A thought on global warming

I just read this piece over at Economist’s View and here’s my solution to the global coordination problem.

Set up an international carbon tax and direct the revenue to an overseeing organization.  (If cap and trade can generate revenue for government that could work too.)  The funds should then be dedicated to carbon mitigation and climate change adaptation — with the rules deliberately set so there is a generous annual transfer from developed to developing countries.  Finally, any country that turns out to be faking things like carbon offsets will have the funds that flow to government decreased so that international monitoring of offsets and similar policies can be funded

The basic idea that I think would be very useful is to take the revenue from a carbon tax — or cap and trade — and use that revenue to deal with the issue of aiding the transition for developing countries.

On Lords of Finance

I’ve just started reading Lords of Finance (about 1/3 through) and unfortunately I’m really put off by character descriptions that seem to belong more to the world of fiction than to non-fiction.  I just don’t understand how it is possible in a work of non-fiction to have an omniscient narrator make statements like:  “He displayed an astounding self-confidence.  This was not a facade.”

I have rarely met anybody who was outwardly confident without being inwardly insecure.  In fact, I would say that it is precisely those who present themselves as uncertain who have the deepest confidence — that is, they are confident enough to display openly that there’s a lot they don’t know and don’t worry about how the world judges them.  In short, I would argue that the character of someone who died some sixty years ago is in some sense unknowable.

That’s why biographers use lengthy quotes.  What a man’s wife has to say about him always says something about the man — even if it’s only about the kind of wife he chose.   But surely this issue:  whether a character description says more about the speaker or the object of the description is for the reader to decide.   Thus, the introduction of an omniscient narrator into a work of non-fiction is problematic — the reader has difficulty judging whether the character descriptions say more about Liaquat Ahamed or about the character he’s describing.

Given my discomfort with Ahamed’s approach to the subjects of his book, I can’t help but wonder what evidence the author has for his diagnosis of Montagu Norman as suffering from “severe manic depression“.  This reads to me as an outrageous case of pop psychology, which may be supported by nothing more than Carl Jung’s diagnosis in 1913 of GPI and death within months  (Norman lived until 1950) and episodes of moodiness.  There seems to be strong evidence that Norman suffered from more than one “nervous breakdown”, but conflating a reaction to excessive stress with mental illness strikes me as one of those decisions that says far more about Ahamed than about Norman.

On an alternate note in Ahamed’s takedown of the competence of the governors of the Bank of England (whom he notes in the same pages made the best decisions) he derides the real bills doctrine as “clearly fallacious” — and goes on to explain why it held true:  because it was espoused in an environment with a gold standard.  The author shows no awareness whatsoever that the purpose of the real bills doctrine was to protect the economy from inflation caused by speculative bubbles and frauds.

Despite the preceding criticism, I am learning a lot about finances throughout Europe during World War I and the interwar period.  And it appears to me that when Ahamed focuses on factual information he is generally careful to be accurate.

Economics and complacency

There is a faith amongst some economists that growth will save us — but economists don’t have a good grasp of why economic growth does or does not take place — a fact that most of them will admit.  The current fad is to attribute growth to “institutions” — with the understanding that the specification of what institutions matter to growth, what institutions don’t matter and what institutions hinder growth has hardly been started (with the exception of the importance of property rights).

The foundation of the belief that growth will come seems to be the view that financial crises are just extreme versions of recessions and recessions are followed by recoveries.  This is an extremely ahistoric approach to economics since there are many examples of failed recoveries:  Holland in the late 18th c, Britain in the 1920s, Japan in the 90s.

This is probably related to the fact that most of the research on the Depression of the 30s takes the view that our ancestors made mistakes that we would never make.  Therefore, the outcome of our crisis has to be better than the outcome of their crisis.  However, as someone who has studied the 19th c approach to central banking, I suspect that we have made mistakes that our ancestors would never have made.

For example, about six years ago I corresponded with a researcher at a Federal Reserve Bank.  My question was this:  When tracking monetary data, why does the Fed report the “Non-financial commercial paper” series, but not the “Financial commercial paper” series?

The answer:  Financial commercial paper is used to make loans, so the assets and liabilities of the financial companies will zero out and have no effect on the money supply.

Think about that answer for moment.  The Fed’s policy was literally to ignore the increase in the liabilities of financial institutions because they did not affect measures of the money supply.  The Fed had a policy of ignoring credit growth on the part of financial institutions.  This is an error that 19th century bankers would never have made.  I suspect it grows out of the lazy habit of using Arrow Debreu based models where financial institutions don’t matter.

At the time I pointed out to the Fed researcher that the Fed should be keeping an eye on measures like financial commercial paper, because they were likely to be correlated with the risk of financial instability (and that I drew this conclusion from my knowledge of 19th c central banking).

On credit growth and central banking.

It looks like Schularick and Taylor — along with most of the rest of the economics profession — need to brush up on their Ralph Hawtrey and Benjamin Strong reading.  (Note that there’s a short version of the paper at the Economists’ Forum.)  They state:  “Our ancestors lived in an Age of Money, where aggregate credit was closely tied to aggregate money, and formal analysis could use the latter as a reliable proxy for the former.”  While it is possible that early central bankers could have relied on money as a proxy for credit, the fact is that they did not.  In fact, I can’t help but wonder Schularick and Taylor have their causality backwards:  Perhaps it was because early central bankers focused equally on credit growth and on price levels, that they maintained a relatively stable relationship between credit and money.

The evidence that early central bankers focused much of their attention on the state of credit is overwhelming.  Early central bankers didn’t even view themselves as implementing monetary policy, they implemented credit policy.  In Hawtrey’s The Art of Central Banking published in 1932, credit and money are given equal emphasis.  Similarly in Interpretations of federal reserve policy in the speeches and writings of Benjamin Strong, we find that Strong wrote in 1923:

Some people think that prices should be the guide …
Just as credit is one of the influences upon the price level, so the price level should be one of the influences in guiding a credit policy. There are other influences which affect prices, and so there must be other influences which affect a credit policy. Here are a few briefly suggested:
Is labor fully employed?
Are stocks of goods increasing or decreasing?
Is production up to the country’s capacity?
Are transportation facilities fully taxed?
Is speculation creeping into the productive and distributive processes?
Are orders and repeat orders being booked much ahead?
Are bills being promptly paid?
Are people spending wastefully?
Is credit expanding?
Are market rates above or below … Bank rates?
What this country and the world needs is stability. … The banking system’s … best policy is to supply enough credit and not too much — enough for legitimate enterprise, but not enough to satisfy those who want simply cheap and limitless supplies of credit regardless of the consequences they are too blind to perceive.

So when Schularick and Taylor find that:

Our results also strengthen the idea that credit matters, above and beyond its role as propagator of shocks hitting the economy. The credit system is not merely an amplifier of economic shocks as in the financial accelerator model of BGG. The importance of past credit growth as a predictor for financial crises and the robustness of the results to the inclusion of other key macro variables, raises the strong possibility that the financial sector is quite capable of creating its very own shocks.

we learn that careful empirical research in the 21st century can confirm traditional principles that central bankers recognized in the early years of the 20th century.

How much do monetary and fiscal policy matter?

Paul Krugman:

The truth is that policy should be piling on, not looking for the exit. But central bankers can’t wait to pull away the punchbowl, even though the party hasn’t started, and shows no signs of starting for years to come.

And:

We’ve got the president telling Fox News that he’s worried about a double-dip recession if he doesn’t reduce the deficit soon — as opposed to the concern I and other have that he’ll have a double dip if he doesn’t provide more support.

I’m not sure Krugman is asking the right questions.  The way I see things is this:  If we fix the financial system quickly — use the bankruptcy process to wipe out a lot of real economy debt and deal with the resulting bank failures via a resolution authority and by making sure that the remaining banks are well-capitalized — what Krugman calls a “liquidity trap” will disappear.  Only once consumers and firms feel that they no longer face a crushing debt burden will they be able to participate fully in the economy.

After the bankruptcies and bank closures have taken place, the Fed will no longer need to hold rates at ridiculously low levels to recapitalize the banking system and cause savings to move from Treasuries into CDs.  In this scenario the banking system can lead the recovery and government spending is of only secondary importance to the health of the economy.

On the other hand, if we fix the financial system, the spending that Krugman proposes won’t do any harm either, because we will be able to grow out of our debt.

I’m really just not sure whether or not government spending to support the economy matters very much.  In my view it is far, far, far more important to fix the financial infrastructure — by ending the policy of extend and pretend — so natural economic forces can drive a recovery.

On leverage and growth

Simon Johnson has found some research produced by Morgan Stanley that claims the following:

We think the regulators will balance the need for reducing systemic risk with the need for economic growth. … we think the demand for growth and access to credit will trump desire for unprofitable capital levels

The claim that maintaining the high levels of economic growth to which we have become accustomed requires that the financial system operate with minuscule levels of capital has sustained ever increasing leverage ratios in the financial system for decades.  I worried in this post that Morgan Stanley’s analysts are right and the crisis of the past year has indeed not been enough to dispell the idea that negligible levels of capital are the long term solution to our financial problems.

Lately I am often reminded of the fact that China’s experiment with fiat money lasted about 200 years — and I date  our current experiment with fiat money as starting in 1797.

On supporting Wall Street

In an excellent post on the problems the Fed is facing right now, Tim Duy writes

Fed officials see this a bit differently – they see supporting Wall Street as their mechanism for supporting Main Street

Does anybody else find something odd about this statement?  Supporting the commercial banking system as a means of supporting Main Street makes sense, but Wall Street?  How is it possible for Wall Street financiers to be such bad risk managers that they need support?  They don’t take bank deposits and carry illiquid loans.  How on earth did Wall Street get itself into a liquidity crisis — their standard business model should not involve carrying large quantities of high risk assets on their balance sheets.

If upstart companies want to make money making markets in junk bonds and other products of highly variable value that’s fine.  Let them enjoy their boom and bust cycle — making money in the good times and going bankrupt in the bad.  But why would companies that want to be around for the long-term ever get into these markets in a big way?

Yves Smith has the answer:  After Wall Street firms went public, they stopped being managed in a way that would allow them to be around for the long-term.  Prior to the 70s Wall Street firms were partnerships and every partners’ personal wealth was at risk in the event of failure.  Effectively financiers had professional liability exposure just like doctors — and the market was the arbiter of misconduct. For this reason, Wall Street firms didn’t fail.  They also didn’t make markets in junk bonds or other high risk assets.  They established the stock and commodities exchanges to reduce their exposure to loss from market making activities. In short, they understood the risks involved in market making and they were careful to minimize them.

Over the last quarter of the 20th century changes in the financial system allowed huge new markets in illiquid assets to develop.  As extraordinary levels of debt grew, this debt facilitated growth in the same way that increasing the money supply stimulates growth.  Unfortunately the foundations on which this debt was issued — and thus the foundations of this growth — were not sound.  Thus we find ourselves at the start of the 21st century trying to sort out how to maintain a functioning economy when the system of capital allocation (i.e. Wall Street) is completely broken.  The transition is sure to be difficult.  But if we recognize that the view that government has a duty to support investment banks has little or no historical support and that Wall Street functioned well in the past by treating the personal wealth of the financiers as the obvious source of funds for creditors of a bankrupt investment bank, then we can start to solve the problem.

Was TARP a failure?

Brad DeLong is arguing that the government’s actions since the Lehman failure have been good — and thus that TARP was not a failure because it saved the financial system.  I think the issue is this:

If we ask the question:  Given that passing a resolution authority was impossible, was TARP a failure?  Then I think the answer is no.  If you take the best solution out of the set of possibilities, then the Treasury and the Fed did what they could given the constraints they faced.  In other words TARP was better than using the bankruptcy process as it is currently structured to resolve the crisis.  (Note:  Steve Lubben is proposing that a modified Chapter 11 process would be a superior alternative to a resolution authority.)

However, if you simply ask the question:  Was TARP a failure?  Then you have to take into account the fact that passing a resolution authority in September/October 2008 was a possibility. The sense in which TARP was a failure was that a conscious decision was made to transfer funds from the taxpayer to the financial system in a way that all but ensured that a large chunk of the money would be lost (see CIT bankruptcy).  This was necessary because there was no resolution authority and no way for the government to provide DIP financing (as it did for the GM and Chrysler).  Thus, the responsibility for TARP’s “failure” lies with whoever took the possibility of passing a resolution authority off the table.

We need a MFPA too

As one hears about all the municipalities that have gotten over their heads in derivatives, it becomes clear that we need a Municipal Financial Protection Agency too.  The MFPA can define the terms of plain vanilla products that are designed for municipalities.  Each state or local government can then decide to what degree employees are allowed to enter into products that are not plain vanilla muni products.

Which comes first democracy or rule of law?

My point is that respect for the rule of law does not necessarily result from free and open elections.  Respect for the role played by the rule of law in the general welfare may need to exist before democratic institutions can establish strong foundations.

Daron Acemoglu argues that “if you wish to fix institutions, you have to fix governments” and I’m not sure that I agree that governments are the starting point for reform.  On the other hand, his view that we should push non-democratic regimes to be more transparent and democratic and encourage foreign citizens to use technological tools to organize themselves can be supported on first principles without an appeal to economic growth.

Thus, while I am supportive of Acemoglu’s specific recommendations, I am not sure that they are sufficient to “fix institutions”.  Think about European history.  Europe exited the middle ages and began to develop a merchant class long before it could lay claim to democratic governance.  The development of wealthy merchant enclaves in Italy led kings in other parts of Europe to cede their legal jurisdiction to “merchant law” in special economic zones that facilitated the growth of taxable wealth.   Over time cities where merchant interests predominated became centers of wealth throughout Europe — and the value of “merchant law” became obvious.  In England trade facilitated the merger of common law with the merchant law developed on the continent and helped lay the foundations of economic growth there.  Thus, the foundations of contract law had deep roots in Europe that preceded the revolutions which subjected monarchs to the rule of law by centuries.

In short, only after the value of the rule of law in common affairs was well established were democracies able to flourish in Europe.  Thus, if the goal is to “fix institutions”, it is possible that supporting economic growth in non-democratic regimes by pursuing goals like those of Paul Romer’s charter cities may be more effective than pushing democracy on countries that lack the economic foundations to maintain their democracies.