The circle of economic life or flaming wheels of commerce (Irving Fischer, Brad De Long)

The economist Irving Fischer (1867-1947) and internet-pioneer public intellectual economist Brad De Long (1960-) provide some wonderful intuitive toy examples to help visualize and better understand:

1. The circular flow of economic activity (See diagram above)
2. The nature of a credit economy (debt is natural, loans abound, financially sober and punctual good citizens with good credit ratings) 

Credit and the circular flow of economic life grinds to a halt and the economy fails to function properly under the extreme case of debt deflation and depression, also the name of Irving Fischer's 1933 paper describing the forces at work as the US slid into the Great Depression (Read paper).

The velocity of money falls precipitously but later, during the subsequent recovery, shoots up again. Fischer brings to life a world where velocity of money is falling. De Long brings to life the rising velocity of money of an economic revival. 

First, the quantity theory of money: which emphasizes the positive relationship of overall prices (P) to the quantity of money (M) most noticeable under hyperinflation when a government prints money (M) like a madman and the general price level (P) shoots through the roof. (See ten trillion dollar Zimbabwe banknote below currently in use and Bronte Capital's suggestion that Zimbabwean central bankers should be appoint to run the US central bank to make US monetary policy seem more reckless).



Here's the simple but powerful equation:

M.V = Q.P

M = money supply
V = velocity of money
Q = the quantity of output (real value of final expenditures)
P = the general price level in the economy

When the economy is humming along at a snappy pace the velocity of money is a constant.

With extreme levels of leverage and debt, one day you will inevitably hit a gigantic pothole in the cart path. 
 

...once extreme over-indebtedness occurs, fiscal and monetary policy become impotent in spurring economic growth because money velocity will decline — something that is currently happening [now]. Individuals and businesses struggle to repay debt with harder dollars, and saving begins to rise as caution prevails." (See The Great Experiment and WSJ Real Time Economics and Seeking Alpha)

Fischer weaves an old-fashioned story of economic causality, vicious cycle of deflation, deflationary spiral, life-threatening drunk at the wheel swerving erratically into the oncoming traffic (Stiglitzian analogy for current Fed monetary policy):

1. A state of over-indebtedness leads to liquidation through the alarm either of debtors or creditors or both.
2. Debt liquidation leads to distress selling
3. Bank loans are paid off. 
4. This leads to a contraction in bank deposits and a slowing down of the velocity of bank deposits, i.e. the velocity of circulation (V).  
5. This contraction in deposits and velocity leads to a fall in the general level of prices in the economy (deflation).
6. This deflation leads to a fall in the net worths of business which precipitates bankruptcies.
7. Deflation also causes a fall in profits
8. With a fall in profits comes business losses and a reduction in output, in trade, and employment of labour.
9. Business losses, bankruptcies, and unemployment leads to pessimism and the loss of business confidence.
10. Loss of business confidence leads to hoarding.
11. Hoarding further slows down the velocity of circulation
12. The nominal rate of interest falls and the real rate of interest rises

Economic life rises again out of the primeval mud or Alice, Beverly, Carol, and Deborah rediscover the credit economy

At the depths of depression and deflation, the flower of life still throbs in the heart of the jungle. Fisher’s solution to this deflation mess is reflation. Hopefully not as economist Joseph Stiglitz describes it:

The Federal Reserve is swerving all over the place...In some ways, the Fed resembles a drunk driver who, suddenly realising that he is heading off the road starts careening from side to side. The response to the lack of liquidity is ever more liquidity. When the economy starts recovering, and banks start lending, will they be able to drain the liquidity smoothly out of the system? Will America face a bout of inflation? Or, more likely, in another moment of excess, will the Fed over-react, nipping the recovery in the bud? Given the unsteady hand exhibited so far, we cannot have much confidence in what awaits us. (Source: Guardian)

But rather a more orderly and civilized reflation as Brad De Long describes: 

Suppose that we have four agents: Alice, Beverly, Carol, and Deborah.

Suppose that Beverly has $500 in cash that she owes Carol, due in two months. Suppose that Alice and Carol are both unemployed and idle.

In one scenario in two months Beverly goes to Carol and pays her the $500. End of story.

In a second scenario Beverly says to Alice: "I have a house. Why don't you build a deck--I will pay you $500 after the work is done. Here is the contract." Alice takes the contract and goes to Carol. She shows the contract to Carol and says: "See. I will be good for the debt. Cook me meals so I will have the strength to build the deck--here's another contract in which I promise to pay you $500 within 90 days if you cook for me." Carol agrees.

Two months pass. Carol cooks and feeds Alice. Alice goes and builds the deck.

Alice then asks Beverly for payment. Beverly says: "Wait a minute." She goes to Carol and says: "Here is the the $500 cash I owe you." Beverly pays the money to Carol. Beverly then says: "But now could I borrow the cash back by offering you a long-term mortgage at an attractive interest rate secured with an interest in my newly more-valuable house?" Carol says: "Sure." Beverly files an amended deed showing Carol's mortgage lien with the town office. Carol gives Beverly back the $500. Beverly then goes to Alice and pays her the $500. Alice then goes to Carol and pays her the $500.

The net result? (a) Alice who would otherwise have been idle has been employed--has traded her labor for meals. (b) Carol who would otherwise have been idle has been employed--has traded her labor for a secured lien on Beverly's house. (c) Beverly has taken out a mortgage on her house and in exchange has gotten a deck built. (d) Carol has the $500 cash that Beverly owed her in the first place.

Alice has more income and consumption expenditure than if she hadn't taken Beverly's job offer. Carol has more income and saving than if she hadn't cooked for Alice and then invested her earnings with Beverly. Beverly has an extra capital asset (the deck) and an extra financial liability (the mortgage) than if she had never offered to hire Alice.

A deck has gotten built. Meals have been cooked and eaten. Two women have been employed. And all this has happened without printing any extra money.

John Cochrane would say that this is impossible. John Cochrane would say:

[I]f money is not going to be printed, it has to come from somewhere. If Beverly borrows a dollar from Carol, that is a dollar that Carol does not spend, or does not lend to Deborah to spend on new investment. Every dollar of increased Beverly spending must correspond to one less dollar of Carol or Deborah spending.  Alice's job created by Beverly spending is offset by a job lost from the decline in Carol or Deborah spending. We can build decks instead of fountains, but Beverly stimulus can’t help us to build more of both. This is just accounting, and does not need a complex argument about “crowding out”...

John Cochrane is wrong.

You sometimes see this mistake in freshmen students in Economics 1, students who do not fully understand either the circular flow of economic activity or what a credit economy is. They think--like Cochrane--that the flow of spending must be constant unless somebody "prints money" because, you see, you need "money" in order to buy things.

The premise is true--you do need "money" to buy things--but the conclusion is false: the flow of spending is not necessarily constant. In the world in which Beverly does not hire Alice but instead pays the $500 directly to Carol, that $500 turns over only once--its velocity of circulation is equal to one. In the world in which Beverly does hire Alice, the velocity of circulation of the $500 is four--it goes from Beverly to Carol, from Carol to Beverly, from Beverly to Alice, and from Alice to Carol.

Cochrane's mistake--an elementary, freshman mistake--is because he has not thought enough about how a credit economy works to recognize that the velocity of circulation can be an economic variable and is not necessarily a technological constant. And as the velocity of circulation varies, the amount of the flow of spending varies as well: it is now longer the case that if Beverly borrows a dollar from Carol that is a dollar that Carol does not spend.

This is a recession; bankers shouldn't be forced to lend (Thailand case)

The US Bank bailout or TARP was not a "forced lending program."

It was a "re-capitalization program," an "emergency government effort to keep banks from being forced to write down capital losses and risk insolvency."

Lending always slows down radically during recessions (See graph at News N Economics).

It seemed counter-intuitive that TARP bailout money in the US would not get banks lending again:

"TARP definitely has its problems, but it was developed to prevent a systemic crisis, and not to force lending. Were it not for TARP, more banks may have failed, and lending would be negligible, if not falling precipitously.

"The government should allow the bankers to make rational lending decisions, and right now focus its efforts on keeping the banking system afloat. And later, in the resolution phase of the banking crisis, the government should focus on the actual availability of credit and regulation (the flow of lending). (Source: News N Economics, This is a recession; bankers shouldn't be forced to lend, link)

The banks are using the bailout funds to recapitalize, strengthen their balance sheets, and avert failure.

In Thailand the banks haven't even been bailed out but similar arguments are being made:

The central bank has cut interest rates radically but commercial banks are not cutting their rates and lending more like they should (See article)

With global recession looming on the horizon reticence to loan by Thai banks could only be considered natural.

An old argument has been revisited: Bank lending dominates business financing in Thailand so the Stock Exchange of Thailand (SET) should be jump started to increase the importance of equity financing (See article).

When Thaksin faced reticence of banks to lend in the early 2000s he tried to get the stock market going but was only partly successful (Pasuk and Baker, 2004, Thaksin: The business of politics in Thailand, 109-115).  [To be covered in more detail in later post...]

Then the capital gains tax free sale of Shin Corp ignited the storm and everything else is history....

This is a recession; bankers shouldn't be forced to lend (Thailand case)

The US Bank bailout or TARP was not a "forced lending program."

It was a "re-capitalization program," an "emergency government effort to keep banks from being forced to write down capital losses and risk insolvency."

Lending always slows down radically during recessions (See graph at News N Economics).

It seemed counter-intuitive that TARP bailout money in the US would not get banks lending again:

"TARP definitely has its problems, but it was developed to prevent a systemic crisis, and not to force lending. Were it not for TARP, more banks may have failed, and lending would be negligible, if not falling precipitously.

"The government should allow the bankers to make rational lending decisions, and right now focus its efforts on keeping the banking system afloat. And later, in the resolution phase of the banking crisis, the government should focus on the actual availability of credit and regulation (the flow of lending). (Source: News N Economics, This is a recession; bankers shouldn't be forced to lend, link)

The banks are using the bailout funds to recapitalize, strengthen their balance sheets, and avert failure.

In Thailand the banks haven't even been bailed out but similar arguments are being made:

The central bank has cut interest rates radically but commercial banks are not cutting their rates and lending more. (See article)

With global recession looming on the horizon reticence to loan by Thai banks could only be considered natural.

An old argument has been revisited: Bank lending dominates business financing in Thailand so the Stock Exchange of Thailand (SET) should be jump started to increase the importance of equity financing (See article).

When Thaksin faced reticence of banks to lend in the early 2000s he tried to get the stock market going but was only partly successful (Pasuk and Baker, 2004, Thaksin: The business of politics in Thailand, 109-115).  [To be covered in more detail in later post...]

Then the capital gains tax free sale of Shin Corp ignited the storm and everything else is history

Thailand's public debt build up after the 1997 Crisis compared to other countries

In Thailand many are concerned about what fiscal stimulus and increased government spending will do to government budget deficits and public debt (Read Bangkok Post article).

How long do the negative after-effects of a  banking crisis last?

This is the subject of a  recent VoxEU article by economist Carmen M. Reinhart based on an upcoming paper in the prestigious American Economic Review (Read paper from her publications list).  

There is typically a sharp rise in public debt in the three years following a banking crisis.

(See comparison above graph from paper that shows "cumulative increase in real public debt in the three years following the banking crisis").

After the 1997 crisis Thailand's public debt build up was slightly below the historical average of 86%.

Thailand was subject to an IMF austerity programme during part of this period.

Would the public debt ballooned to an even greater level if this had not been the case?

The paper also compares other negative after-effects including: declines in housing prices, increase in unemployment, government budget deficits, and credit rating downgrades. 

Throw money out of helicopters to stimulate the US economy?

This is what Bronte Capital suggests might be the best alternative to jump-start the US economy seeing as everything else has failed:

Creating expectations that there will be inflation in the future is difficult precisely because people believe that the US economy is managed so well that this will never happen:

* It is not enough to print money (increase money supply) because everyone thinks that the Fed will pull the money out when the crisis is over.

* The Fed has to be "credibly irresponsible" and "visibly reckless" to convince people there will be inflation.  

* You need to convince people not to hold money like they do in a liquidity trap.  You need to convince them that cash is trash, you need to decrease their demand for money, and get people running to convert their cash to some other (albeit more risky) asset.

How do you do this?

Throw money randomly from helicopters:

The Federal Reserve should hire a couple of hundred helicopters and load each one 10 million dollars in neatly bound parcels of $1000 each.  Total cost $2 billion plus trivial helicopter hire.

It should fly them over 200 randomly picked American cities and throw the money out the window.  It should press release this – but press coverage will be excessive.  Indeed I suspect that the press coverage would give the Fed’s inflation policy greater awareness than the Coca Cola Company.  (The Coca Cola Company’s annual advertising budget is $2.8 billion – so this is already cheap compared to some private sector alternatives.)  

The press release should be simple.  We are doing this to induce inflation.  If there is no inflation as a result we will simply do it again.

Of course people will fall of roofs after searching for money that might have landed on their house.  They might die.  Of course people might get trampled in the crush.  They might die too.  

All of this increases the visible recklessness of the policy.

But the charm of this.  It may actually induce mass spending of American dollars for (self-fulfilling fear of inflation)– a massive stimulus.  And it will do it all for $2 billon.  Obama has a stimulus package of $1.2 trillion – or about 600 times as large.  This is relatively cheap.

The real case for throwing money out of helicopters is that it looks like it will work better than anything else that anyone has come up with yet.

And it will be cheap.  Much cheaper than alternatives that are actually being implemented.

The secondary benefit is that most of the losses from inflation will be in the hands of the Chinese who have built huge reserves of soon-to-be-deflated US dollars.  

Hey what better – lets kick start the economy and get the Chinese to pay.

[Comment: This must be tongue-in-cheek. It certainly underlines the necessity that both the US and China are in this together. That it takes two to tango.]

It takes two to tango: Asian savings glut or US savings dearth?

Here's something relevant to Asian economies like Thailand that you might have missed. 

Thailand and other economies in Asia such as China, Malaysia, and South Korea share many things in common:

1. Heavy reliance on exports to drive economic growth.
2. Large current account surpluses.
3. Large accumulations of US dollar foreign exchange reserves.
4. Great downside risk exposure in case of a US economic slowdown.

In the massive US Economic Report of the President released recently there is a play-by-play description of the US financial crisis that reached boiling point this September:

* The roots of the current global financial crisis began in the late 1990s. A rapid increase in saving by developing countries (sometimes called the "global saving glut") resulted in a large influx of capital to the United States and other industrialized countries, driving down the return on safe assets. The relatively low yield on safe assets likely encouraged investors to look for higher yields from riskier assets, whose yields also went down. What turned out to be an underpricing of risk across a number of markets (housing, commercial real estate, and leveraged buyouts, among others) in the United States and abroad, and an uncertainty about how this risk was distributed throughout the global financial system, set the stage for subsequent financial distress.

* The influx of inexpensive capital helped finance a housing boom. House prices appreciated rapidly earlier in this decade, and building increased to well-above historic levels. Eventually, house prices began to decline with this glut in housing supply.

* Considerable innovations in housing finance "the growth of subprime mortgages and the expansion of the market for assets backed by mortgages" helped fuel the housing boom. Those innovations were often beneficial, helping to make home ownership more affordable and accessible, but excesses set the stage for later losses.

* The declining value of mortgage-related assets has had a disproportionate effect on the financial sector because a large fraction of mortgage-related assets are held by banks, investment banks, and other highly levered financial institutions. The combination of leverage (the use of borrowed funds) and, in particular, a reliance on short-term funding made these institutions (both in the United States and abroad) vulnerable to large mortgage losses.

* Vulnerable institutions failed, and others nearly failed. The remaining institutions pulled back from extending credit to each other, and interbank lending rates increased to unprecedented levels. The effects of the crisis were most visible in the financial sector, but the impact and consequences of the crisis are being felt by households, businesses, and governments throughout the world. (Source: Economic Report of the President (ERP) via Econbrowser)

Another description of what happened:

"The process by which U.S. output was sustained through the long-period of growing imbalances could not have occurred if China and other Asian countries had not run huge current account surpluses , with an accompanying “savings glut” and a growing accumulation of foreign exchange reserves …. flooding the US market with dollars and thereby helping to finance the lending boom." (Source: Brad Setser)

To summarize:

1. China's currency remained undervalued.
2. Chinese exports remained cheap and competitive in international markets.
3. China ran huge current account surpluses from massive exports.
4. China accumulated massive US dollar foreign exchange reserves.
5. China collectively saved money through these reserves.  
6. China invested these savings back in the US.
7. Some of this investment was via Sovereign Wealth Funds.

Searching for someone to blame when bad things happen is probably a natural thing for humans to do but as Brad Setser observes both "debtor and the creditor tend to share responsibility for most financial crises."

Or as Menzie Chin puts it: "excess saving from East Asia and oil exporters enabled...the US housing boom, and the search for yield" but was not the only cause.

In other words: It takes two to tango:

"Some economists have gone so far as to suggest that the growing imbalance problem was entirely the the consequence of the savings glut in Asian and other surplus countries. In our view, there was an interdependent process in which all parties played an active role. The United States could not have maintained growth unless it had been happy to sponsor, or at least permit, private sector (particularly personal sector) borrowing on such an unprecedented scale.”

"Savings glut" might not be the right term:

"Monetary printing in China to swap Renmimbi for US dollars (so that China could keep its currency artificially low) does not constitute a "savings glut". Nor does enormous carry trades in Japan." (Source: Mish)

It is not that people in Asia were saving too much, people in the US were saving too little (savings dearth).

The US savings rate "fell precipitously" over the period 1996-2004 because interest rates were held low for too long causing a disincentive to save:

...there is every reason for the U.S. savings rate to have fallen: The Fed continuously held interest rates too low thereby creating a negative incentive for anyone to save. Eventually a near unanimous belief set in that asset prices were a one way street headed North and the purchasing power of the dollar a one way street headed South. So why save?

And after the Greenspan Fed foolishly cut rates to 1% in the wake of the dotcom bust, there was a mad dash out of cash, culminating with panic buying of houses. That panic in turn was followed by cash out refis to support consumption as people bit off more house than they could really afford. This is the origin of the much talked about negative savings rate. (Source: Mish)

Lurching towards bank nationalization worldwide

Thailand's banks may be in healthy condition but banks in the US certainly not (Read on Thai banks). There is more and more discussion of bank nationalization in both the US and the UK (following loosely based on Surowiecki):

* A “nationalize now” meme has taken hold in the blogosphere
* But people are talking about nationalization very casually
* Sweden and Norway in the early 1990s is the example where quick and vigorous nationalization worked (Read best report via Bronte Capital).

But there are reasons to be sceptical:

* The US has no prior experience with nationalizing large chunks of its economy like Sweden did. (!!!!)
* Private enterprise is typically better at efficiently allocating resources than government In the US
* Having the state ration credit would be problematic for many in the US

Advocates of nationalizing are downplaying:

1. The magnitude of change.
2. The duration of change.

To be more specific:

In Paul Krugman’s Op-Ed on Monday, for instance, he suggested that nationalization would be like what the Resolution Trust Corporation did with the savings and loans at the end of the nineteen-eighties: seizing the banks, hiving off their bad assets, paying off debts to make them solvent, and then selling the banks to new owners. But when you nationalize the entire banking system, who, exactly, are these “new owners” who are buying the cleaned-up banks supposed to be? And what investor is going to be interested in putting up money to acquire a bank that has to compete with nationalized, and therefore subsidized, banks (since the government presumably won’t be able to privatize all at once). Krugman also adds that any government takeover will be “temporary.” But does that mean eighteen months, or does it mean a decade?

Then what?

Once the big banks are nationalized, the government can take its time salvaging whatever assets are still worthwhile and preparing for the reconstruction of a private banking system under a completely new system of regulation, a task that is likely to take several years (Source).

Then there is the "bad bank-good bank" model:

That is not the only possible plan. An alternative would be to allow banks to divide themselves into two entities, a bad bank with all the toxic assets and a good bank, with lending etc. Ownership of these two entities will be allocated pro quota to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with 30 billion of bad assets and 70 billion of good assets will see its debt divided 30-70 and its equity divided 30-70. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity.

...After the spin off, the toxic assets will not contaminate the lending part of the business anymore. On the one hand, bad banks would simply be closed-end funds holding the toxic assets. If these assets turn out to be worth more, the original investors will be rewarded. If they are worth less, the most junior claimants (common and preferred equity) will be wiped out.

The good news is that these entities could be allowed to fail, because their failure would only be a rearrangement of their liability structure with no negative consequences on the economy. On the other hand, good banks will have a clean balance sheet and will be able to raise private capital without too many problems. If private capital is nowhere to be seen is because sovereign wealth funds that tried to take advantage of the situation experienced enormous losses. In November 2007, for instance, when the Abu Dhabi’s sovereign wealth fund took a stake in Citigroup the stock was trading at $29 per share, while today is worth only $3.5. After these bad early experiences all the smart money stayed away.

By eliminating the uncertainty on the magnitude of the losses in good banks, the spinoff will make it appealing for private capital to invest in these banks. Even if private capital would not flow back (which I doubt), a government equity infusion in the good banks would be cheaper and more effective. Cheaper because the value of debt in the good banks would be close to par and thus an equity infusion will not go to bail out the existing creditors, but only to promote lending. More effective, because instead of trying to improve the capital ratio of a $100 billion entity (in the example), the government will do it only with respect to a $70 billion one.

(Source Luigi Zingales at Vox EU)