Perry Mehrling's blog

(Way) Beyond Diamond-Dybvig

The problem with Dodd-Frank, and with Basel III as well, is that they start with the banking system, not the shadow banking system.

Give credit where credit is due. Everyone (I hope) now appreciates that so-called “microprudential” safeguards are not enough, and this is so even if we extend the traditional focus on solvency (capital adequacy) to include also liquidity.

“Macroprudential” safeguards are needed also, to put bounds on the apparent instability of the system as a whole. Everyone says it, but what does it mean?

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But not by him

“Unredeemably opaque”, so Alan Greenspan terms the operation of the invisible hand that guides international financial markets.

He means this literally. “The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems.” If he had said “hardly ever get” rather than “can never get”, I think we could all agree.

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The illusion of black swan-proofing

It is easy to poke fun at those in Utah, and not just in Utah, who think that the road to safety is paved with gold. But much the same survivalist ideology shows up also in more financially sophisticated circles, in calls for greater “diversity and self-sufficiency”.

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The concept of bank capital

“Not yet, Bank of America,” says the Fed, “but the rest of you guys go right ahead. Yes, even you, Citi.”

Thus the second round of stress tests came to an end with the conclusion that key players in the banking system are sufficiently well-capitalized that they can be allowed once again to pay dividends to shareholders.

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Capital Flows, Cross-border Banking, Shadow Banking, and the Dollar

Inspired by the recent yen kerfuffle, in which the G7 central banks intervened to take the opposite side of the speculators’ trade that was driving up the yen, let’s try to connect some dots on the way to drawing a picture of the monetary side of financial globalization.

First big dot, global imbalances. The big story is of course the Chinese trade surplus, and its counterpart the US trade deficit. For our purposes, more important is the mirror image of these trade imbalances in capital flows, meaning foreign asset accumulation in China and foreign borrowing in the US.

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From MIT to IMF

By the evidence of the recent IMF conference, there is apparently now consensus that the global financial crisis has killed--“shattered” (David Romer), “destroyed” (Stiglitz)--pre-crisis academic economic orthodoxy. But that orthodoxy had many dimensions, and there is no consensus on where repair efforts are most immediately necessary.

Instead, we see a division of labor emerging in which everyone focuses on that one dimension where they feel themselves to have some special expertise. In such a situation, an overall map may be helpful for making sense of the reconstruction effort as a whole. Read more

Or Does It?

History will record that the IMF’s conference last week (March 7-8), titled ”Macro and Growth Policies in the Wake of the Crisis”, marked a turning point in mainstream economic debate within academia, probably only one turning point in the crooked road that lies ahead, but nonetheless a significant moment.

Olivier Blanchard, Director of Research at the IMF, struck the significant note in the opening minutes of the first session (2:50 in Session 1). According to him (and I paraphrase), before the crisis, mainstream economic thinking had converged on a beautiful construction in terms of monetary policy, namely “inflation targeting”. We had convinced ourselves that it was enough to focus our attention on one target (inflation), and one instrument (the policy interest rate) to achieve that target.

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A Money View

One enduring lesson of the crisis is the truth of the old saw “banking is as banking does.” It has never made much intellectual sense to confine attention to a particular class of regulated entities that are called banks, or to track the movements of their assets and liabilities while ignoring the assets and liabilities of entities doing functionally identical business.

If policymakers did so at one time, it was for practical reasons—they were responsible for the things called banks, and had some control over them as well. Non-banks, even if they were functionally identical to banks, were someone else’s problem, and a tough problem too since there were no very evident points of control.

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Exit Strategies and the New Normal

Now comes the ECB testing the water for a possible rate rise, and at the same time the Fed testing the water for a possible stand pat.  The interesting thing is that both justify their policy with exactly the same argument—they are both trying to influence long run inflation expectations. 

The ECB wants to raise rates in order to send the message that it is prepared to be tough on inflation.  Rising commodity prices are seen as a harbinger of future inflation, so it is important to send a contrasting policy message now, as a harbinger of a different future.

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What kind of “Minsky Moment”?

Ralph Hawtrey, the British economist whose textbook Currency and Credit was the standard for an earlier generation, saw financial instability as the abiding tendency of credit markets, and the attempt to tame that instability as the abiding task of central bankers.  His hope was that attentive discount rate policy could stem divergence, either upward or downward, before it built up strength and became unstoppable. Lender-of-last-resort responsibility brought with it an interest in avoiding the last resort.

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