resilience, not stability

Archive for the ‘Monetary Policy’ Category

The Influence of Special Interests and Rentiers on Monetary and Fiscal Policy

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Triggered by Robert Kuttner’s column in the American Prospect, the explanation du jour of our current economic malaise blames the ‘rentier class’ i.e. owners of financial assets – the thesis being that wealthy Americans do not want any more inflationary policies to be enacted and may even prefer deflation instead. Paul Krugman argues that wealthy Americans do not want inflation because financial securities are overwhelmingly held by the richest 10% of the population. But what matters for the incentives of rich households is what proportion of their balance sheet is made up of nominal financial securities. And Edward Wolff’s paper shows us that a significant proportion of the balance sheet of wealthy Americans is made up of real assets – real estate, stock and business holdings.

Similarly, a return to deflation will result in a fall in demand for products and services sold by businesses and a deterioration in bank balance sheets with increased and disruptive bankruptcies. As Brad DeLong noted, no one benefits from a deflationary collapse in the economy. A much better explanation is offered by Matthew Yglesias when he observes that “the Fed has hardly been indifferent to the potential for monetary expansion. It’s just that the goal of monetary expansion has been to do just enough to stabilize financial asset prices without going far enough to produce catch-up growth in the labor market.” What wealthy Americans, businesses and banks share is a common interest in supporting asset prices (real and nominal), a lack of interest in seeking full employment unless it is a prerequisite for supporting asset prices, and an aversion to any policies that can trigger wage inflation.

This bias towards asset price inflation doesn’t just impact the amount of stimulus. It has an influence on the type of stimulus that is preferred in this class conflict. The goal of asset price inflation without wage inflation is best achieved by an exclusive reliance on monetary policy – as I discussed in a previous post, a combination of “liquidity” facilities to prevent a collapse in shadow money supply and open market operations/QE to reduce real rates across the risk-free curve. Given the anaemic state of household balance sheets and insensitivity of corporate investment to interest rates due to a cronyist corporate sector, lower rates will not trigger sufficient real economic activity to trigger wage inflation but they will support real asset prices. Even within the ambit of fiscal policy, supply-side incentives for businesses are preferred. Given a less than competitive corporate sector, these will feed through to business profits more than they will feed through to wage inflation and employment.

Some of you may have noticed the distinctly Marxist tone of this debate – an emphasis on class conflict that rarely permeates economic discussion in mainstream circles. This is not a coincidence – as I observed in an earlier post, the dynamics of a crony capitalist economy resemble a zero-sum Marxian class struggle. Rather than expanding the size of the economic pie, economic agents focus their energies on trying to capture a larger slice of a static, stagnant output.

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Written by Ashwin Parameswaran

June 13th, 2011 at 4:58 am

Forest Fire Suppression and Macroeconomic Stabilisation

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In an earlier post, I compared Minsky’s Financial Instability Hypothesis with Buzz Holling’s work on ecological resilience and briefly touched upon the consequences of wildfire suppression as an example of the resilience-stability tradeoff. This post expands upon the lessons we can learn from the history of fire suppression and its impact on the forest ecosystem in the United States and draws some parallels between the theory and history of forest fire management and macroeconomic management.

Origins of Stabilisation as the Primary Policy Objective and Initial Ease of Implementation

The impetus for both fire suppression and macroeconomic stabilisation came from a crisis. In economics, this crisis was the Great Depression which highlighted the need for stabilising fiscal and monetary policy during a crisis. Out of all the initiatives, the most crucial from a systems viewpoint was the expansion of lender-of-last-resort operations and bank bailouts which tried to eliminate all disturbances at their source. In Minsky’s words: “The need for lender-of-Iast-resort operations will often occur before income falls steeply and before the well nigh automatic income and financial stabilizing effects of Big Government come into play.” (Stabilizing an Unstable Economy pg 46)

SImilarly, the battle for complete fire suppression was won after the Great Idaho Fires of 1910. “The Great Idaho Fires of August 1910 were a defining event for fire policy and management, indeed for the policy and management of all natural resources in the United States. Often called the Big Blowup, the complex of fires consumed 3 million acres of valuable timber in northern Idaho and western Montana…..The battle cry of foresters and philosophers that year was simple and compelling: fires are evil, and they must be banished from the earth. The federal Weeks Act, which had been stalled in Congress for years, passed in February 1911. This law drastically expanded the Forest Service and established cooperative federal-state programs in fire control. It marked the beginning of federal fire-suppression efforts and effectively brought an end to light burning practices across most of the country. The prompt suppression of wildland fires by government agencies became a national paradigm and a national policy” (Sara Jensen and Guy McPherson). In 1935, the Forest Service implemented the ‘10 AM policy’, a goal to extinguish every new fire by 10 AM the day after it was reported.

In both cases, the trauma of a catastrophic disaster triggered a new policy that would try to stamp out all disturbances at the source, no matter how small. This policy also had the benefit of initially being easy to implement and cheap. In the case of wildfires, “the 10 am policy, which guided Forest Service wildfire suppression until the mid 1970s, made sense in the short term, as wildfires are much easier and cheaper to suppress when they are small. Consider that, on average, 98.9% of wildfires on public land in the US are suppressed before they exceed 120 ha, but fires larger than that account for 97.5% of all suppression costs” (Donovan and Brown). As Minsky notes, macroeconomic stability was helped significantly by the deleveraged nature of the American economy from the end of WW2 till the 1960s. Even in interventions by the Federal Reserve in the late 60s and 70s, the amount of resources needed to shore up the system was limited.

Consequences of Stabilisation

Wildfire suppression in forests that are otherwise adapted to regular, low-intensity fires (e.g. understory fire regimes) causes the forest to become more fragile and susceptible to a catastrophic fire. As Holling and Meffe note, “fire suppression in systems that would frequently experience low-intensity fires results in the systems becoming severely affected by the huge fires that finally erupt; that is, the systems are not resilient to the major fires that occur with large fuel loads and may fundamentally change state after the fire”. This increased fragility arises from a few distinct patterns and mechanisms:

Increased Fuel Load: Just like channelisation of a river results in increased silt load within the river banks, the absence of fires leads to a fuel buildup thus making the eventual fire that much more severe. In Minskyian terms, this is analogous to the buildup of leverage and ‘Ponzi finance’ within the economic system.

Change in Species Composition: Species compositions inevitably shift towards less fire resistant trees when fires are suppressed (Allen et al 2002). In an economic system, it is not simply that ‘Ponzi finance’ players thrive but that more prudently financed actors get outcompeted in the cycle. This has critical implications for the ability of the system to recover after the fire. This is an important problem in the financial sector where as Richard Fisher observed, “more prudent and better-managed banks have been denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business”.

Reduction in Diversity: As I mentioned here, “In an environment free of disturbances, diversity of competing strategies must reduce dramatically as the optimal strategy will outcompete all others. In fact, disturbances are a key reason why competitive exclusion is rarely observed in ecosystems”. Contrary to popular opinion, the post-disturbance environment is incredibly productive and diverse. Even after a fire as severe as the Yellowstone fires of 1988, the regeneration of the system was swift and effective as the ecosystem was historically adapted to such severe fires.

Increased Connectivity: This is the least appreciated impact of eliminating all disturbances in a complex adaptive system. Disturbances perform a critical role by breaking connections within a network. Frequent forest fires result in a “patchy” modularised forest where no one fire can cause catastrophic damage. As Thomas Bonnicksen notes: “Fire seldom spread over vast areas in historic forests because meadows, and patches of young trees and open patches of old trees were difficult to burn and forced fires to drop to the ground…..Unlike the popular idealized image of historic forests, which depicts old trees spread like a blanket over the landscape, a real historic forest was patchy. It looked more like a quilt than a blanket. It was a mosaic of patches. Each patch consisted of a group of trees of about the same age, some young patches, some old patches, or meadows depending on how many years passed since fire created a new opening where they could grow. The variety of patches in historic forests helped to contain hot fires. Most patches of young trees, and old trees with little underneath did not burn well and served as firebreaks. Still, chance led to fires skipping some patches. So, fuel built up and the next fire burned a few of them while doing little harm to the rest of the forest”. Suppressing forest fires converts the forest into one connected whole, at risk of complete destruction from the eventual fire that cannot be suppressed.

In the absence of disturbances, connectivity builds up within the network, both within and between scales. Increased within-scale connectivity increases the severity but between-scale connectivity increases the probability of a disturbance at a lower level propagating up to higher levels and causing systemic collapse. Fire suppression in forests adapted to frequent undergrowth fires can cause an accumulation of ladder fuels which connect the undergrowth to the crown of the forest. The eventual undergrowth ignition then risks a crown fire by a process known as “torching”. Unlike understory fires, crown fires can spread across firebreaks such as rivers by a process known as “spotting” where the wind carries burning embers through the air – the fire can spread in this manner even without direct connectivity. Such fires can easily cause systemic collapse and a state from which natural forces cannot regenerate the forest. In this manner, stabilisation can cause changes which cause a fundamental change in the nature of the system rather than simply an increased severity of disturbances. For example, “extensive stand-replacing fires are in many cases resulting in “type conversions” from ponderosa pine forest to other physiognomic types (for example, grassland or shrubland) that may be persistent for centuries or perhaps even millennia” (Allen 2007).

Long-Run Increase in Cost of Stabilisation and Area Burned: The initial low cost of suppression is short-lived and the cumulative effect of the fragilisation of the system has led to rapidly increasing costs of wildfire suppression and levels of area burned in the last three decades (Donovan and Brown 2007).

Dilemmas in the Management of a Stabilised System

In my post on river flood management, I claimed that managing a stabilised and fragile system is “akin to choosing between the frying pan and the fire”. This has been the case in many forests around the United States for the last few decades and is the condition into which the economies of the developed world are heading into. Once the forest ecosystem has become fragile, the resultant large fire exacerbates the problem thus triggering a vicious cycle. As Thomas Bonnicksen observed, “monster fires create even bigger monsters. Huge blocks of seedlings that grow on burned areas become older and thicker at the same time. When it burns again, fire spreads farther and creates an even bigger block of fuel for the next fire. This cycle of monster fires has begun”. The system enters an “unending cycle of monster fires and blackened landscapes”.

Minsky of course understood this end-state very well: “The success of a high-private-investment strategy depends upon the continued growth of relative needs to validate private investment. It also requires that policy be directed to maintain and increase the quasi-rents earned by capital – i.e.,rentier and entrepreneurial income. But such high and increasing quasi-rents are particularly conducive to speculation, especially as these profits are presumably guaranteed by policy. The result is experimentation with liability structures that not only hypothecate increasing proportions of cash receipts but that also depend upon continuous refinancing of asset positions. A high-investment, high-profit strategy for full employment – even with the underpinning of an active fiscal policy and an aware Federal Reserve system – leads to an increasingly unstable financial system, and an increasingly unstable economic performance. Within a short span of time, the policy problem cycles among preventing a deep depression, getting a stagnant economy moving again, reining in an inflation, and offsetting a credit squeeze or crunch….As high investment and high profits depend upon and induce speculation with respect to liability structures, the expansions become increasingly difficult to control; the choice seems to become whether to accomodate to an increasing inflation or to induce a debt-deflation process that can lead to a serious depression”. (John Maynard Keynes pg163–164)

The evolution of the system means that turning back the clock to a previous era of stability is not an option. As Minsky observed in the context of our financial system, “the apparent stability and robustness of the financial system of the 1950s and early 1960s can now be viewed as an accident of history, which was due to the financial residue of World War 2 following fast upon a great depression”. Re-regulation is not enough because it cannot undo the damage done by decades of financial “innovation” in a manner that does not risk systemic collapse.

At the same time, simply allowing an excessively stabilised system to burn itself out is a recipe for disaster. For example, on the role that controlled burns could play in restoring America’s forests to a resilient state, Thomas Bonnicksen observed: “Prescribed fire would come closer than any tool toward mimicking the effects of the historic Indian and lightning fires that shaped most of America’s native forests. However, there are good reasons why it is declining in use rather than expanding. Most importantly, the fuel problem is so severe that we can no longer depend on prescribed fire to repair the damage caused by over a century of fire exclusion. Prescribed fire is ineffective and unsafe in such forests. It is ineffective because any fire that is hot enough to kill trees over three inches in diameter, which is too small to eliminate most fire hazards, has a high probability of becoming uncontrollable”. The same logic applies to a fragile economic system.

Update: corrected date of Idaho fires from 2010 to 1910 in para 3 thanks to Dean.

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Written by Ashwin Parameswaran

June 8th, 2011 at 11:35 am

Negative Real Interest Rates and the Risk Premium

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In my post on monetary policy and real rates, I made a provocative assertion: “in the absence of a truly risk-free asset that preserves purchasing power, the very idea of a “risk premium” is meaningless. In the language of Kahneman and Tversky, it is the category boundary between certainty and uncertainty that matters most to an investor.” The idea that monetary policy has an impact on asset prices is not controversial. In a speech in 2003, Ben Bernanke concluded that easy money policies increase asset prices primarily via a reduction in risk premiums: “The most powerful effect of an unanticipated monetary tightening is to increase the perceived risk premium on stocks, either by increasing the riskiness of stocks, by reducing people’s willingness to bear risk, or both. Reduced willingness of investors to hold relatively more risky stocks drives down stock prices.” In the same speech, Bernanke concludes that the changes in the expected evolution of real rates from changes in the Fed Funds rate are minimal. This conclusion does not hold for programs such as QE2 which directly drive down the level of the real rate curve.

My conjecture is simply the following: As the real rate curve turns negative, there is a non-linear transition in the risk premium for all “risky” assets towards a level close to zero (see below for an idealised chart). Risk premiums may never be exactly zero –  even under the most dovish monetary regime, the market expects real rates to turn positive at some time in the future. But the effective risk premium in a market that expects negative real rates for above 5 years may not be very far above zero. A great example of such a regime is a developing market like India which has experienced long and frequent periods of negative real rates (see below for current real rates across emerging markets). A consequence of such a pronounced negative real rates regime is that almost no one in India regards short-term bank deposits as a “risk free” asset. Of course this means that a move back from negative real rates territory towards positive real rates will likely have violent negative consequences for risky asset prices – a fate that Indian equity prices (see below) may be experiencing right now in the wake of the Reserve bank of India’s unexpected acceleration of the tightening cycle.


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Written by Ashwin Parameswaran

May 12th, 2011 at 6:37 am

Posted in Monetary Policy

Monetary Policy and Financial Markets: A “Real Rates” Lens

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In recent years, central banks on both sides of the Atlantic have implemented a raft of monetary policy initiatives that many people view as having no precedent in history. This opinion is understandable when compared to recent history – During the Great Moderation, monetary policy was largely restricted to adjustments in short-term nominal rates. But when viewed in the context of the longer history of fiat currency monetary policy, almost every policy implemented by central banks during this crisis has a historical precedent. In this post, I analyse fiat currency monetary policy (conventional or unconventional) as an attempt to influence the real interest rate curve under the constraint of inflation and employment/GDP targets – this is not intended to be a comprehensive theory, simply a lens that I find useful in analysing the impact of monetary policy.

The primary dilemma faced by governments today is the tension between the need to rein in government indebtedness in the long run and stimulate economic growth in the short run. The task of stimulating growth is complicated by the high levels of consumer indebtedness. There are no easy solutions to this problem – reducing government indebtedness itself is critically dependent upon maintaining economic growth i.e. ensuring that the GDP in the debt/GDP ratio grows at a healthy rate. In the fiat currency era (post 1945), one solution has usually been preferred to all others – the enforcement of prolonged periods of low or even negative real interest rates. In an excellent paper, Carmen Reinhart and Belen Sbrancia have analysed the role of “financial repression” in engineering negative real interest rates and reducing real government debt burdens between 1945 and 1980. Given the similarity of our current problems to the post-WW2 situation, it is no coincidence that a reduction in real rates has been a key component of central banks’ response to the crisis.

As Paul Krugman notes, the textbook monetary policy response to a liquidity trap requires that central banks “credibly promise to be irresponsible…to commit to creating or allowing higher inflation…so as to get negative real interest rates”. In the context of the current crisis, the central bank response has involved two distinct phases. In the first phase of the crisis, the priority is to prevent a deflationary collapse. Short of untested schemes that try to enforce negative nominal rates, deflation is inconsistent with a reduced real interest rate. In trying to mitigate the collapse, short rates were rapidly reduced to near-zero levels but equally critically, a panoply of “liquidity” programs were introduced to refinance bank balance sheets and prevent a collapse in shadow money supply. It is fair to critique the expansion of the Fed balance sheet for the backdoor bailout and resulting incentive problems it engenders in the financial sector. But in purely monetary terms, the exercise simply brings hitherto privately funded assets into the publicly funded domain.

Even after the deflationary collapse had been averted, simply holding short rates at zero and even a promise to hold rates at near-zero levels may be insufficient to reduce real rates sufficiently at the long end of the treasury curve. The market may simply not believe that the central bank is being credible when it promises to be “irresponsible”. Therefore the focus shifts to reducing the interest rates on longer-dated government bonds or even chosen risky assets via direct market purchases – MBS in the case of QE1 but there is no reason why even corporate bonds and equities could not be used for this purpose. If a fiat-currency issuing central bank does not care about inflation, it can enforce any chosen nominal rate at any maturity on the risk-free yield curve. Of course, in reality, central banks do care about inflation and therefore, instead of phrasing QE as a binding yield target, central banks limit themselves by the quantity of long-term bonds bought. As Perry Mehrling notes, QE2 is most similar to war finance and differs only in the choice of a quantity rather than a yield target. During WW2 the Fed essentially fixed the price of the entire government bond yield curve. Perry Mehrling describes it well in his excellent book“Throughout the war, the interest rate on Treasury debt was fixed at 3/8 percent for three-month bills and between 2 and 2½ percent for long-term bonds, and it was the job of the Fed to support these prices by offering two-way convertibility into cash…it was not until the Fed-Treasury Accord of March 1951 that the Fed was released from its wartime responsibility to peg the price of government debt.” The Fed-Treasury accord in 1951 that signalled the end of this phase was a consequence of an outbreak of inflation brought upon by the Korean War.

Arbitrage and Negative Real Rates

The textbook arbitrage response to ex-ante negative real rates is to buy and store the goods comprising one’s future consumption basket. In the real world, this is often not a realistic option and negative real rates can prevail for significant periods of time. This is especially true if inflation only exceeds risk-free rates by small amounts. Maintaining risk-free rates at low levels while running double-digit inflation levels risks demonetisation and hyperinflation but a prolonged period of small negative real rates may achieve the dual objective of growth and reduced indebtedness without at any point running a significant risk of demonetisation. So long as the central bank’s “pocket picking” is not too aggressive, the risk of demonetisation is slim.

As Reinhart and Sbrancia note, the option of enforcing negative real rates was available in the post-1945 environment only because “debts were predominantly domestic and denominated in domestic currencies.” Therefore although the US and Britain may try to follow the same policy again, it is clear that this option is not available to the peripheral economies in the Eurozone. Reinhart and Sbrancia argue that “inflation is most effective in liquidating government debts (or debts in general), when interest rates are not able to respond to the rise in inflation and in inflation expectations. This disconnect between nominal interest rates and inflation can occur if: (i) the setting is one where interest rates are either administered or predetermined (via financial repression, as described); (ii) all government debts are fixed- rate and long maturities and the government has no new financing needs (even if there is no financial repression the long maturities avoid rising interest costs that would otherwise prevail if short maturity debts needed to be rolled over); and (iii) all (or nearly all) debt is liquidated in one “surprise” inflation spike.” Condition (ii) is not satisfied in either the US or Europe whereas attempting to liquidate debt with one surprise inflation spike risks losing the credibility that central banks have fought so hard to acquire. Which leaves only option (i).

But even if investors cannot store their future consumption basket, could they simply not move into commodities or currencies with higher real rates of return? As James Hamilton notes, “there’s an incentive to buy and hold those goods that are storable…..episodes of negative real interest rates have usually been associated with rapidly rising commodity prices.” But the investment implications of negative real rates regimes are not quite so straightforward.

Implications for Financial Markets and Investment Strategies

In Reinhart and Sbrancia’s words, “inflation is most effective in liquidating government debts when interest rates are not able to respond to the rise in inflation and in inflation expectations.” If interest rates track the rise in inflation and real rates are positive, then a risk-averse investor simply needs to be invested in short-duration bonds (e.g. floating rate bonds) to preserve his purchasing power. In countries such as Australia, floating-rate bonds and short-duration bonds may preserve purchasing power in the same manner that inflation linkers can. But this does not hold for a countries such as the United States or the United Kingdom where real rates at the short-end are negative. Ex-ante negative real interest rates ensure that there is no “risk-free” asset in the market that can preserve one’s purchasing power. As Bill Gross notes: “bond prices don’t necessarily have to go down for savers to get skunked during a process of debt liquidation.” The logical response is to move to real assets or, as Bill Gross suggests, “developing/emerging market debt at higher yields denominated in non-dollar currencies” with a positive real interest rate. But as always, there are no free lunches.

Let’s assume that the market expects no “real rate suppression” to start with and the Fed surprises the market with an announcement that it intends to suppress the rate to the extent of 20% over the next decade. Assuming that Australian and Brazilian monetary and fiscal policy expectation remains unchanged by this announcement, the market should immediately revalue the Australian Dollar (AUD) and the Brazilian Real (BRL) upwards by 20%, a revaluation that it will give back over the next decade. Anyone who invests in either currency afterwards will not earn a superior return to what is available to him in USD. This idealised example makes many assumptions e.g. currency parity, ignores risk premiums and abstracts away from uncertainty. But the point that I am trying to make is simply this: Once real rate suppression has commenced, all asset prices will necessarily adjust to reflect the expected amount of suppression. Even a cursory look at the extent of recent appreciation in AUD or BRL tells us that much of this adjustment may have already taken place. In other words, there is no free lunch in moving away from USD to any other asset – an investment in real assets or foreign currency bonds only makes sense if one believes that the actual extent of suppression will exceed the current estimate.

Risk premiums will not change the above analysis in any meaningful manner. The idea that one can earn higher returns simply by turning up a “risk” dial is tenuous at the best of times but in the absence of a truly risk-free asset that preserves purchasing power, the very idea of a “risk premium” is meaningless. In the language of Kahneman and Tversky, it is the category boundary between certainty and uncertainty that matters most to an investor.

But the key difference between the above idealised example and the real world is the uncertainty about the extent and the pace of real rate suppression that a central bank will follow through with. The critical source of this uncertainty is the inflation and employment target that guides the central bank. The central bank may change its plans midway for a variety of reasons – a spike in inflation may put pressure on it to hike rates even if growth remains sluggish, a revival in real GDP growth may also allow it to unwind the program early. Even worse, inflation may slip below target despite the CB’s best efforts to stimulate investment and consumption demand i.e. the Japan scenario.

The expectation and distribution of real rate suppression influences the valuation of every asset price and the changes in this expectation and distribution become a significant source of market volatility across asset classes. What is also clear that for many real assets and foreign currency bonds, the present scenario where the economy muddles through without falling into either the Japan scenario or managing a strong recovery is the “best of all worlds”. To put it in the language of derivatives, if we define the amount of “real rate suppression” as the risk variable, then many real assets represent a “short volatility” trade. Obviously, this does not take into account the sensitivity of some of these assets to the economic conditions but this does not make it irrelevant even for assets such as US equities. The expected valuation uplift in equities from a strong economy may easily be at least partially negated by the reduced expectation of real rate suppression. This also illustrates how a jobless recovery that doesn’t turn into the Japan scenario is the ideal environment for equities. So long as monetary policy is guided by the level of employment, GDP growth without a pickup in employment maximises the expectation of rate suppression and by extension, the valuation of equity markets.

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Written by Ashwin Parameswaran

May 10th, 2011 at 6:28 am