Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Thursday, September 29, 2016

Beveridge curves

The Beveridge Curve refers to relationship between job vacancies and unemployment or, more generally, between business sector recruiting activity and household sector job search activity.

Theoretically, the Beveridge Curve should be negatively-sloped in V-U space. When economic prospects look promising, firms wanting to expand capacity begin to post more vacancies. For a given level of unemployment, there is an increase in labor market tightness (V/U) which makes finding a job easier for unemployed workers. The unemployment rate declines as the vacancy rate rises. The reverse holds true when economic prospects are diminished.

Empirical Beveridge Curves don't always have the clean shape suggested by theory. Sometimes, the Beveridge Curve appears to "shift." Beginning with Lilien (1982), there's been an inclination to interpret shifts in the Beveridge Curve as reflecting the effects of "structural" shocks as opposed to the "cyclical" shocks that drive the normal U-V dynamic. For some recent work in this area, see my interview with Gianluca Violante here: "What Shifts the Beveridge Curve? Recruitment Effort and Financial Shocks."

I'm not going to provide much in the way of analysis in what follows. The primary purpose of this post is just to share some data that may or may not stimulate some hypotheses. Let me begin with the BC using the JOLTS data.


Here you see the familiar cyclical pattern driven by the Great Recession and recovery. Except that the BC appears to have shifted outward. In other words, given present levels of recruiting intensity, we would have expected (based on historical experience) the unemployment rate to be significantly lower. The pattern is similar if we instead use an alternative measure of job vacancies from the HWOL (the Conference Board Help Wanted Online series).


Because the size of worker flows between employment and out-of-the-labor-force are as large as the flows between employment and unemployment, I sometimes like to use a broader measure of job search (available to work) like nonemployment (you may prefer one of the alternative measures listed here.)




This representation of the data suggests that the U.S. labor market looks a lot different today than it did prior to the Great Recession.

One of the benefits of the HWOL data is that measurements are available at the MSA level. (I also have the benefit of a great research assistant, Andew Spewak, who did all the leg work for us.) Here are few examples.


 Or, in terms of nonemployment rates...






So some MSAs display a relatively stable BCs in V-U and V-N space, whereas others do not.

To get some additional sense of the heterogeneity existing at the MSA level, consider the following data, which plots the ppt change in vacancies and unemployment over the recession (2007-09) and the recovery (2009-16) for a set of selected MSAs (most of the largest ones).


Not surprisingly, the unemployment rate shot up across all the MSAs in this sample and the vacancy rate declined, though not by very much in many jurisdictions. Here is how the same set of MSAs behaved during the recovery.


 Again, not a very surprising pattern, apart from the extent of the heterogeneity. If we repeat the exercise above replacing the unemployment rate with the nonemployment rate, during the recession we see,


And during the recovery,


That is, recruiting intensity in the recovery appears to be up across the board. One would expect the employment rate to be up across the board as well. But it is not. MSAs like Seattle, Denver, and Phoenix, for example, have experienced declines in the employment rate despite marked increases in their respective job vacancy rates. These differences are interesting and could have implications for (say) the relative merit of policies targeted at the aggregate vs. sectoral/regional level.

Friday, August 26, 2016

Jackson Hole and Fed Communication

Fed chair Janet Yellen gave what I considered to be a good speech at this year's Jackson Hole conference (see here).  Not everyone seems impressed, however. The Fed has no credibility, it seems. For example, it keeps saying it's going to do things, like raise its policy interest rate, only to repeatedly back off. I mean, what the heck? Don't they even know what they're doing?

At some level, this degree of frustration is understandable. (I am less sympathetic, however, when it comes to informed journalists and market traders, who should know better.) Let me try to help ease your frustration.

The first thing to keep in mind is that monetary policy is not a precise science. Much remains to be discovered, especially since the environment (technology in particular) continues to evolve. Keep in mind that most central banks employ the services of research divisions. As Einstein is purported to have said: "If we knew what it was we were doing, it would not be called research, would it?"

That's not to say that monetary policy makers are completely clueless. Evidence. Theory. Discussion. Debate. Experience. Wisdom. They all have a role to play in the process of formulating monetary policy. There is considerable consensus along some dimensions (e.g., keeping inflation low and stable). There is outright disagreement along other dimensions. That's just the way it is. And it's likely to remain this way for the foreseeable future. But in the meantime, if you live in the U.S., try to take some solace in this:

Annual Inflation Rates
Now, in terms of Yellen's Jackson Hole speech, what are people complaining about? Well, consider this WSJ article: Yellen Cries Wolf, with the subtitle: Fed chairwoman tries to convince market that a rate rise is coming but investors aren't listening. Of course, digging deeper into the article, the author clarifies that Yellen did not actually say that, only that she came "close" to saying it. Sigh.

The main issue here, I think, is what people expect in the way of Fed communication in terms of its economic outlook and its description/explanation of its policy rule. These are two conceptually distinct objects and are often confused.

My own personal view is that a central bank should make its policy rule clear, but that it should refrain from providing an economic outlook. So, for example, the Fed should want to make it clear that a sharp uptick in inflation would be met with a correspondingly sharp increase in its policy rate (assuming that this is an appropriate policy response). But what would be the use in having the Fed provide an outlook (a probability assessment) over future inflation? All that people need to know, really, is that the Fed is committed to keeping inflation in check. The credibility of this belief is ultimately based on reputation (see diagram above). As for forecasting the contingencies that would trigger this or that policy response, let the private forecasters do their job.

But some people want more from the Fed. They want the Fed to tell them how the economy is going to evolve in the foreseeable future (and in some cases, beyond). As if the Fed, or anyone for that matter, can actually know.

Now, if people generally appreciated the inherent difficulty in offering forecasts of this sort, I'd say that it would do no harm for a central bank to offer its economic outlook--a prognosis that would find its way in a portfolio of outlooks generated by other agencies. Market participants could then combine the information in these outlooks and, together with the Fed's clearly stated policy rule, make their own forecast of (say) the future path of short-term interest rates.

But perhaps I'm being naive. If a central bank was to just state its policy rule and refrain from offering its outlook, it would surely be criticized for not providing the market with enough "guidance." It is the demand for this "guidance" that compels central bankers to offer an economic outlook. Here is the outlook provided by JY (emphasized phrases my own):

Looking ahead, the FOMC expects moderate growth in real gross domestic product (GDP), additional strengthening in the labor market, and inflation rising to 2 percent over the next few years. Based on this economic outlook, the FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives. Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months. Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee's outlook
And, as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy. In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight. For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide--a point illustrated by figure 1 in your handout...The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted.

And so, there you have it. Evidently, the Fed plans to raise its policy rate soon. And if it doesn't, its credibility will be diminished. Or if it does raise rates even though conditions do not warrant it, its credibility will be again be diminished. Or, as the fan chart above demonstrates, the Fed evidently has no idea where interest rates will go. There's no winning this game. Go back and look at the first diagram again and give it a rest.


Tuesday, June 14, 2016

DSGE Theory

This post is for my students, and whoever else is interested in what DSGE theory is and why I find it useful.

Dynamic Stochastic General Equilibrium (DSGE) theory refers to a methodology employed by macroeconomists to build DSGE models -- mathematical representations of the macroeconomy. DSGE models, like all models, are used for a variety of purposes. They are used to help organize thinking. They are used to interpret data. They are used to help make conditional forecasts. They are used to predict and evaluate the possible consequences of government policies (especially useful for policies that have never been tried before). They are used to help make policy recommendations.

The use of DSGE theory is often criticized in ways that reflect what I view as a deep misunderstanding of the research program, how it fits in with the evolution of macroeconomic theory over time, and how it is actually applied by (say) central bank policy makers. This is, I think, to some extent the fault of DSGE practitioners who, accustomed to speaking in their specialized trade language, find it difficult to translate core ideas and findings in the vernacular. (This is an issue with most trade associations, of course, but is especially acute in economics because so many non-specialists take an interest in the subject.)

Let me first provide some context for my views. We are all scientists trying to understand the world around us. We use our eyes, ears and other senses to collect data, both qualitative and quantitative. We need some way to interpret/explain this data and, for this purpose, we construct theories (or hypotheses, or models, or whatever term you prefer). Mostly, these theories exist in our brains as informal "half-baked" constructs. This is not meant to be a criticism (as long as we recognize the half-baked nature of our ideas and why some humility is always in order). Often it seems we are not even aware of the implicit assumptions that are necessary to render our views valid. Ideally, we may possess a degree of higher-order awareness--e.g., as when we're aware that we may not be aware of all the assumptions we are making. It's a tricky business. Things are not always a simple as they seem. And to help organize our thinking, it is often useful to construct mathematical representations of our theories--not as a substitute, but as a complement to the other tools in our tool kit (like basic intuition). This is a useful exercise if for no other reason than it forces us to make our assumptions explicit, at least, for a particular thought experiment. We want to make the theory transparent (at least, for those who speak the trade language) and therefore easy to criticize. Constructive criticism is the fuel that fires the furnace of new ideas in academia. [ End of philosophical rant :) ]

Now let me turn back to DSGE theory. I think it will be useful to break the acronym into its parts and discuss each component separately.

The "D" stands for dynamic--as in--the phenomena in question involve a time element. The opposite of dynamic is static. While static models have their uses, who's going to argue that a dynamic element isn't desirable? Almost all decisions like consumption and saving, deficit-finance, human capital investments, have a time dimension to them. No controversy here, I hope.

The "S" stands for stochastic--as in--societies appear subject to random events, like unforeseen technological breakthroughs, unexpected changes in government policy regimes, or just random acts of nature. Again, I don't think there's much controversy with this idea. Note, however, many DSGE models do not have the S, in which case we might instead employ the acronym DGE. (For a history of the evolution of these acronyms, see here.)

The "G" stands for general--as in--well, it's not entirely clear. There is a traditional distinction in economics between partial and general equilibrium theory. The partial equilibrium approach (associated with Alfred Marshall) refers to the supply-demand curve analysis that most people are familiar with. The analysis is "partial" in the sense that it typically restricts attention to a particular market--like the market for motor vehicles, taking the price of other goods as given. In contrast, the general equilibrium approach (associated with Leon Walras) strives to model the economy as a closed system, paying particular attention to how markets interact with each other and how prices are determined jointly. Importantly, the "G" insists on giving an explicit account of the government budget constraint (i.e., a government is not to be modeled as Jesus feeding the multitude.) Another way to think about "G" is that it means to capture the possibility of "feedback effects." The notion of feedback effects in macroeconomic systems is not, I do not think, controversial.

This leaves us with the "E," which stands for equilibrium. Here lies the controversy. But why? For all sorts of reasons, some of which are based on legitimate concerns, and some of which are based on simple misunderstanding.

Let me first address the misunderstanding. The concept of "equilibrium" in economics has evolved to mean something quite specific and something quite different from the notion of a "system at rest" (which is closer to what economists label a steady-state). Technically, an equilibrium is simply a set of conditions imposed by the theorist to help determine the outcome of an hypothetical social interaction. In this sense, an equilibrium is probably better thought of as a solution concept. There is no unique way to specify an equilibrium solution concept. In the game theory, there is plethora of alternatives, beginning with the Nash equilibrium. The classical theory of Walras uses the concept of a competitive equilibrium. In my own view (probably not representative), I even think of general disequilibrium as just another type of equilibrium concept. Every theorist has to have a solution concept in mind when deducing the likely outcome of an hypothetical social interaction. There is no right or wrong way to specify an equilibrium concept--there are just more or less useful ways in doing so.

Another misunderstanding is that insisting on equilibrium analysis necessarily implies that one assumes markets always "clear" in the sense prices adjust to ensure supply equals demand at all times. This is understandable because many DSGE models (especially the RBC variety) do in fact make this assumption. But, of course, there's a large class of DSGE models that do not (e.g., the NK variety). More to the point, it's important to understand that the concept of equilibrium is not wedded to the concept of competitive market-clearing models. In DSGE models that replace centralized Walrasian markets with decentralized search markets, conventional "supply and demand" curves do not even exist. In search models, prices are determined through bilateral negotiations and the "clearing" mechanism operates through quantity variables, like labor-market tightness (the ratio of vacancies to unemployment).

A more legitimate concern relates to the equilibrium concept of "rational expectations." Because of the "D" element, the theorist must take a stand on how expectations are formed and updated over time. Macroeconomic theorists have grappled with this question for over a century, if not longer (see Laider, 1999). There is little controversy that people are forward-looking. But exactly how are they forward-looking? John Muth (1961) suggested that, in the context of a model, we might begin by assuming that our modeled agents (somehow) form model-consistent expectations (i.e., "rational" expectations). Intuitively, the idea is that we should not model people as forming expectations that are wildly at odds with the reality unfolding around them and, that as a limiting case, we might even begin by assuming that expectations are formed in a manner that is perfectly consistent with the surrounding reality. Among other things, model agents are assumed to possess common knowledge (see, Geanakoplos, 1992).

Now, if all of this sounds like a bit of a stretch, it no doubt is. The relevant criticism and response is recorded in section 6.4 Stationary Models and the Neglect of Learning in Lucas and Sargent (1979). I'm not going to get into it here, but suffice it to say that there's been a large and vibrant literature on non-rational-expectations "learning" models since Lucas and Sargent wrote that piece. And you'd be very wrong to think it hasn't had any influence in the way policymakers, central bankers in particular, think about policy and its effects. St. Louis Fed president James Bullard, for example, is among those who have made significant academic contributions in this area (you can view his works here).

In terms of their use in policy making, DSGE models are no different than their predecessors. Some applications entail large scale quantitative models to make conditional forecasts. But their main value is the manner in which they (along with other models) are used to organize thinking in policy deliberations. I think I disagree with Narayana Kocherlakota here when he suggests that DSGE models are built purposely not be useful for day-to-day policy making--for example, in helping to answer the question of whether the interest rate should be changed in the upcoming FOMC meeting. Instead, he views DSGE models as useful for thinking about policy rules (which I agree with). But his view here seems inconsistent with a view he has expressed elsewhere, namely, that isolated changes in the policy rate are largely irrelevant--that what is important is how the path of interest rates is expected to evolve over time (I agree with this too). I think that the decision of whether to move rates today has to be made in the context of what the policymaker views as wise policy principles based on some combination of theory, evidence, and experience. These principles should no doubt make allowances for the necessity of discretionary and ad hoc policy actions. But this allowance does not mean that reference to a DSGE model (or any other model) cannot be useful for thinking through the likely consequences of a contemporaneous policy action. [Note: I may have misunderstood the point NK was trying to make.]

In terms of a defense of the use of DSGE theory for policy, I can do no better than Chris Sims here (video, highly recommended). See also this interview with Tom Sargent, who defends modern macro theory. Finally, I have my own related post: In Defense of Modern Macro Theory.

Sunday, May 29, 2016

Some questions concerning equity-financed banking

John Cochrane has another fun and provocative post making his pitch for equity-financed banking. He makes a lot of great points. But I'm still left feeling a little uneasy. In particular, I wonder whether some of his sweeping claims have any firm theoretical backing. It could be I just haven't thought hard enough or long enough about it. In any case, in the spirit of promoting discussion, let me describe some of the things that bother me.

Actually, before I start, I should preface my concerns with a couple of observations. Policies directed toward stabilizing the banking sector target both the asset and liability side of bank balance sheets. The "narrow banking" proposal of 100% reserves, for example, is a policy designed to make bank assets safe. The "100% equity-financed banking" proposal on the other hand is a policy designed to render bank liabilities safe (run-proof). According to Cochrane, "...bank assets aren’t risky! A diversified, mostly marketable portfolio of loans and mortgage backed securities is far safer than the profit stream of any company." The problem evidently lies on the liability side. Moreover, the issue here is not simply one of ascertaining whether banks are "over-levered" (I'm willing to agree that they probably are). The issue is whether debt (fixed-value promises), especially demandable debt, has a role to play in the business of banking at all.
 
The main question I have is: where's the theory? In the benchmark neoclassical model, some version of the Modigliani-Miller theorem typically holds. The theorem states that under a very specific set of assumptions, the liability structure of a firm does not matter. We know that these assumptions (e.g., symmetric information) do not literally hold in reality. When information is asymmetric, debt can be superior way to fund assets relative to equity (see here and here, for example). Demandable debt may have socially desirable properties when liquidity demands are private information; see here. In a world where exchange media (including collateral assets) are valued, it could matter very much how the "pizza" is sliced into tranches designed to serve special uses.

What explains the widespread use of the debt contract and the prevalence of fractional reserve banking? The explanation is unlikely (in my view) to be "government distortions" or "greedy bankers." It seems to me that asymmetric information in financial markets is a pertinent real-world friction. Could it be that debt represents a sort of "second-best" solution to the problem of efficient (low-cost) financing in a world of asymmetric information? Might the same not be true of demandable debt? Implicitly, Cochrane must be thinking that these benefits are quantitatively small. Maybe so, but senior liability tranches do seem rather highly valued in the market place, especially as exchange media. Private monetary instruments have always been in the form of debt, not equity. Why has this been the case?

Cochrane begins his post with the statement "My premise is that, at its core, our financial crisis was a systemic run. The mechanism is familiar from Diamond and Dybvig."  The Diamond and Dybvig (1983) model can indeed be interpreted as a theory of bank sector fragility. But we should keep in mind it's also a theory that explains the benefits of an illiquid bank sector (a point stressed by Wallace, 1996). Moreover, it's also a theory that explains the desirability of demandable debt. We want demandable liabilities (according to this theory) because, well, imagine going to an ATM wanting to withdraw cash and then having the blasted thing make you fill out an insurance claim attempting to verify whether you do indeed have a pressing need for liquidity. (In fact, banks were known to do this during the banking panics of the 20th century.)

Now, I suspect that Cochrane may reply that while demandable debt in its traditional form once had a useful role to play, markets and communication technologies are now developed to the point that renders the demand deposit liability superfluous. Call me a hopeful skeptic. Cochrane claims that "unlevered bank equity would have 1/10 less the volatility it has today, so we're talking about 2% volatility on an annual basis." I'm not sure where he gets these numbers, though I do agree with him qualitatively. (On the other hand, how do we know that banks will not hold riskier assets if they are equity financed?)


In any case, just how much volatility is "too much" for depositors wanting transactions balances with a steady value to ensure that payment obligations can be met in all circumstances on a timely basis? Evidently, depositors value the fact that they can redeem their bank money at par for cash quite a bit. What Cochrane advocates is the replacement our present ATMs with one-armed bandits spitting out random returns whenever we want to redeem our bank equity shares for cash. That sounds like a lot of fun, but it may not be very practical. Perhaps the volatility of these returns will not be so great (how do we know?). Maybe we'll be able to withdraw only 98 cents on the dollar more often than not "by chance" (as the Gorton-Pennacchi insiders skim us outsiders while claiming "bad equity returns" as the culprit. Again, how do we know?)

I want to be clear here. I am not suggesting that Cochrane's proposals are a bad idea when all considerations are factored in. I'm just questioning whether it's the open-and-shut case he makes it out to be. If it is such a great idea, I wonder why banks have not offered the product on their own? (I am sure there is no shortage of explanations here, but still, it's worth having them spelled out.)
 
There is one final thing I want to touch on before I sign off here. The main reason Cochrane preferes equity over debt is because equity is evidently "run-proof." I don't know, he may have his own special definition of "run." There are macroeconomic models of multiple equilibria (see Roger Farmer) where shareholders might be compelled to "run" on equity, driving its price lower, leading to all sorts of negative pecuniary externalities and self-fulfilling crises. Getting rid of debt will not necessarily get rid of financial crises.

Of course, getting rid of debt will get rid of bankruptcy. But I am sometimes led to question whether bankruptcy is quantitatively relevant for causing or exacerbating recessions. As Cochrane points out:
Our crisis and recession were not the result of specific business operations failing. Failure is failure to pay creditors, not a black hole where there once was a business. Operations keep going in bankruptcy. The ATMs did not go dark.
Absolutely. I can recall several times when an airline went bankrupt with no noticeable side-effects (passengers were treated terribly, but that was normal even outside of bankruptcy). Bruce Smith (2002) reports evidence suggesting that bank panics are not always associated with output losses. If so, then what's the big deal? As Cochrane explains, when equity takes a plunge, we all pull out our hair, but the firm is under no obligation to do anything on our behalf. But with debt--demandable debt in particular--we can demand--demand--our money back. And the firm has to ... has to what? I'm not really sure. The firm can just continue to operate as usual and restructure its debt, no? After all, bankruptcy is just a rearrangement of claims against a firm's assets (well, I suppose in some cases senior management gets the ax, but not always). In the old days, banks were permitted to temporarily suspend withdrawals without legal repercussion. As well, bank clearinghouses might issue currency substitutes in lieu of specie, etc.

These considerations lead me to wonder whether interventions on the asset side of bank balance sheets might not be a better way to promote a run-free banking system. Alternatively, as Cochrane suggests, we might consider opening up the central bank's balance sheet to the public. As I've mentioned before, the U.S. treasury does permit the public to hold online UST accounts at www.treasurydirect.gov. While the system is not set up for making payments, there is no reason why, in principle, it could not be. I'm not suggesting this as a panacea, of course. But I think the idea, or some variant of it, deserves serious consideration.

Thursday, May 5, 2016

Why the Blockchain should be familiar to you

From L2R: Michael Casey (MIT Media Lab), David Andolfatto (FRB SL),
Simon Johnson (MIT) and John Schindler (FSB)
I'm freshly returned from Consensus 2016: Making Blockchain Real where I participated in a panel on "Digital Cash for Central Bankers." Michael Casey did a stellar job in crafting the session. It was fun and informative to have Simon Johnson and John Schindler as co-panelists. As we didn't get booed off the stage, I think maybe the audience enjoyed what we had to say as well. (I left the session with almost a kilogram of business cards--odd that paper is still so widely used in this capacity. By the way, some of what I had to say can be found in my blog post here.)

Today's post is more about marketing the idea of blockchain. The word sounds intimidating to many people. That's probably because attempts to explain it often make use of a highly technical trade language that few people understand. My goal here is to think of ways to communicate the idea of blockchain in a manner that will make people feel like the concept is familiar to them. Indeed, I believe that the broad conceptual idea of blockchain should be familiar to us all.

Renowned Bitcoin expert Andreas Antonopoulos writes here:
It will take time for the idea of decentralized trust through computation to become a part of mainstream consciousness, and until then, the idea creates cognitive dissonance for those accustomed to centralized trust systems. With thousands of years of practical use, centralized systems of trust are accepted unconditionally and without much thought as the only model of trust.
It's an excellent article and I highly recommend you read it. What I want to do here is push back a little on the notion that decentralized trust systems should necessarily create cognitive dissonance. In particular, I should like to point out that we've had tens of thousands of years of experience with decentralized trust systems. Alright, so let's get started.

Consider the following scenario. You are attending a cocktail party with dozens of people present and you are asked by your hostess to deliver a short speech. Now suppose you utter something outrageous, e.g., "I think the Fed should buy the existing stock of bitcoin and store it as a foreign currency reserve!" The audience will stare at you, mouths agape (especially if you're a central banker, or a renowned Bitcoin enthusiast). You wake up the next day and regret your rash public remark. You wish you could take back what you said, but how? The only way this could be done is if you could somehow persuade the group to forget what you said. But just think about how difficult it would be to do that. Especially if the number of people in attendance was large.

What has just been demonstrated (I hope) is the power of a distributed database validated through a communal consensus algorithm. The database here is your silly statement above together with the time you made it (a timestamp). The information in this database is shared on a distributed network of brains (what you said and when you said it is imprinted forever in the memories of all who witnessed the event). The consensus algorithm here is "let's all agree to remember what was actually said (as opposed to some alternative, fabricated statement)."

A database in this form is extremely secure. It will survive intact even if some brains holding the database are destroyed. The database can be communicated to other brains (who can confirm the validity of the statement by seeing how it squares with the memories of others). If one or more people tried to fabricate an alternative history, the attempt would almost surely fail (we cannot rule out the possibility entirely, however). If your remark instead lived only as an electronic recording in a central databank, the task of re-writing history would be much easier.

Now imagine living in a primitive village. Relevant elements of the database would include observations like: [1] John had his wound tended to by Bob at date t, [2] John killed a wild pig and shared it with the village at date t-1, etc. The database in this case can be organized in a sequence of time-dated blocks X(t) = {x(t), x(t-1),...}, where x(t) is the database (block) at date t, and X(t) is the "blockchain." So, the blockchain is just a communal databank recording some relevant aspects of villagers' activities. In village economies, this communal memory typically exists in a virtual state (written records are a much more modern invention).

Notice how the blockchain described above could serve a very useful economic purpose. In particular, note that the act of consumption (medical services) in [1], John is effectively using [2] as currency. At least, this is how things work in what anthropologists describe as "gift-giving societies." And if you think about it for a while, you'll notice that the same principle is at work in the various groups you interact with on a daily basis (your friends, your family, coworkers, etc.). Much, quite possibly most, economic exchange occurs via such localized trust networks.

The problem with this ancient blockchain technology is that it doesn't scale very well. There's only so much data we can fit in our brains.  So as populations grew and as people started forming large communities, a new type of record-keeping system was needed. The model that came to dominate is one in which databases are collected and maintained by trusted third parties. Much effort is expended in keeping these private databases secure (not always successfully). It is often difficult for these agencies to communicate and reconcile their databases (as in when you try to send money from your bank account to your friend's foreign bank account overseas).

And so enter the "new" technology, blockchain. I hope I have convinced you what is new here is not the principle of the blockchain. The new technological developments are: [1] bigger brains (increased capacity for data storage and processing via computers); [2] better communications (the Internet); and [3] computer-based algorithms to serve as communal consensus mechanisms (e.g., proof-of-work).

These innovations will permit a revolution in the truest sense of the word: we are traveling back to where we began--but with planet earth as our village.

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PS. Please let me know if this was helpful or how it could be improved. After writing this post, I came across this short video: Blockchain for Dummies. Some of the comments are critical of it, but I thought it communicated the idea in a nice way.

Monday, May 2, 2016

On Cochrane's dream of equity-financing banking

John Cochrane has a dream where the banking sector is financed entirely with equity. The dream is premised on the notion that debt-financed endeavors--especially those using short-term debt--are prone to runs. Run-prone structures can cause, or contribute to, financial crises. The possibility of crisis invites government regulation. Government regulation leads to regulatory arbitrage, much of which occurs in the shadows of the financial market. Which leads to more (now harder-to-monitor activities), leading to ... well, you get the picture. Why not just structure a regulatory framework that permits equity-financed banking ventures, like SoFi, to weave their (run free) magic? It's a good question. I'm not sure what the answer is. But I wonder if it's all as easy and straightforward as Cochrane makes it out to be.

I don't want to nitpick here but, I don't think I'd classify SoFi as a "bank" in the legal or economic sense. True, SoFi is acting as a financial intermediary. But insurance companies and pension funds are also financial intermediaries, and we do not think of them as banks. SoFi is more like a venture capital fund. It sounds like it's doing a wonderful job matching savers to borrowers. But matching savers to borrowers is not (the main) business of banking. Even a simple bond market matches savers to borrowers. We do not need banks to do that.

So what do banks do? We can get a grasp of their business model by comparing the structure of their balance sheets to other financial intermediaries. In many respects, the asset side of these balance sheets looks broadly similar: they consist of cash reserves, bonds (government and corporate) and other securities. Retail banks also hold personal and small business loans, which they typically originate as a part of their business. The differences on the liability side of financial intermediaries are much more striking. Pension funds issue time-dependent liabilities. Insurance companies issue state-contingent liabilities. Banks issue demandable liabilities. In all three cases, one wouldn't be so far off in forming the impression that financial intermediaries are fundamentally just "asset-transformers" (they transform a set of assets into structured liability products that people find useful).

Banks, in other words, are in the business of supplying a particular structured liability product: the demand deposit liability (DDL). It is Cochrane's worst nightmare. That's because the DDL is a "fixed-value promise." Specifically, a DDL promises redemption at (or close to) par for cash. But it's even worse than this because the promise is to redeem on demand (rendering the DDL a form of short-term debt). Worse still, the banking system does not possess enough cash in reserve to honor these short-term obligations in the event that all DDLs are presented for redemption at once (this is what it means to be a fractional reserve banking system). And as if things could not get any worse, they actually do. These bank-created DDL products -- they're used widely as payment instruments. That's right, banks are in the business of creating money (out of their assets).

Before I go on, I want to say something about the manner in which "deposits" is used in discussions of banking. It is sometimes said that "banks take deposits." But what does this mean? Even a Las Vegas slot machine takes deposits (and issues a very unattractive state-contingent liability in exchange, I might add). Well, yes, I can make a deposit of cash at my local bank. And my employer "deposits" my paycheck in my bank account (in reality, just a debit-credit operation on a ledger). But this is probably not the best way to think about "deposits." I sometimes like to say that banks don't take deposits--they create deposit liabilities. Related to this notion, the banking system does not "lend out cash." The banking system funds its assets (including loan creation/acquisitions) by creating DDLs. (At the individual level, banks need to acquire cash to fund their operations only to the extent they want or need to meet some reserve requirement). Cash finds its way into circulation whenever the owners of DDLs exercise the redemption option embedded in the DDL contract. Alright, with this out of the way, let me continue.

It's not been easy to discover the fundamental economic (or social) rationale for banks (defined here as intermediaries that fund their assets, including their loans, through DDLs). Economists have struggled to understand debt, never mind demandable debt. Probably the best theory of bank debt we have is still the Diamond and Dybvig (1983) model. Like any model of debt, certain "financial market frictions" need to be present; else, the Modigliani-Miller theorem holds, in which case we should all be living in Cochrane's dream world (assuming no bad government fairy, of course).

The root frictions appear to be what economists label "private information" and "limited commitment." Among other things, limited commitment renders all sorts of assets, like our human capital, illiquid. In a frictionless world, there is no reason why I shouldn't be able to buy my Starbuck's latte by peeling off a slice of my house or my future earnings. It just doesn't work. That's what banks are for. They measure the value of my house, my future earnings, and they create DDLs that are backed by their assessed value of the collateral I have to offer. They would be performing an equivalent service by acting as licensing agents whose job is to verify the quality of the promises I issue (imagine an Andolfatto-IOU stamped as "BoA approved.") What's not entirely clear is why banks couldn't just get me the money I need by the way SoFi does--by first acquiring state-created money from willing lenders?

To put things another way, if banks are primarily in the business of payment services, why are they not limited to that business? Why are banks permitted to create money? (Why should banks help render my illiquid assets liquid?) Why not make banks hold 100% cash reserves? And then let the financial market handle matching lenders with borrowers, a la SoFi? This is the line taken by those who favor "narrow banking" proposals (see, e.g., Musgrave, 2014).

I have yet to digest all the arguments made by Musgrave and others. But they make enough sense to be taken seriously (so I plan to continue reading). I have a lot of questions. I am not bought into Cochrane's claim that equity is a run-proof security. The equity traded on junior exchanges, for example, does not appear run-proof (one can "run" to your stock broker and scream "sell, sell, sell!" just as easily as you can "run" to your bank to ask for your money). Moreover, there's a lot of evidence to suggest that equity makes lousy money. Gorton and Pennacchi, 1990 claim this is the case because equity is "informationally sensitive," and (senior tranches of) debt is not. Like it or not, most contracts are drawn up in nominal terms. In such a world, it would be terribly inconvenient, I think, to have floating NAV MMMF shares used as an exchange medium. People seem to like fixed-exchange rate systems (which is what DDLs are, after all).

What I would really like to see is how their claims stack up in a formal model. After all, the Diamond and Dybvig model does suggest the possibility of a trade-off. Maturity transformation enhances risk-sharing (when conventional markets are absent or too costly to operate), but potentially exposes the bank sector to self-fulfilling bank runs. A narrow banking regime kills risk-sharing but enhances financial stability. So in some jurisdictions, the switch to narrow banking might be worth making (although, there may be other ways to enhance the stability of fractional reserve banks, like central bank lender-of-last resort facilities, etc.).

I suspect that narrow banks might work relatively well in low-inflation environments, but possibly not so well in high-inflation regimes. The reason is because high inflation imposes a big tax on cash reserves (unless they pay interest, I guess). In such an environment, fractional reserve banks may be preferred as a way to escape the inflation tax by offering a higher rate of return on their DDLs. (Of course, it would be better to encourage a low-inflation regime, but that's not always possible).

So, these are just a few of the thoughts that came to mind after reading about Cochrane's dream. It's an interesting debate and I look forward to reading a lot more about it.

Sunday, May 1, 2016

Monetary policy implications of blockchain technology

As I'll be at Consensus 2016 event speaking in a session on "Digital Cash for Central Banks" (agenda available here), I thought this might be a good time to gather my thoughts on what central bankers should be thinking about as a new wave of financial innovation comes crashing on our shore. (Warning: the views I hold presently are subject to change. And, of course, my personal views do not necessarily represent the official views of any central bank anywhere!)

Before talking about policy, what is a "blockchain technology?" Like a lot of new terms that are bandied about, it means different things to different people. But for my purpose, I'm just going to think about it as a different way to keep account of information. The Bitcoin blockchain, for example, is a distributed public ledger that records the entire history of bitcoin transactions (the movement of BTC credits from account to account), where the ledger is updated, maintained, and kept secure by profit-seeking accountants (miners) who are incentivized through a clever algorithm to act in the interests of the Bitcoin community (their actions are also publicly observable so any shenanigans, should they occur, are likely to be short-lived.) There are many possible variations of this basic idea.
   
Now, it just so happens that money is just a type of ledger, as I explain here: Money and Payments, or How We Move Marbles. The notion of money as a record-keeping device goes back at least to Ostroy (1973). We worry about record-keeping systems because people are opportunistic and cannot be trusted. This is what Kiyotaki and Moore (2001) meant when they quipped that Evil is the Root of All Money. A well-designed record-keeping system constitutes a solution to a social problem (the existence of people willing and able to fabricate information for their private benefit at the expense of the community). Similarly, money should be viewed as a solution to a social problem.

Needless to say, none the solutions that have emerged over time have been perfect although, a Darwinian might claim that there is a time and a place for every species (see also: The Byrds). And now, as the technological environment evolves, a mutation threatens the prevailing order. What are the implications for monetary policy?

In what follows, when I speak of cryptocurrencies, I'll I focus on Bitcoin, first, because of its relative popularity, and second, because it's designed to compete directly with central bank money and payment systems. But what I have to say pertains more broadly to all innovations in this space. I'll also sometimes refer to the Fed but, of course, feel free to substitute in your favorite central bank.

1. Currency competition. To a domestic central bank, Bitcoin looks just like a foreign currency which, of course, it is (since its monetary policy is governed by an entity that is outside the domestic government's jurisdiction). Viewed from this perspective, Bitcoin presents central banks with an old and familiar threat: currency competition. Americans traveling abroad are familiar with the phenomenon--one is often presented an opportunity to exchange USD for local currency at unofficial exchange rates. People in these countries are often just trying to avoid a very high inflation tax. 

Annual Inflation Rate
The willingness and ability of domestics to substitute into a competing currency with a more stable value will put limits on the ability of a government to use the inflation tax as a revenue device. Governments sometimes go to great length to restrict the use of currency substitutes. The new threat poised by Bitcoin is that it's likely going to be much more difficult to enforce domestic currency controls. Anyone with a phone and access to the Internet will have access to an alternative digital bearer asset to use as an exchange medium. Bitcoin, or even just the threat of Bitcoin, will put much stricter limits on the amount of revenue governments can extract through the inflation tax. 

2. Maturity transformation using a foreign currency. While Bitcoin is unlikely to displace a major world currency any time soon, it's likely to play a prominent role in certain niches. I am reminded of the role the USD plays in some countries. An issue that arises in those jurisdictions is the creation of USD denominated bank deposit liabilities by foreign-based banks. Fractional reserve banking can be problematic in the best of times, but could you imagine U.S. banks offering loans denominated in BTC and, more importantly, redeemable on demand for BTC? This type of arrangement is not fantasy--it happens all the time in the so-called Eurodollar market and elsewhere. How should regulators respond to such an activity? How can a central bank act as a lender-of-last resort when, in a crisis, people are wanting their BTC bank deposits and not USD? What role, if any, might the treasury in these circumstances? Lender-of-last resort interventions are not limited to central banks, after all.

3. The safe asset phenomenon. A safe asset is not a risk-free asset--it's an asset that people flock to in times of crisis. (They are more accurately described as "flight-to-safety" assets.) In the 1970s, real estate was a safe asset, and investors ran away from the USD/UST (hence, inflation and high interest rates). In the late 2000s, the USD/UST was a safe asset (hence low inflation and low interest rates), and people ran away from real estate. The set of assets that investors perceive to be "safe" evidently varies over time. Could BTC be the next great safe asset? Maybe yes, maybe no. But monetary policy is all about formulating contingency plans. What if BTC denominated deposit liabilities are a significant source of financing, like CUF denominated mortgage loans in Hungary prior to European crisis? And what if BTC is regarded a safe asset in our next crisis, the way CUF is perceived to be in Europe? If this happened in the U.S., it would mean a large depreciation in the USD/BTC exchange rate, price inflation (measured in USD), price deflation (measured in BTC) and, of course, all of the other wonderful things that accompany financial crises. Except that the Fed would have no direct control over the supply of BTC (i.e., for the purpose of expanding its supply to accommodate the elevated demand for BTC, thereby alleviating the BTC deflation). To the extent that the UST is not a safe asset in this event, the Treasury's powers would also be greatly diminished. 

4. Securities exchange. The standard macroeconomic model typically assumes that securities are exchanged in frictionless financial markets, where trade is instantaneous and property rights are enforced at zero cost. Needless to say, this abstraction is ill-suited for the purpose of understanding monetary policy. Most bonds are thinly-traded on over-the-counter (OTC) markets and so, are highly illiquid. Even the most liquid of bonds, like the 10-year on-the-run U.S. treasury, is prone to unsettling "liquidity events" (e.g., Oct 15, 2015). Despite improvements over time, it can still take days to settle and clear securities transactions. This delay, along with other frictions, generates a huge demand for collateral, largely in the form of USTs to guard against counterparty risk. Improvements in securities exchange brought about by the application of blockchain (or other) technologies has the potential to release billions (or more) of dollars in collateral assets into the market place. The effect of this is likely to lower the liquidity premia on USTs, leading to higher interest rates. The implication for the treasury is obvious, but clearly any force that is likely to impinge on the structure of interest rates is also relevant for monetary policy.

5. Financial stability. There are some who claim that blockchain applications will one day render fractional reserve banking (or maturity transformation in general) obsolete. Maybe. But I am not so sure. One way this might happen is if every asset, our homes, our human capital, can be somehow transformed into perfectly liquid bearer instruments. This won't be happening any time soon. Proponents of blockchain technology point out that it has the potential to remove opacity in financial markets, something that would surely lead to a more stable financial system. However, it's worth pointing out that the leading economic theory of bank sector fragility, the Diamond and Dybvig model, does not rely on the existence of opacity in the financial market. In that model, the portfolios of banks are perfectly transparent. A bank run may nevertheless be triggered by the expectation of a mass redemption event, which subsequently becomes a self-fulfilling prophecy. It is also interesting to note that (in the same model) bank-runs can be eliminated if banks adopt a credible policy of suspending redemptions once they run out of cash (this commits the bank not to firesale assets to meet short-term debt obligations). The perception of perfect credibility is essential for the result and, needless to say, the degree of credibility needed here is frequently lacking. If the suspension clause could somehow be made to trigger automatically and mechanically--perhaps a smart contract could be employed--then depositors would never have an incentive to run a bank and the contract would never be exercised. Of course, this solution relies on the common knowledge assumption required in MAD (see footnote 1 below). I'm not sure what implications for policy this has, but it's fun to think about and, well, who knows where all this might lead. 

6. Central bank digital cash. The existing structure of money and payments (including central bank design) was built for the pre-Internet world. The world is now changed and we must deal with it. Among other things, there is no reason why, in principle, central banks could not offer online digital money accounts for the public. I'm thinking here of a basic utility account, a place to keep your money safe and pay bills. (Private banks could still compete by offering full service accounts). There is a sort of precedent for this: the U.S. Treasury, for example, offers online digital bond accounts. And while that system is not specifically designed to make payments, it could be (again, in principle). There are a number of advantages to consider. First, there would be no need for deposit insurance since the central bank accounts have no default risk (they can just print the money, after all). Second, cash managers at large corporations could simply park their money overnight at the central bank, rather than seek collateralized lending arrangements (repo) in the shadow banking sector. Third, the cost of maintaining the paper money supply can be eliminated. Fourth, it is easy to pay interest (possibly, negative) on digital money accounts, leaving central banks with an additional monetary policy tool. There is the issue of how such an arrangement may impact the funding of private banks. But such an object, if it was to exist, could I think, compete favorably with Bitcoin and other cryptocurrencies, assuming that monetary policy is conducted responsibly, of course. (I discuss a more radical form of central bank digital cash--one designed to compete more directly with Bitcoin--in this blogpost: Fedcoin.)

There are so many more things to discuss, but I think I'm at my limit for blog post length. If you have ideas to share, or papers to link to, please feel free to comment below. Thanks!

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Footnote 1: Naturally, one would never want anything to trigger a mutually-assured-destruction clause in a contract. And such an event would never occur, theoretically at least, if everyone is perfectly rational. Few people need to be convinced that this assumption is rather extreme. However, if the collective punishment cost is not too large (well, at least finite), then one might be able to live with the occasional "mistake" and subsequent punishment. I am reminded of the "contract" that governed Roman legions. Good behavior was rewarded (after 20 or so years of service) with land to retire on. While bad behavior in battle was easy to identify collectively, it was sometimes hard to identify individually (a legion consisted of thousands of men). To discipline group effort, a credible threat of group punishment is needed (Holmstrom 1982). Credibility (the ability to commit) seems to have posed no problem for the Romans (how they ever became Italians, I have no idea). A legion deemed to have performed in a cowardly manner was punished by having each soldier draw lots, with a 1 in 10 chance of winning the lottery. The "winners" were then summarily clubbed to death by their colleagues. (Incidentally, this is where we get the word decimation--to reduce in number by one-tenth.) The punishment was not carried out very often, suggesting that the credible threat of the punishment worked reasonably well.