(Continued from Part I)


Central Banks as Lender of the Last Resort (LOLR)

What has been the guiding principle of central banks in dealing with crises? The author explains central banks’ roles defined throughout history, the birth of the concept of LOLR(Lender of the Last Resort) that became the ultimate name of central banks and how it has become synonymous with bail-outs along with banks’ moral hazard.

Due to failure of controlling inflation during the Great Inflation in 1970s after the world broke up with the Gold Standard, the ‘price stability’ has been mandated as the most important mission in the name of ‘inflation targeting’ along with central banks’ independence. Federal Reserves in the US has been assigned with ‘the dual mandate’ of controlling the price stability and the financial stability in the form of output and employment. Through history, central banks were seen as ‘heroes’ for delivering the decade of the Great Stability and for preventing a relapse into a second Great Depression after 2008. They were also seen as ‘villains’ for having failed to rein in the excesses of the banking system and then for creating money on a massive scale. Taking charge of money supply at their core, central banks had the right to create liquidity in the form of printing money or to use interest rates to effect on money supply through history.

When have we started to use the term LOLR? The author quotes Walter Bagehot, the famous editor of the Economist, who wrote the classic study of central banking, Lombard Street, where he set out the doctrine of the LOLR – lend freely against good collateral at a penalty rate to banks facing a run. The author states that the book became the bible for central bankers wondering how to respond to financial crises including Ben Bernanke at the Federal Reserve. According to Bagehot, it’s the proposition that liquidity support is not designed to save an individual bank but is carried out in the collective interest of the system as a whole. In doing that, the central bank may need to take strong and unpopular action – the creation of ’emergency money’.

The author claims that today this phrase is widely misused to any action that deals with a financial crisis with a massive injection of liquidity so much so that the expressions ‘lender of last resort’ and ‘bailout’ have become synonymous. He points out that the provision of insurance without a proper charge is an incentive for banks to take excessive risks creating moral hazards. This is the reason why banks came to rely on central banks to bail them out in difficulty. He describes why the good principle has changed into bail-out as below.

The expressions ‘lender of last resort’ and ‘bailout’ have become synonymous. … Bagehot’s argument was very different. In essence, the problem was that the banking system was an intermediary financing illiquid assets by promising instant liquidity to depositors. For the economy as a whole, the promise cannot be met. When enough depositors want their money back, the banking system cannot provide it. If this additional demand for liquidity is temporary, then the provision of emergency money by the central bank can tide the system over until the panic subsides. But if the assets have genuinely lost value, then the central bank must be careful not to subsidise insolvent undertakings. The problem is that in a world of radical uncertainty it is never clear whether a bank is solvent or insolvent, and in a crisis there is rarely time to find out. Actions by a LOLR can prevent a liquidity problem turning into a solvency problem, although not all solvency problems can be converted into liquidity problems by LOLR lending, as governments have painfully discovered in recent times. – Monetary Policy in Bad Times: Emergency Money, Chapter 5. Heroes and Villains: The Role of Central Banks, p191

What needs to be done? The author suggests to convert the crisis function of LOLR into a new regime that serves in both good and bad times.

Aware of the importance of ‘lending freely’ in a crisis, and the problems caused by the need to lend against good collateral and at a penalty rate, central banks and governments have relaxed the conditions of a traditional Bagehotian lender of last resort and turned to bailouts. This creates risks to taxpayers and incentives for banks to expand the alchemy of the system. The solution is to convert the crisis function of the lender of last resort into a regime that determines the amount a bank can borrow in both good times and bad, and ensures that a bank will have posted sufficient collateral in good times that it will have access to liquidity in bad times adequate to meet the demands of short-term creditors. – Monetary Policy in Bad Times: Emergency Money, Chapter 5. Heroes and Villains: The Role of Central Banks, p207

Central Banks as Pawnbroker For All Seasons (PFAS)

So what does central banks’ strategy have to be in order to cope with radical uncertainty? And how does the new scheme work? The idea that banks have to stop creating money and must provide one hundred per cent equity has been there since early twentieth century under Chicago Plan. The author develops his idea from Chicago Plan and the concept of collateralised loans that can survive the liquidity crisis. He suggests central banks become a new model – the pawnbroker for all seasons(PFAS) – where they provide urgent liquidity to banks against their assets. In this way, central banks serve their purpose as lender of the last resort against good collaterals as originally intended by Walter Bagehot, without causing bank runs. No more free bailouts. The author explains why PFAS is the solution and elaborates on the scheme’s three underlying principles as below.

It is time to replace the lender of last resort by the pawnbroker for all seasons(PFAS). A pawnbroker is someone who is prepared to lend to almost anyone who pledges collateral sufficient to cover the value of a loan – someone who is desperate for cash today might borrow $25 against a gold watch. Since 2008, central banks have become used to lending against a much wider range of collateral than hitherto, and it is difficult to imagine that they will be able to supply liquidity insurance without continuing to do so. In the spirit of not letting a good crisis go to waste, I think it is possible to build on two of the most important developments in central banking since the crisis – the expansion of lending against wider collateral and the creation of money by quantitative easing – to construct a new role for a central bank as such a pawnbroker. I stress this point because so many proposal for reform create alarm among bankers, and often therefore governments, since they are a step into the unknown. In contrast, the idea of PFAS is a natural extension of measures already introduced. When there is a sudden jump in the demand for liquidity, the pawnbroker for all seasons will supply liquidity, or emergency money, against illiquid and risky assets. Only a central bank on behalf of the government can do this. But it will do so within a framework that eliminates the incentive for bank runs. The idea of the PFAS is a coping strategy in the face of radical uncertainty. – A New Approach: The Pawnbroker For All Seasons(PFAS), Chapter 7. Innocence Regained: Reforming Money and Banking, p270

The aim of the PFAS is threefold. First, to ensure that all deposits are backed by either actual cash or a guaranteed contingent claim on reserves at the central bank. Second, to ensure that the provision of liquidity insurance is mandatory and paid for upfront. Third, to design a system which in effect imposes a tax on the degree of alchemy in our financial system – private financial intermediaries should bear the social costs of alchemy. – A New Approach: The Pawnbroker For All Seasons(PFAS), Chapter 7. Innocence Regained: Reforming Money and Banking, p270

What’s the justification? Is this realistic? The author strongly claims that banks are part of a market economy, so the social costs they impose on society in a crisis has to be borne by them. He stresses that the PFAS rule is not a pipe dream and some central banks have already moved in that direction including Bank of England.

The debate about whether banks are ‘too important to fail’ boils down to a simple question. Are banks an extension of the state, as they are in centrally planned economies, or are they part of a market economy? If the latter, then to correct for the social costs they impose on society in a crisis, banks should be made to take out compulsory insurance through the PFAS and have sufficient ‘loss-absorbing capacity’, on the liability side of their balance sheets, to reduce the implicit taxpayer guarantee to bank creditors. Only equity finance guarantees that capacity. The introduction of a PFAS would aid the gradual evolution of expectations towards the view that banks will not be bailed out. It is a question of creating a banking and financial system in which governments feel little incentive to step in and bail out failing firms. – A New Approach: The Pawnbroker For All Seasons(PFAS), Chapter 7. Innocence Regained: Reforming Money and Banking, p280


Limitations in Modern Macroeconomics on Booms and Depressions

As I’ve mentioned, the author’s stance toward modern macroeconomics frame -both Keynesian and Neoclassical – is they fail to provide sufficient explanations on booms and depressions. He states it’s because they are about economics of ‘stuff’ rather than economics of ‘stuff happens’ and a new macroeconomic frame has to be studied and developed in this regard.

Modern neoclassical economic models on crisis confines it in mathematical certainty and people base their behaviour on rational optimisation. The author disapproves this view in three points. First, people are neither mathematical nor optimised under radical uncertainty. They cope and correct their behaviour based on life-time budget constraints in radical uncertainty. Second, the fuzziness they experience on life-time budget constraints creates disequilibrium between spending and saving. Third, people are rational in radical uncertainty under the stability heuristic. In radical uncertainty, they change their spending based on the changed narratives.

The crisis raised deep questions about the foundations of the economic models used by central banks around the world. Those models ignore radical uncertainty and assume that everyone has rational expectations. In so doing, they assume away the coordination problems that are the consequence of radical uncertainty. Yet, the concept of ‘rational’ expectations has no clear meaning in a world of radical uncertainty. Many economists will be reluctant to abandon the assumption of rational expectations because to do so appears to undermine the subject as a science and opens the door to a line of reasoning where expectations have a life of their own – the indiscipline of behavioural economics. I am sympathetic to those concerns. Great damage was done in the past by drawing policy conclusions from economic models with arbitrary assumptions about expectations.But ideas that by their nature cannot be expressed in a formal mathematical model should not be dismissed out of hand. I do not suggest that we abandon the assumption that people try to behave in a rational manner. But as explained in Chapter 4, the question facing households and businesses is what it means to be rational in the face of radical uncertainty. I suggested that saving and investment decisions might be better understood by referring to them as the result of ‘coping’ than ‘optimising’ behaviour. – A Different Story: Fuzzy Budget Constraints, Narratives and Disequilibrium, Chapter 8. Healing and Hubris: The World Economy Today, p310

The Keynesian models also have limitations since they confine the crisis as loss of confidence and rise of fear. This perspective convinced governments and central banks to respond by injecting liquidity to revive the lost confidence first of all. The author argues this policy response is not successful because the cause of the crisis is rather related with narrative revision coming from the life-time budget constraints. Also, this is why the policy response fails to deliver current weak demand to pre-crisis level. Hence, the need for a change in current policy response based on a new macroeconomic frame.

The Keynesian story of a recession is one in which the inability to coordinate future spending plans means that a loss of confidence in the willingness of others to spend leads businesses to cut back on investment and production, resulting in a cumulative contraction in total demand – ‘the only thing we have to fear is fear itself’, in the words of President Franklin Roosevelt in 1933. When we view the problem facing households and businesses in the light of coping strategies, we can see that there is an alternative reason for episodes of weak aggregate demand. There can be lengthy periods during which the information used to construct estimates of lifetime income(here, the stability of the path of total spending) is providing no signal to households that their own current spending is unsustainable. At some point a new signal arrives that leads all households to make corrections in their spending. When the narrative for lifetime income changes, then a major adjustment to spending plans occurs. That new level of demand is not a temporary deficiency of aggregate demand in a Keynesian sense, but a rational response to the realisation that past spending was based on a misperception of lifetime income. … Both explanations of a downturn derive from radical uncertainty, and they are by no means incompatible. But the crucial difference between the two stories lies in the appropriate policy response to weak demand. In a Keynesian downturn, policies to boost aggregate demand in the short term, by monetary or fiscal stimulus, can help to dispel fear and restore both confidence and spending to their previous paths. In a narrative revision downturn, however, it is a mistake to try to return to the earlier path of spending. Policies to boost demand in the short term may appear to help but do not alter the need for a correction of the disequilibrium. – A Different Story: Fuzzy Budget Constraints, Narratives and Disequilibrium, Chapter 8. Healing and Hubris: The World Economy Today, p316

Financial crises are often seen as the materialisation of a low probability event that was simply not expected. People were caught by surprise. But as Chapter 1 showed, financial crises are fairly frequent. So it seems odd to see them as the consequence of very infrequent events. Another explanation is that people underestimates the likely frequency of extreme outcomes which, in fact, are drawn from probability distributions with ‘fat tails’, that is, the likelihood of extreme outcomes is much greater than normally assumed. As Alan Greenspan remarked, ‘the tails must not be merely fat but morbidly obese to explain what has happened over the years’. The problem with all such interpretations is that they see crises as the result of a throw of the dice by the economic gods, randomness that fools mere mortals. What is missing is the possibility that the evolution of the economy itself creates a build-up of misperceptions and mistakes. Sharp swings in sentiment are not irrational, the product of random changes in ‘animal spirits’ independent of economic circumstances, but the result of rational attempts to cope with radical uncertainty. And when judgements about lifetime incomes are revised, as reality eventually dawns, they produce the sudden and large changes in asset values associated with a crisis. – A Different Story: Fuzzy Budget Constraints, Narratives and Disequilibrium, Chapter 8. Healing and Hubris: The World Economy Today, p317

2008 Crisis Revisited: Proper Policy Response to Tackle Recessions Today

Why do we revisit the past crisis? The author tries to find the missing link that can provide a clue for current weak growth coming from low demand. By diagnosing the real cause, he tries to find what the right policy response has to be.

The author argues that not all crises or recessions have a similar cause requiring similar remedies. Out of four types of recessions, he considers the past crisis as a narrative revision downturn that requires a different policy response.

The key lesson from the experience of 1920-1 is that it is a mistake to think of all recessions as having similar causes and requiring similar remedies. Sharp swings in inventory prices and stocks may be self-correcting. A Keynesian downturn resulting from a lack of confidence can be overcome by policies that restore confidence in the future path of total spending. A recession created by central banks trying to bring down inflation can be undone by restoring monetary policy to its normal setting once inflation expectations have been reduced to a desired level. And a narrative revision downturn can be resolved only by moving the economy to a new equilibrium in which spending comes into line with realistic perceptions of lifetime budget constraints. The appropriate policy response, therefore, depends upon the nature of the downturn. Sometimes a recession reflects more than one cause. In 2008, the shock to confidence following the banking collapse led to a Keynesian downturn around the world on top of which was superimposed the adjustment to businesses and households’ earlier ‘mistake’ in assessing the sustainable level of spending. As explained above, that complicated the required policy response and led to the paradox of policy. … No single model will capture all the relevant features of a crisis, and that is one of the dangers of the mindset instilled by the ‘economics of stuff’. – Causes and Consequences of The 2008 Crisis, Chapter 8. Healing and Hubris: The World Economy Today, p327-8

What especially needs to be addressed in reviewing the past crisis? The author makes a distinctive case regarding our understanding of aggregate demand. Only after understanding this can we move on with the right remedy.

The danger with the ‘economics of stuff’, whether Keynesian or neoclassical, is that it leads to the complacent view that a chronic deficiency in demand is always of a Keynesian type and is the sole explanation of slow growth in the world today. Once we recognise that demand is divided between consumption today and consumption tomorrow, and also between consumption of goods made exclusively at home and goods that can be traded overseas(either exports or imports), and that total spending can be either consumption or investment, then it is clear that ‘aggregate demand’ is an incomplete concept for understanding the current situation.The problem with limiting the diagnosis to a shortage of aggregate demand is that it has led economists to infer that the remedy is to boost current spending through whatever means is to hand – easier monetary policy, fiscal expansion or words of encouragement by governments that the worse is over.Causes and Consequences of The 2008 Crisis, Chapter 8. Healing and Hubris: The World Economy Today, p325

The author considers two aspects as the most important things to tackle current and prospective weak demand: The continuing disequilibrium between spending and saving between economies and within economies and the changed narratives due to the past crisis. The extraordinary monetary stimuli continued after the crisis was over in 2009 only resulted in bringing forward future consumption, leaving no room for future demand. Therefore, without bringing disequilibrium to a new level with a revised narrative, we cannot end stagnation.

In the wake of a powerful shock to confidence, monetary and fiscal stimulus in 2008 and 2009 was the right answer. But it exhibits diminishing returns. In recent years, extraordinary monetary stimulus has brought forward consumption from the future, digging a hole in future demand. With a prospect of weak demand in the future, the expected return on investment becomes depressed. Even with unprecedentedly low interest rates and the printing of money, it becomes harder and harder to stimulate domestic consumption and investment. What began as an imbalance between countries has overtime become a major internal disequilibrium between saving and spending within economies. Spending is weak today, not because of irrational caution on the part of households and businesses following the shock of the crisis, but because of a rational narrative that in countries like the US and UK, consumer spending was unsustainably high before the crisis and must now follow a path below the pre-crisis trend. In countries like China and Germany, exports were unsustainably high, and they too are now experiencing weak growth as demand in overseas markets slows. Neither individually nor collectively have those countries been able to move to a new equilibrium, and until they do, recovery will be held back. In circumstances characterised by a paradox of policy – in which short-term stimulus to spending takes us further away from the long-term equilibrium – Keynesian stimulus can boost demand in the short run, but its effects fade as the paradox of policy kicks in. Only a move to a new equilibrium consistent with the revised narrative will end stagnation. Low growth in the global economy reflects less a lack of ‘animal spirits’ and more the inability of the market, constrained by governments, to move to a new set of real interest rates and real exchange rates in order to find a new equilibrium. – The Audacity of Pessimism, Chapter 9. The Audacity of Pessimism: The Prisoner’s Dilemma and The Coming Crisis, p356-7


What has changed after the crisis was over in 2009? And what has not? It seems the crisis left only the scar in the form of stagnation we experience today without changing much of other aspects. The disequilibrium before the crisis continues today. The extraordinary low interest rates, that have fallen further since the crisis, continues to drive asset prices and debt levels higher. Central banks are trapped into a policy of low interest rates because of the continuing belief that the solution to weak demand is further monetary stimulus. Are we seeing seeds for another crisis? The answer seems yes, according to the author. Where do we see fragility? What do we need to do? The author calls for collective efforts for reform under ‘audacious pessimism’.

The narrative revision downturn triggered by the crisis, has left a hole in total spending. Central banks have, largely successfully, filled that hole by cutting interest rates and printing electronic money to encourage households and businesses to bring forward spending from the future. But because the underlying disequilibrium pattern of demand has not been corrected, it is rational to be pessimistic about the future demand. That is a significant deterrent to investment today, reinforced by uncertainty about the composition of future spending. Since traditional macroeconomic policies will not lead us to a new equilibrium, and there are no easy alternatives, policy-makers have little choice but to be audacious. What should they do to escape the trap of rational pessimism? In broad terms, the aim must be twofold – to boost expected incomes through a bold programme to raise future productivity, and to encourage relative prices, especially exchange rates, to move in a direction that will support a more sustainable pattern of demand and production. Those aims are easy to state and hard to achieve, but there is little alternative, other than waiting for a crash in asset values and the resulting defaults to reset the economy. With the audacity of pessimism, we can do better. – The Audacity of Pessimism, Chapter 9. The Audacity of Pessimism: The Prisoner’s Dilemma and The Coming Crisis, p359

How to systematically work to solve the world’s disequilibrium? The author claims that a prisoner’s dilemma is holding back the speed of recovery. If any of central banks were to raise interest rates, they would risk a slowing of growth and possibly another downturn. What should be a sensible coping strategy to deal with this problem? The author asserts that it is not artificially to coordinate policies that naturally belong to national governments, but to seek agreement on an orderly recovery and rebalancing of the global economy. The interests of all countries should be to find a common timetable for that rebalancing, with IMF as the natural broker for an agreement. He considers the use the price mechanism as the best chance of solving the prisoner’s dilemma, while retaining national sovereignty.

The way in which each country will choose to rebalance is a matter for itself, but it is in the interests of all countries to find a common timetable for that rebalancing. The natural broker for an agreement is the IMF. Our best chance of solving the prisoner’s dilemma, while retaining national sovereignty, is to use the price mechanism not suppress it. Arrangements to fix or limit movements of exchange rates tend to backfire as unexpected events require changes in rates to avoid economic suffering. At the heart of the problem is the question that so troubled the negotiators at Bretton Woods. How can one create symmetric obligations on countries with trade surpluses and trade deficits? The international monetary order set up after the Second World War failed to do so, and the result is that fixed exchange rates have proved deflationary. For a long time the conventional wisdom among central banks has been that if each country pursues a stable domestic monetary and fiscal policy then they will come close to achieving a cooperative outcome. There is certainly much truth in this view. But when the world becomes stuck in a disequilibrium, the prisoner’s dilemma bites. Cooperation then becomes essential. Placing obligations on surplus countries has not and will not work. There is no credible means of enforcing any such obligations. Enlightened self-interest to find a way back to the path of strong growth is the only hope. The aim should be four-fold: to reinvigorate the IMF and reinforce its legitimacy by reforms to its voting system, including an end to a veto by any one country; to put in place a permanent system of swap agreements among central banks, under which they can quickly lend to each other in whichever currencies are needed to meet short-term shortages of liquidity; to accept floating exchange rates; and to agree on a timetable for rebalancing of major economies, and a return to normal real interest rates, with IMF as the custodian of the process. The leadership of the IMF must raise its game. – Escaping The Prisoner’s Dilemma: Wider International Reforms, Chapter 9. The Audacity of Pessimism: The Prisoner’s Dilemma and The Coming Crisis, p352-3

The author makes three suggestions for a reform programme: to boost productivity, to promote trade, and to restore floating exchange rates.

A reform programme might comprise three elements. First, the development and gradual implementation of measures to boost productivity. Since the crisis, productivity growth has been barely noticeable, and well below pre-crisis rates. A major reason for this disappointing performance is that there has been a sharp fall in the growth rate, and perhaps even in the level, of the effective capital stock in the economy. Part of this reflects the fact that past investment was in some cases a mistake, directed to sectors in which there was little prospect of future growth, and is now much less productive than had been hoped. … Part reflects pessimism about future demand and uncertainty about its composition which has led to a fall in business investment spending around the world. … A higher ratio of labour to effective capital explains weaker productivity growth. Reforms to improve the efficiency of the economy, and so the rate of return on new investment, would stimulate investment and allow real interest rates to return to a level consistent with a new equilibrium. Over time, as investment rebuilt the effective capital stock, productivity growth would return to rates reflecting the underlying innovation in a dynamic capitalist economy. … Changing the narrative about expected future incomes is the only alternative to large and costly shifts in relative prices. … Today, however, the attraction of reform is that the anticipation of higher productivity will boost current spending, helping economies to emerge from the present relative stagnation. Second, the promotion of trade. Throughout the post-war period, the expansion of trade has been one of the most successful routes to faster productivity growth, allowing countries to specialise and exchange ideas about new products and processes. Third, the restoration of floating exchange rates. The experimentation with fixing exchange rates has not been successful and it is important that exchange rates are free to play their stabilising role in order to correct the current disequilibrium. The principle behind such a programme is to raise expected future incomes, not by recreating the false beliefs held before the crisis, but by boosting productivity. … Export-led growth is no longer a viable strategy for a large emerging market because Europe and North America cannot sustain the domestic demand required to import so much. – The Audacity of Pessimism, Chapter 9. The Audacity of Pessimism: The Prisoner’s Dilemma and The Coming Crisis, p359-362

(To be continued in Part III)


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