Other Alpha Sources (Academic Version)

By Claus Vistesen, on January 11th, 2011

If you ask the layman about what economics is the answer you get is likely to contain the notion of money. This is understandable. After all, if economists do not study money in some form or the other what are we doing then?

As such, you might be surprised to learn that in the grand sweep of the economic literature, economists have often found it very difficult to explicitly model the role of money and indeed to incorporate this role into the overall model framework. Put very generally, graduate econ students will see two types of models which incorporate money. The first is the money in utility model (MIU) where money is simply added, alongside consumption, to the utility of the representative individual and where some form of monetary instrument (e.g. bonds) are added to the wealth and thus inter the problem through the budget constraint. The other is the cash in advance model (CIA) where we essentially assume that consumers must hold cash solely for the purpose of buying the goods that they want. Or in more convuluted terms; to facilitate the exchange of goods and services.

If the story above is the one that trickles down into the the university classroom the real world is of course more complicated and any student who starts to dig deeper will find a diverse literature which, notably, have been greatly enriched on the back of the financial crisis.

A paper from the Chicago Fed by Ed Nosal, Christopher Waller, and Randall Wright takes a look at recent endeavors in this field.

The first question which you would probably like to ask is; why the neglect by economists of money and the explicit modelling of something so important? Well, in the word of the authors, blame it on the general equilibriumnistas;

The reason many economists either ignore institutions like money, or slip them in with short cuts, is this: they do not take seriously the nature of the process of exchange. Following classical general equilibrium theory, agents do not trade with each other, but trade only against their budget constraints. Any bundle that is worth no more than the value of one’s endowment is available, with no discussion of how it is to be acquired. Everyone worth his salt understands that there is no role in Debreu’s frictionless paradigm for money, intermediation, or anything else that facilitates the process of exchange since this process is not part of model.

But this is not the whole explanation (fortunately). As the authors go on to explain, many economists sees the working of money as the plumbing behind the scene and thus that it should be assumed to simple do its work (i.e. facilitate the exchanges in a Arrow-Debreu GE world). However, as the authors point out; what happens when the plumbing goes wrong? Indeed, what happens when liquidity, credit and ultimately money transmission mechanisms breaks down?

Some have argued that modeling the details of exchange and intermediation is nothing more than studying the “plumbing”of the economy –it all works well behind the scenes and so we do not need to pay attention to it. This seems wrong. How do we know it is working well if we do not pay attention to it? What happens if the “plumbing”goes bad? We know what this entails, and it is not pretty. We believe that it is dangerous to ignore the details of “plumbing”and that the recent …nancial crisis makes this obvious. We therefore think that it is important to study institutions that help to facilitate exchange, and the papers in this special issue do just that.

And here then is the cue to go read the paper or at least to bookmark it. Note in particular how the authors group recent contributions in the context of money, credit and liquidity and thus what was originally simply a facilitator of exchange has now become a much broader concept.

Naturally, economists of an Austrian pedigree have known this for a while and one decidedly fruitful consequence of the financial crisis is the nascent incorporation of their thoughts into the mainstream economic methodology [1].

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A lot has been written about Japanese savings and especially about when they would run out so as to make the country dependent on foreigners for the financing for the ever growing mountain of public debt. I have written extensively about this basically arguing that while the flow of savings in Japan is indeed inadequate for the ongoing financing of the debt, Japan has two things in their favor. The first is a large stock of domestic savings of which not everything, yet, is parked in government bonds and secondly, central bank which will be forced into taking up any bid that would otherwise have gone to yield hungry bond vigilantes.

A recent working paper by Tokuo Iwaisakoy and Keiko Okadaz from the Japan Ministry of Finance Policy Research Institute (PRI) looks to be well worth reading; (my emphasis);

The decline in Japan’s household saving rate accelerated sharply after 1998, but then decelerated again from 2003. Such nonlinear movement in the sav- ing rate cannot be explained by the monotonic trend of population aging alone. According to the life cycle model of consumption and saving, popu- lation aging will increase short-run ‡uctuations in the saving rate, because the consumption of older households is less sensitive to income shocks. Ana- lyzing income and spending data for di¤erent age groups, we argue that this is exactly what happened during the recession following the banking panic of 1997/98. Two important changes in income distribution are associated with this mechanism. First, the negative labor income shock, which in the initial stages of the “lost decade”was mostly borne by the younger genera- tion, spread to older working households in the late 1990s and early 2000s. Second, there was a signi…cant income shift from labor to shareholders asso- ciated with the corporate restructuring being undertaken during this time. This resulted in a decline in the wage share, so that the increase in corporate saving o¤set the decline in household saving.

An important aspect of Japan’s economy is the ongoing increase in corporate savings which is just about the only chart on the Japanse economy (apart from the public debt to GDP one) going up. Indeed, it may just be one of the most important charts to understand Japan’s economy;

(click for larger image)

Retained earnings have grown at an average of 4% since 2000 and has thus offset, to a large extent, the decline in private household savings.

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[1] – Indeed Austrians seem have become more mainstream in the aftermath of the financial crisis as a whole. This is no doubt to their great lament since it means you actually have to provide policy advice and not just advocate eternal damnation and bloodletting.



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10 Points Americans Must Understand About the Economy

By Thersites, on January 15th, 2010

1. The interest rate is a price – the price of credit like the price of any good.  In a free market the price would be set like the price of any good at the intersection of the supply of funds (our savings), and demand for funds (businesses’ and individuals’ investing wants).  Instead, we have an interest rate that is arbitrarily picked by a handful of economists from the Federal Reserve Banks.  To repeat, one committee centrally plans the cost of credit, of which interest rates on all debt are directly or indirectly based.

2. The Federal Reserve has the monopoly power to print or inflate the money supply, thus artificially lowering the cost of money (the aforementioned interest rate).  This means that they can (and always do) devalue the money in your pocket as every dollar printed decreases the value of all dollars to come before them.  Inflating the money supply may not lead to an increase in prices if an equal or greater amount of goods is produced, but the purchasing power of the dollar will still be reduced because without printing money, your dollars would have been able to buy more goods.  Alternatively, if more dollars are printed than goods are produced, prices will increase though not necessarily uniformly across all goods.  Inflation may not manifest itself in explicitly higher prices but merely impede prices from falling for certain goods as they would were the money supply to remain constant.

3. When you deposit money in a regular checking account, the bank doesn’t hold onto this money.  Banks only keep a small percentage of the money you deposit on hand in their reserves, lending the majority of the money you (or the Fed for that matter) deposit to others who lend it to still others and so on, in the process substantially increasing the money supply.  This is known as fractional reserve banking.  If everyone in America or even a decent percentage of Americans tried to take their money out of the bank on a given day, millions would be unable to access their cash.  Effectively, even with FDIC Insurance, all of the banks are insolvent as they do not hold anywhere near 100% of the money you deposit in their vaults.  The hypothetical that the Fed could potentially print up money for the FDIC to distribute is beyond the scope of this post.

4. The government’s debt is merely an insidious tax like inflation.  Government debt can only be paid down by taxing the people.  This tax can occur through direct confiscation by government, or indirectly when holders of our government’s debt demand a higher rate of interest, which in turn signals to markets that our economy is not generating sufficient revenues to pay down the debt, which leads to a perception of economic weakness and thus an increased cost of borrowing for everyone in the economy.  If the government prints money to pay down debt (which in and of itself should cause our creditors to flood the markets with our debt and thus raise interest rates on everyone), this will represent a tax on the people as well.

5. Deflation, or a decrease in the money supply is the only antidote to inflation.  If the money supply is decreased, each dollar in your pocket becomes worth more.  The concomitant fall in prices will correct the artificial initial rise in prices from government printing of money.  In the process, since decreasing the money supply increases the cost of money, unsustainable enterprises with heavy debt loads will be put out of business, cleansing the economy by freeing up unproductive resources.  Where debtors benefit from an increase in the money supply because they can pay down their borrowings with cheaper dollars, creditors will benefit from a decrease in the money supply because they are paid back with more valuable dollars, which is one of the reasons why government prefers to inflate as it can lessen its own debt load and that of its constituents.  Deflation in prices while a symptom of deflation of the money supply is also the natural result of increases in productivity, as goods produced more cheaply in greater quantities (in the absence of money printing) will lead to falling prices which benefits consumers.  The so-called “paradox of thrift” that the MSM uses to vilify deflation in prices is wrongheaded, as people will spend on all sorts of products knowing that over time they will fall in price, as we have witnessed with numerous electronics over the years.  Even during a depression, when asset prices fall to certain levels there will necessarily be buyers, presumably those who saved prior to the downturn.  And if people are paying off their debt and/or saving in a time of falling prices in lieu of spending, this will be good for the economy because deleveraging corrects the excesses of the boom and increasing the pool of real savings lowers the interest rate and allows businesses and individuals to borrow funds for investment at a lower cost, legitimately stimulating the economy.

6. The last point mentioned above is imperative.  Growth in an economy occurs when real savings increase.  This is true whether in a booming market or a depression.  In fact, saving is the only way out of a depression.  Saving creates a pool of funds for banks to lend to businesses so they can expand their capital, increase expenditures on R&amp and generally take the entrepreneurial risks necessary for innovation and growth.  Americans have long consumed far more than we have produced, leaving us as massive net debtors to the rest of the world.  The only way to get out of debt and expand our economy is to save.  One cannot solve a problem of too much money and credit with more money and credit.  This however is what our government is trying to do by continuing to run the printing presses, trying to inflate our way out of debt.

7. Government cannot create wealth.  All it can do is take money from some people and redistribute it to others.  Every dollar the government uses must be taken from the private economy. Printing money to pay for things as we noted merely devalues your dollars, effectively taxing you.  Government financing through debt represents a claim on your wealth, a tax which as noted may be paid directly or indirectly.  Thus, while federal, state and local taxes may appear on a historical basis relatively low, the tax rate is deceptively masked by excluding government bilking through inflation and debt.  In addition, all government enterprises ultimately fail because government is not subject to the profit and loss mechanism of the market and thus does not respond to the demands of consumers, amongst other reasons.  In the process of failing, government wastes resources that could be better put to use by private individuals.  Government is a wealth killer, not a wealth creator.

8. The purchasing of all sorts of less than creditworthy assets from the big banks by the Federal Reserve allows the government to pump money into the financial system, and allows the banks to foist assets it doesn’t want onto the back of the taxpayer.  When we combine these asset purchases with the rest of the wasteful deficit spending on government jobs and reckless bailouts of the financial institutions and auto companies, our appraisal of the situation is as follows: while the little guy delevers, the government counteracts this necessary private balance sheet cleansing by levering up its own balance sheet at the expense of the taxpayer,  for the benefit of the financiers and the unions.

9. The real estate problem in our economy centers on the fact that people owe more money on their mortgages than they are able to pay down.  The only fix to this problem is for people to either generate more income to service their mortgages, or default.  Any intervention to keep people in homes they can’t afford will merely perpetuate market imbalances, propping up the value of real estate and preventing qualified buyers from purchasing homes at fair prices.  There will be no true recovery in the mortgage-backed securities  market until the forces of supply and demand sort out this mess (a mess which will be made worse as there are continued resets in mortgage rates over the coming years).  The same goes for any of the other assets whose values were bid up to unjustified levels because of easy money and credit.

10. Our economic crisis at the most basic level occurred because too much money and credit were pumped into the economy, given that again the interest rate was set artificially low not by supply and demand in the market but by government fiat.  The recession signals that we must fix the distortions and malinvestments resulting from the centrally planned interest rate. The healthy path to recovery is to allow prices to fall (aided by debt repayment), liquidate failed enterprises (reallocating of land, labor and capital to more productive and profitable lines of business) and encourage saving to increase the pool of loanable funds for economic expansion. Any actions to the contrary (i.e. more or less all government policies being implemented or bandied about) will merely prolong the pain.

Note that this is by no means a comprehensive study of the above subjects, but rather a cursory look at essentials that the American public must grasp before we can ever expect to return to prosperity.


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