Sunday, January 17, 2010

Economics and the Economy: Recent Views

There are two recent pieces on the economy worth reading. One by Solow and the other by Mankiw.

Let me start with Mankiw and the excess reserve issue. We noted nine months ago about the excess reserves that appear on the banks balance sheets as they appear also on the FED. The NY FED published a paper a month ago trying to explain these.

The quantity of reserves in the U.S. banking system has risen dramatically since September 2008. Some commentators have expressed concern that this pattern indicates that the Federal Reserve’s liquidity facilities have been ineffective in promoting the flow of credit to firms and households. Others have argued that the high level of reserves will be inflationary. We explain, through a series of examples, why banks are currently holding so many reserves. The examples show how the quantity of bank reserves is determined by the size of the Federal Reserve’s policy initiatives and in no way reflects the initiatives’ effects on bank lending. We also argue that a large increase in bank reserves need not be inflationary, because the payment of interest on reserves allows the Federal Reserve to adjust short-term interest rates independently of the level of reserves.

Mankiw in his article seems to state what we observed nine months ago but which the NY FED seems to say is a misinterpretation. Makiw states:

The Federal Reserve has also been rapidly creating money. The monetary base — meaning currency plus bank reserves — is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years....

Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.

Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times. With banks content holding idle cash, the broad measure called M2 (including currency and deposits in checking and savings accounts) has grown in the last two years at an annual rate of only 6 percent.

The NY FED replied last month as follows:

This view has lead to proposals aimed at discouraging banks from holding excess reserves, such as placing a tax on excess reserves (Sumner, 2009) or setting a cap on the amount of excess reserves each bank is allowed to hold (Dasgupta, 2009). Mankiw (2009) discusses historical concerns about people hoarding money during times of financial stress and mentions proposals that were made to tax money holdings in order to encourage lending. He relates these historical episodes to the current situation by noting that “[w]ith banks now holding substantial excess reserves, [this historical] concern about cash hoarding suddenly seems very modern.”

The NY FED concludes:

The idea that banks will hold a large quantity of excess reserves conflicts with the traditional view of the money multiplier. According to this view, an increase in bank reserves should be “multiplied” into a much larger increase in the broad money supply as banks expand their deposits and lending activities. The expansion of deposits, in turn, should raise reserve requirements until there are little or no excess reserves in the banking system. This process has clearly not occurred following the increase in reserves depicted in Figure 1. Why has the money multiplier “failed” here?

The textbook presentation of the money multiplier assumes that banks do not earn interest on their reserves. As described above, a bank holding excess reserves in such an environment will seek to lend out those reserves at any positive interest rate, and this additional lending will decrease the short-term interest rate. This lending also creates additional deposits in the banking system and thus leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself, with banks making more new loans and the short-term interest rate falling further.

This multiplier process continues until one of two things happens. It could continue until there are no more excess reserves, that is, until the increase in lending and deposits has raised required reserves all the way up to the level of total reserves. In this case, the money multiplier is fully operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts.

Thus the FED argument is that the "textbook" analysis is wrong and it appears that the textbook approach is what Mankiw is using. What is happening. This then trickles down to what the Administration is also doing to banking. The dynamics appear as follows:

1. Banks, yes including Goldman Sachs, gets money free from the FED.

2. Banks have three businesses. One is loaning money which is deposited. Not a very profitable business. A second is the classic role of intermediary in markets bringing investors together with investments and skimming a fee, not a bad business but there is little of it now. Third, investing in their own deals. This is their own trading desks. This is where the money is made.

3. The banks, Goldman, Chase and the usual suspects are back to making tons of dollars by getting money at zero interest, using it in a leveraged manner to bet on the market. The result is they are pushing the market higher. Frankly not bad for developing consumer confidence. It was this action which for the most part caused the turn around since March.

4. Turning the market is just a confidence builder, albeit an important one. They are doing what they could as bank traders in making the economy work on paper. Money is flowing in that sector. It does not mean that the investors and investments are getting together and it does not mean that banks are lending using the leverage from deposits, even though deposits are growing.

5. Thus if we were to tax banks as proposed, we would be disincenting those who pushed up the market and then this would be a pressure on pushing the market back down and possibly collapsing everything.

It appears as if Mankiw has not recognized this effect and thus may fall in line with the current Administration. Perhaps textbook writers need to get into the trenches.

Now to Solow. He has reviewed the Cassidy book, and one would perceive somewhat favorably. Yet his review is classic Solow. Let me focus on a few points. First that of externalities. He states:

Yet another requirement is the absence of significant external effects or “externalities.” An externality occurs whenever one person’s or one firm’s behavior directly affects the well-being of other persons or firms positively or negatively without the first party bearing the costs or being remunerated for the costs or benefits that it inflicts or bestows on the others. Thus, if my chemical plant is allowed freely to stink up the neighborhood, there will be more such chemicals produced than the Invisible Hand would like. And if others can read the scientific literature and use the results of your basic research without paying you for it, there will be less basic research done than would be efficient. Again, externalities are ubiquitous in a densely populated modern economy. Some taxes and subsidies, instead of being distortions, are designed to correct the distortions that arise from such externalities (carbon taxes, cap-and-trade systems), and many regulations are intended to prevent or minimize negative externalities (no pig farms in city limits, no billboards in scenic areas).

The problem is that there is not a word of Coase. Solow's view is that the only way to regulate externalities is to have the Government do so. Coase states that if there were well defined property rights and that the transaction costs were de minimis then they could be more efficiently regulated by and between the parties.

As I have stated before the example is farmers and the railroads. If a railroad has tracks adjacent to say a corn field and from time t time it sets off sparks and burns the corn, then if there were well defined property rights and de minimis costs to litigate then the farmer could readily sue the railroad and get his money back plus a reasonable return. No regulation. But we don't have that we have regulation. That means that the railroad must conform everywhere to the no spark standard, a costly adherence, and the farmer has no rights, since the Government has high litigation costs. The result is via regulation we have "controlled" the problem but at a very high social cost. Both Solow and Cassidy know that one could assume but they both are proponents of Government becoming the arbiter it appears.

Now Solow goes on to state something interesting about Goldman:

Take an extreme example. I have read that a firm such as Goldman Sachs has made very large profits from having devised ways to spot and carry out favorable transactions minutes or even seconds before the next most clever competitor can make a move. Deep pockets in a large market can make a lot of money out of tiny advantages. (Of course, if you have any such advantage the temptation is irresistible to borrow a lot of money to enlarge your bets and your profits. Leverage is good for you, until it isn’t. It is not so good for the system.) A lot of high-class intellectual effort naturally goes into trying to invent ways to find those tiny advantages a few seconds before anyone else.

Now ask yourself: can it make any serious difference to the real economy whether one of those profitable anomalies is discovered now or a half-minute from now? It can be enormously profitable to the financial services industry, but that may represent just a transfer of wealth from one person or group to another. It remains hard to believe that it all adds anything much to the efficiency with which the real economy generates and improves our standard of living.

Yes, Goldman has developed an interesting money making machine. It is a fact that stocks can be "sticky" in the short term. The very short term, milliseconds. Thus if you can be in the unique position of having the ability to buy and sell as a buyer and seller, then by seeing short term trends you can buy at the beginning of an up tick and sell at the beginning of a down tick. Small gains, but if you are Goldman you have zero transaction costs. Further if you have fiber between the exchanges, with delays equal to the speed of light for the minimal distances involved, you can do this before anyone else.

You have a unique position to make money at de minimis risk. Further if you get "free money" from the FED you can make billions, which they did. That is the point that Solow seems to be getting at. Second is that even though this is legal it does not create economic value, it is in effect a "tax" on all the poor schlubs who think they are pari passu in the market. In effect the Government has given Goldman a pure profit stream in return for pumping up the market.

The devil is in the details and perhaps economists need to get down a layer or two and explain how this works. The folks at Zero Hedge seem to be at that level and are always a few yards ahead of others in understanding this. We need to have the economists and those who tell their tales to get at the same level.