightened uncertainty. Pellegrino, Castelnuovo and Caggiano (2020) show that financial uncertainty shocks have real-economy effects. They find that US monetary policy responded more aggressively to output after the Global Financial Crisis (GFC), and, by doing so, offset around half of the losses of the uncertainty shock. The Covid uncertainty shock could generate output losses twice as large as the GFC, but again a suitably aggressive monetary policy response could reduce these losses by around half. A large literature (see Mendes, Murchison and Wilkins (2017)), has looked at the conduct of monetary policy in the presence of broad-based uncertainty. De Grauwe and Ji (2020) show that during crises it is better for monetary policy to respond to current data, rather than forecasts, due to the uncertainty around the economic outlook. Bordo, Levin and Levy (2020) propose the explicit use of different clinical/epidemiological scenarios (eg whether or when an effective vaccine is developed) in central bank strategy and communications, to illustrate profound non-economic uncertainty and its potential implications for the path of policy.

The heterogeneous sectoral effects of Covid has prompted research on what optimal monetary policy can do for sectoral reallocation of resources. Woodford (2020) shows that, with a ‘Covid shock’ driving activity in some sectors below welfare-maximising levels, monetary policy cannot offset cross-sectoral distortions and so cannot stabilise the effects of these shocks. This is similar to the result found in a paper on production networks, in which no monetary policy can implement the first-best allocation (La’O and Tahbaz-Salehi (2020)). Woodford argues that targeted fiscal transfers are better suited to addressing demand deficiencies, and may be able to achieve the first best allocation of resources without any need for a monetary policy response.

Tool choice and efficacy

Covid has hit at a time of historically low international policy rates and large central bank balance sheets, when central banks were already re-thinking their toolkits. Alongside the short-term demand consequences, Jordà, Singh and Taylor (2020) find that the equilibrium interest rate has fallen persistently after past pandemics, which would further reduce the policy space available for rate setters. This raises the prospect that policymakers will need to routinely reach for unconventional tools developed since the GFC, and potentially to countenance some new ones.

Research is underway on the effects of central bank interventions since March 2020. Hartley and Rebucci (2020) study QE announcements across 21 central banks and find that the declines in 10-year government bond yields in developed market economies were slightly smaller than those seen in the aftermath of the GFC. Altavilla et al (2020) find that the co-ordinated actions of monetary and prudential policymakers in the Eurozone was particularly effective at supporting bank lending. Less encouragingly, Coibion, Gorodnichenko and Weber (2020) find that the beliefs and spending plans of US households did not respond to forward guidance post-Covid.

At the same time, theorists are hard at work looking at the mechanisms at play for unconventional tools. Sims and Wu (2020) distinguish between lending to the financial sector (‘Wall Street QE’) and to non-financial firms (‘Main Street QE’). If a shock impairs financial firms’ balance sheets (eg, the GFC), the two types of QE are perfect substitutes. But for a shock in which non-financial firms face cash-flow shortages (eg, the Covid shock), ‘Main Street QE’ is substantially more effective, given that it supports firms reliant on debt finance. Caballero and Simsek (2020) argue that a large non-financial shock, such as Covid, generates an endogenous fall in risk tolerance. In this case, QE can mitigate the effects of the shock by transferring risk to the central bank’s balance sheet.

Levin and Sinha (2020) analyse the efficacy of forward guidance at the lower bound in a model incorporating frictions in expectations formation, imperfect credibility of policy commitments and the central bank’s uncertainty over the structure of the economy. This framework suggests that forward guidance requires long-lived promises of inflation overshoots, and may therefore be counterproductive if the baseline model of the economy is misspecified. The authors therefore argue that going beyond current FOMC guidance, which they view as intended to clarify the FOMC’s reaction function and close to current market expectations, could bear risks.

Covid has also reinvigorated the debate on the blogosphere on the merits of negative interest rates, although the academic literature on this is still sparse. There are different positions on the effectiveness of past experience. For example Andersson and Jonung (2020) suggest that negative rates in Sweden in 2015–19 had a modest effect on inflation but contributed to increased financial vulnerabilities, while Krogstrup, Kuchler and Spange (2020) argue that the period since the Danish policy rate went negative in 2012 has been more benign. Others have made the case that negative rates will be an invaluable tool for inflation targeting, given market expectations of the need for further easing (eg Lilley and Rogoff (2020) and de Groot and Haas (2020)). This is sure to prompt more future research.

Conclusions

As highlighted in this post, the Covid shock has lit a spark under several new monetary-strategy research themes (eg sectoral differences, new QE mechanisms), but also stoked the flames on a number that have been simmering for a while (uncertainty, unconventional policy tools close to the ELB, equilibrium interest rates). This post has not addressed the recent debate on monetary-fiscal interactions and helicopter money.

Richard Harrison works in the Bank’s Monetary Analysis Division, Kate Reinold works in the Bank’s Monetary Policy Outlook Division and Rana Sajedi works in the Bank’s Research Hub.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied. Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

The ECB Umbrella is here to stay

Published by Anonymous (not verified) on Thu, 12/11/2020 - 5:07am in

On December 10th the European Central Bank Governing Council will likely announce new measures to support governments that have to reach to their wallet again to try to cope with the economic effects of the pandemic second wave. It would not be surprising that the ongoing asset purchase programmes will be extended in size and duration (currently, the Pandemic Emergency Purchase Program, PEPP, is scheduled to run until June 2021). There have been rumors in recent days that the ECB could use this increase in its firepower to put pressure on countries that do not wish to make use of loans from the Recovery Fund and the ESM. ECB board member Yves Mersch yesterday also suggested that the ECB walk that path.

For those who are not into the European debate, it should be recalled that using the loans from European programmes (the ESM covid line, the SURE, and the quota of the Recovery Fund that is not grants) yields savings in interests: the EU will borrow on the markets at more favourable costs than many Member States and redistribute the amounts. If market rates are low, the gain in interest from European loans is reduced and may not be sufficient to offset the fact that these loans come with terms and conditions (and further problems in the case of the ESM). By reducing its purchases of reluctant countries’ assets, the argument goes, the ECB would raise market rates and thus make it convenient, if not inevitable, for them to use financing from European programmes.
I believe that it is very unlikely, if not impossible, that the ECB would engage in such nudging. Its umbrella will remain open for all eurozone countries for a long time to come. Instead of worrying about the presumed unsustainability of the debt that all European countries are accumulating, we should focus on how to spend the money quickly and well. Sustainability depends more on this than on unlikely ECB pressures or unlikely sudden reversals of market confidence.


There are three reasons to doubt that the ECB will use its purchasing programmes to interfere in the financing choices of European Governments. The first reason is technical. Since the Quantitative Easing program started in 2015, purchases of each country’s securities have been proportional to the so-called capital key, the shares of EMU countries in the capital of the ECB, which in turn are linked to population and GDP. This self-imposed proportionality was the price to be paid to avoid that the purchases were concentrated on peripheral countries’ securities, allowing them to pass on their debt to the supposed frugals through the ECB. When last March the new emergency purchase programme was introduced, the ECB relaxed the capital key so that purchases could initially focus on the debt of countries subject to market pressure and (contrary to what Lagarde has suggested just days before) keep spreads under control. However, even in this case, the ECB did not embrace complete discretion, as flexibility was only temporary: at a later stage purchases will have to be rebalanced in order to respect the self imposed proportionality at the end of the programme. Deciding now to move away from the capital key to put pressure on countries that do not want European loans would most likely meet the opposition of the core countries, that feel protected by them. It is interesting that Mersch himself, a few days before suggesting proportionality were scrapped to nudge Member States into EU loans, argued in an interview that “We are bound not by self-imposed limits but by red lines which are of a constitutional nature and which are in the treaty. The self-imposed limits only serve to respect those constitutional limits, which are not at our disposal.”

The second reason why ECB nudging is unlikely has to do with the current macroeconomic situation. One might in fact argue that, pretty much as in the current PEPP, flexibility and nudging could happen in the short run to eventually restore the capital key. But contrary to what many believe, today the ECB necessary to keep rates low. The crisis has generated an enormous mass of savings which, given the economic uncertainty, has mostly been channeled into demand for public debt of all countries. In October’s auctions alone Italy, one of the most problematic EMU countries when it comes to public finances’ sustainability, placed debt at different maturities (with rates close to zero) for around 33 billion euros against a market demand of more than 55 billion euros . Of course, it would be foolish to neglect the role of monetary policy: the ECB’s umbrella has contributed to making public debt safe and therefore attractive. But it is certainly not the only factor; the abundance of savings is increasingly a feature (and a problem) of our economies.
Last, but not least, political reasons, that encompass all th others, reduce the risk of ECB interference in countries’ financing choices. Since 2012, while it has struggled to convince markets of its credibility in sustaining growth and keeping inflation close to its target, the ECB has been very effective in curbing speculation. Ever since Mario Draghi’s 2012 whatever it takes speech, all it took to stop market pressure on peripheral countries, was the certainty that the ECB was ready to do everything (whatever it takes) to prevent speculative attacks to keep markets at bay, make public debt attractive and reduce spreads. A sort of (imperfect) lender of last resort, in sum. Even the PEPP programme, after some massive initial purchases, has settled on limited flows and proportionality is already almost restored. It is frankly quite implausible that the ECB will deliberately risk to increase uncertainty and let spreads widen again, squandering an hard-earned credibility capital just to push hesitant countries to apply for loans from European programmes.


Long story short, the ECB’s umbrella is set to remain open for a long time to come and will contribute, along with the mass of savings in search of placement, to keep the cost of debt low. We should resist getting entangled in the debate on how to finance (and repay) public debt, and focus on the use of the resources available. European countries need to efficiently invest in tangible and intangible infrastructures that will enable us to set out on a path of sustainable and sustained growth. After all, a healthy economy is the best guarantee of sustainable public debt.

Can Algorithmic Market Makers Safely Replace FX Dealers as Liquidity Providers?

Published by Anonymous (not verified) on Mon, 26/10/2020 - 2:42am in

By Jack Krupinski

Financialization and electronification are long term economic trends and are here to stay. It’s essential to study how these trends will alter the world’s largest market—the foreign exchange (FX) market. In the past, electronification expanded access to the FX markets and diversified the demand side. Technological developments have recently started to change the FX market’s supply side, away from the traditional FX dealing banks towards principal trading firms (PTFs). Once the sole providers of liquidity in FX markets, dealers are facing increased competition from PTFs. These firms use algorithmic, high-frequency trading to leverage speed as a substitute for balance sheet capacity, which is traditionally used to determine FX dealers’ comparative advantage. Prime brokerage services were critical in allowing such non-banks to infiltrate the once impenetrable inter-dealer market. Paradoxically, traditional dealers were the very institutions that have offered prime brokerage services to PTFs, allowing them to use the dealers’ names and credit lines while accessing trading platforms. The rise of algorithmic market markers at the expense of small FX dealers is a potential threat to long-term stability in the FX market, as PTFs’ resilience to shocks is mostly untested. The PTFs presence in the market, and the resulting narrow spreads, could create an illusion of free liquidity during normal times. However, during a crisis, such an illusion will evaporate, and the lack of enough dealers in the market could increase the price of liquidity dramatically. 

      In normal times, PTFs’ presence could create an “illusion of free liquidity” in the FX market. The increasing presence of algorithmic market makers would increase the supply of immediacy services (a feature of market liquidity) in the FX market and compress liquidity premia. Because liquidity providers must directly compete for market share on electronic trading platforms, the liquidity price would be compressed to near zero. This phenomenon manifests in a narrower inside spread when the market is stable.  The FX market’s electronification makes it artificially easier for buyers and sellers to search for the most attractive rates. Simultaneously, PFTs’ function makes market-making more competitive and reduces dealer profitability as liquidity providers. The inside spread represents the price that buyers and sellers of liquidity face, and it also serves as the dealers’ profit incentive to make markets. As a narrower inside spread makes every transaction less profitable for market makers, traditional dealers, especially the smaller ones, should either find new revenue sources or exit the market.

      During a financial crisis, such as post-COVID-19 turmoil in the financial market, such developments can lead to extremely high and volatile prices. The increased role of PTFs in the FX market could push smaller dealers to exit the market. Reduced profitability forces traditional FX dealers to adopt a new business model, but small dealers are most likely unable to make the necessary changes to remain competitive. Because a narrower inside spread reduces dealers’ compensation for providing liquidity, their willingness to carry exchange rate risk has correspondingly declined. Additionally, the post-GFC regulatory reforms reduced the balance sheet capacity of dealers by requiring more capital buffers. Scarce balance sheet space has increased the opportunity cost of dealing. 

Further, narrower inside spreads and the increased cost of dealing have encouraged FX dealers to offer prime brokerage services to leveraged institutional investors. The goal is to generate new revenue streams through fixed fees. PTFs have used prime brokerage to access the inter-dealer market and compete against small and medium dealers as liquidity providers. Order flow internalization is another strategy that large dealers have used to increase profitability. Rather than immediately hedge FX exposures in the inter-dealer market, dealers can wait for offsetting order flow from their client bases to balance their inventories—an efficient method to reduce fixed transaction costs. However, greater internalization reinforces the concentration of dealing with just a few large banks, as smaller dealers do not have the order flow volume to internalize a comparable percentage of trades.

Algorithmic traders could also intensify the riskiness of the market for FX derivatives. Compared to the small FX dealers they are replacing, algorithmic market makers face greater risk from hedging markets and exposure to volatile currencies. According to Mehrling’s FX dealer model, matched book dealers primarily use the forward market to hedge their positions in spot or swap markets and mitigate exchange rate risk. On the other hand, PTFs concentrate more on market-making activity in forward markets and use a diverse array of asset classes to hedge these exposures. Hedging across asset classes introduces more correlation risk—the likelihood of loss from a disparity between the estimated and actual correlation between two assets—than a traditional forward contract hedge. Since the provision of market liquidity relies on dealers’ ability to hedge their currency risk exposures, greater correlation risk in hedging markets is a systemic threat to the FX market’s smooth functioning. Additionally, PTFs supply more liquidity in EME currency markets, which have traditionally been illiquid and volatile compared to the major currencies. In combination with greater risk from hedging across asset classes, exposure to volatile currencies increases the probability of an adverse shock disrupting FX markets.

While correlation risk and exposure to volatile currencies has increased, new FX market makers lack the safety buffers that help traditional FX dealers mitigate shocks. Because the PTF market-making model utilizes high transaction speed to replace balance sheet capacity, there is a little buffer to absorb losses in an adverse exchange rate movement. Hence, algorithmic market makers are even more inclined than traditional dealers to pursue a balanced inventory. Since market liquidity, particularly during times of significant imbalances in supply and demand, hinges on market-makers’ willingness and ability to take inventory risks, a lack of risk tolerance among PTFs harms market robustness. Moreover, the algorithms that govern PTF market-making tend to withdraw from markets altogether after aggressively offloading their positions in the face of uncertainty. This destabilizing feature of algorithmic trading catalyzed the 2010 Flash Crash in the stock market. Although the Flash Crash only lasted for 30 minutes, flighty algorithms’ tendency to prematurely withdraw liquidity has the potential to spur more enduring market dislocations.

The weakening inter-dealer market will compound any dislocations that may occur as a result of liquidity withdrawal by PTFs. When changing fundamentals drive one-sided order flow, dealers will not internalize trades, and they will have to mitigate their exposure in the inter-dealer FX market. Increased dealer concentration may reduce market-making capacity during these periods of stress, as inventory risks become more challenging to redistribute in a sparser inter-dealer market. During crisis times, the absence of small and medium dealers will disrupt the price discovery process. If dealers cannot appropriately price and transfer risks amongst themselves, then impaired market liquidity will persist and affect deficit agents’ ability to meet their FX liabilities.

For many years, the FX market’s foundation has been built upon a competitive and deep inter-dealer market. The current phase of electronification and financialization is pressuring this long-standing system. The inter-dealer market is declining in volume due to dealer consolidation and competition from non-bank liquidity providers. Because the new market makers lack the balance sheet capacity and regulatory constraints of traditional FX dealers, their behavior in crisis times is less predictable. Moreover, the rise of non-bank market makers like PTFs has come at the expense of small and medium-sized FX dealers. Such a development undermines the economics of dealers’ function and reduces dealers’ ability to normalize the market should algorithmic traders withdraw liquidity. As the FX market is further financialized and trading shifts to more volatile EME currencies, risks must be appropriately priced and transferred. The new market makers must be up to the task.

Jack Krupinski is currently a fourth-year student at UCLA, majoring in Mathematics/Economics with a minor in statistics. He pursues an actuarial associateship and has passed the first two actuarial exams (Probability and Financial Mathematics). Jack is working to develop a statistical understanding of risk, which can be applied in an actuarial and research role. Jack’s economic research interests involve using “Money View” and empirical methods to analyze international finance and monetary policy.

Jack is currently working as a research assistant for Professor Roger Farmer in the economics department at UCLA and serves as a TA for the rerun of Prof. Mehrling’s Money and Banking Course on the IVY2.0 platform. In the past, he has co-authored blog posts about central bank digital currency and FX derivatives markets with Professor Saeidinezhad. Jack hopes to attend graduate school after receiving his UCLA degree in Spring 2021. Jack is a member of the club tennis team at UCLA, and he worked as a tennis instructor for four years before assuming his current role as a research assistant. His other hobbies include hiking, kayaking, basketball, reading, and baking.

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Are the Banks Taking Off their Market-Making Hat to Become Brokers?

Published by Anonymous (not verified) on Tue, 20/10/2020 - 3:45am in

“A broker is foolish if he offers a price when there is nothing on the offer side good to the guy on the phone who wants to buy. We may have an offering, but we say none.” –Marcy Stigum

Before the slow but eventual repeal of Glass-Steagall in 1999, U.S. commercial banks were institutions whose mission was to accept deposits, make loans, and choose trade-exempt securities. In other words, banks were Cecchetti’s “Financial intermediaries.” The repeal of Glass-Steagall allowed banks to enter the arena so long as they become financial holding companies. More precisely, the Act permitted banks, securities firms, and insurance companies to affiliate with investment bankers.Investment banks, also called non-bank dealers, were allowed to use their balance sheets to trade and underwrite both exempt and non-exempt securities and make the market in both the capital market and the money market instruments. Becoming a dealer brought significant changes to the industry. Unlike traditional banks, investment banks, or merchant banks, as the British call it, can cover activities that require considerably less capital. Second, the profit comes from quoting different bid-ask prices and underwriting new securities, rather than earning fees. 

However, the post-COVID-19 crisis has accelerated an existing trend in the banking industry. Recent transactions highlight a shift in power balance away from the investment banking arm and market-making operations. In the primary markets, banks are expanding their brokerage role to earn fees. In the secondary market, banks have started to transform their businesses and diversify away from market-making activities into fee-based brokerages such as cash management, credit cards, and retail savings accounts. Two of the underlying reasons behind this shift are “balance sheet constraints” and declining credit costs that reduced banks’ profit as dealers and improved their fee-based businesses. From the “Money View” perspective, this shift in the bank’s activities away from market-making towards brokerage has repercussions. First, it adversely affects the state of “liquidity.” Second, it creates a less democratic financial market as it excludes smaller agents from benefiting from the financial market. Finally, it disrupts payment flows, given the credit character of the payments system.

When a banker acts as a broker, its income depends on fee-based businesses such as monthly account fees and fees for late credit card payments, unauthorized overdrafts, mergers, and issuing IPOs. These fees are independent of the level of the interest rate. A broker puts together potential buyers and sellers from his sheet, much in the way that real estate brokers do with their listing sheets and client listings. Brokers keep lists of the prices bid by potential buyers and offered by potential sellers, and they look for matches. Goldman, Merrill, and Lehman, all big dealers in commercial paper, wear their agent hat almost all the time when they sell commercial paper. Dealers, by contrast, take positions themselves by expanding their balance sheets. They earn the spread between bid-ask prices (or interest rates). When a bank puts on its hat as a dealer (principal), that means the dealer is buying for and selling from its position. Put another way, in a trade, the dealer is the customer’s counterparty, not its agent.

Moving towards brokerage activity has adverse effects on liquidity. Banks are maintaining their dealer role in the primary market while abandoning the secondary market. In the primary market, part of the banks’ role as market makers involves underwriting new issues. In this market, dealers act as a one-sided dealer. As the bank only sells the newly issued securities, she does not provide liquidity. In the secondary market, however, banks act as two-sided dealers and supply liquidity. Dealer banks supply funding liquidity in the short-term money market and the market liquidity in the long-term capital market. The mission is to earn spreads by constantly quoting bids and offers at which they are willing to buy and sell. Some of these quotes are to other dealers. In many sectors of the money market, there is an inside market among dealers. 

The money market, as opposed to the bond market, is a wholesale market for high-quality, short-term debt instruments, or IOUs. In the money market, dealing banks make markets in many money market instruments. Money market instruments are credit elements that lend elasticity to the payment system. Deficit agents, who do not have adequate cash at the moment, have to borrow from the money market to make the payment. Money market dealers expand the elasticity daily and enable the deficit agents to make payments to surplus agents. Given the credit element in the payment, it is not stretching the truth to say that these short-term credit instruments, not the reserves, are the actual ultimate means of payment. Money market dealers resolve the problem of managing payments by enabling deficit agents to make payments before they receive payments.

Further, when dealers trade, they usually do not even know who their counterparty is. However, if banks become brokers, they need to “fine-tune” quotes because it matters who is selling and buying. Brokers prefer to trade with big investors and reduce their ties with smaller businesses. This is what Stigum called “line problems.” She explains that if, for example, Citi London offered to sell 6-month money at the bid rate quoted by a broker and the bidding bank then told the broker she was off and had forgotten to call, the broker would be committed to completing her bid by finding Citi a buyer at that price or by selling Citi’s money at a lower rate and paying a difference equal to the dollar amount Citi would lose by selling at that rate. Since brokers operate on thin margins, a broker wouldn’t be around long if she often got “stuffed.” Good brokers take care to avoid errors by choosing their counterparties carefully.

After the COVID-19 pandemic, falling interest rates, the lower overall demand for credit, and regulatory requirements that limit the use of balance sheets have reduced banks’ profits as dealers. In the meantime, the banks’ fee-based businesses that include credit cards late-fees, public offerings, and mergers have become more attractive. The point to emphasize here is that the brokerage business does not include providing liquidity and making the market. On the other hand, dealer banks generate revenues by supplying funding and market liquidities in the money and capital markets. Further, brokers tend to only trade with large corporations, while dealers’ decisions to supply liquidity usually do not depend on who their counterparty is. Finally, the payment system is much closer to an ideal credit payment system than an ideal money payment system. In this system, the liquidity of money market instruments is the key to a well-functioning payment system. Modern banks may wear one of two hats, agent (broker) or principal (dealers), in dealing with financial market instruments. The problem is that only one of these hats allows banks to make the market, facilitate the payment system, and democratize access to the credit market.

Elham Saeidinezhad is Term Assistant Professor of Economics  at Barnard College, Columbia University. Previously, Elham taught at UCLA, and served as a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”.  Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

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