Mostly Economics

Sweden central bank has changed the name of Repo rate to Riksbank policy rate:

The reason for the change is primarily that the old name, “repo rate”, has become misleading. This name refers to a specific instrument, monetary policy repos, which the Riksbank has not used since 2008.

With the change of name to the Riksbank’s policy rate, the interest rate will have a more appropriate name. The function and purpose of the interest rate, to steer the overnight rate and to influence other interest rates in the economy in order to achieve the inflation target, remains unchanged.

The change of name applies from today, Wednesday, 8 June 2022.

In connection with this, the two changes are also being implemented to the Riksbank’s monetary policy operational framework, as decided by the Executive Board on 22 March 2022. These changes mean that collateral requirements for loans in the Riksbank’s standing lending facility are being tightened and that a supplementary liquidity facility is being set up.

What is in a name?

David Glasner in this blogpost pays tribute to Axel Leijonhufvud:

For many baby boomers like me growing up in Los Angeles, UCLA was an almost inevitable choice for college. As an incoming freshman, I was undecided whether to major in political science or economics. PoliSci 1 didn’t impress me, but Econ 1 did. More than my Econ 1 professor, it was the assigned textbook, University Economics, 1st edition, by Alchian and Allen that impressed me. That’s how my career in economics started.

After taking introductory micro and macro as a freshman, I started the intermediate theory sequence of micro (utility and cost theory, econ 101a), (general equilibrium theory, 101b), and (macro theory, 102) as a sophomore. It was in the winter 1968 quarter that I encountered Axel Leijonhufvud. This was about a year before his famous book – his doctoral dissertation – Keynesian Economics and the Economics of Keynes was published in the fall of 1968 to instant acclaim.

Although it must have been known in the department that the book, which he’d been working on for several years, would soon appear, I doubt that its remarkable impact on the economics profession could have been anticipated, turning Axel almost overnight from an obscure untenured assistant professor into a tenured professor at one of the top economics departments in the world and a kind of academic rock star widely sought after to lecture and appear at conferences around the globe.

I offer the following scattered recollections of him, drawn from memories at least a half-century old, to those who interested in his writings, and some reflections on his rise to the top of the profession, followed by a gradual loss of influence as theoretical marcroeconomics, fell under the influence of Robert Lucas and the rational-expectations movement in its various forms (New Classical, Real Business-Cycle, New-Keynesian).

Axel, then in his early to mid-thirties, was an imposing figure, very tall and gaunt with a short beard and a shock of wavy blondish hair, but his attire reflecting the lowly position he then occupied in the academic hierarchy. He spoke perfect English with a distinct Swedish lilt, frequently leavening his lectures and responses to students’ questions with wry and witty comments and asides.  

This BIS paper (by Sirio Aramonte, Sebastian Doerr, Wenqian Huang and Andreas Schrimpf) compares DeFi lending with traditional bank lending.

A core function of the financial sector is to channel savings towards productive investment opportunities. Traditionally, uninformed savers deposit their money with banks to earn interest; banks, in turn, lend out the funds to borrowers, including firms and households. Crucially, as lenders, banks screen borrowers to assess their creditworthiness, thereby ensuring that scarce capital is allocated to its best uses. In screening,
banks combine hard information, such as borrowers’ credit scores, income or educational background, with soft information often acquired through the broader relationship with the borrower.

Seen in this light, the history of financial intermediation is a quest for improving information processing. Indeed, a major purpose of institutions in the lending sector is to collect, distil and transmit information (Holmström and Tirole (1997)). For borrowers that are difficult to screen, lenders may require collateral to secure the loan, thereby mitigating information asymmetry and aligning incentives. For example, entrepreneurs often have to pledge their home equity when applying for a loan. In case of default, lenders can seize the collateral and sell it to recoup losses. For centuries, collateral has played a pervasive role in lending, with the Temple of Apollo in ancient Rome reportedly already issuing loans backed by real estate (Temin (2012)).

DeFi lending platforms also bring together savers and prospective borrowers, but without a central intermediary such as a bank. Activity takes place on platforms – or collections of smart contracts – that administer loans following pre-specified rules. On one side are individual depositors (also known as lenders), who deposit (or “stake”) their cryptoassets into so-called liquidity pools, earning a deposit rate. On the other side are the borrowers, who receive cryptoassets and pay a borrowing rate. The two rates vary by cryptoasset and are determined by the demand for loans and the size of the liquidity pool, which represents the supply of funds. For their services, platforms usually charge fees paid by the borrower. As the process is automated, loan disbursement is nearly instantaneous and associated costs are modest.

Traditional banks rely on information whereas DeFi relies on collaterals:

A key difference between lending in DeFi and in traditional finance is the limited ability to screen borrowers. The identity of borrowers and lenders is hidden behind cryptographic digital signatures. Lenders thus cannot access information such as borrowers’ credit scores or income statements.

As a consequence, DeFi platforms rely on collateral to align the incentives of borrowers and lenders. Only assets recorded on blockchains can be borrowed or pledged, making the system largely selfreferential. The typical DeFi loan is disburse in stablecoins, while the collateral consists of riskier unbacked cryptoasset (IMF (2022)). Smart contracts assign each collateral type a haircut, or margin, that determines the minimum collateral borrowers must pledge to receive a loan of a given amount. The high price volatility of cryptoassets means that there is overcollateralisation: the collateral required tends to be much higher than the loan size. Minimum collateralisation rates typically range between 120% and 150% on major lending platforms (Graph 2, left-hand panel), and depend on the expected price appreciation and volatility of the cryptoassets serving as collateral (centre panel). As DeFi loans are disbursed in cryptoassets and secured by crypto collateral, they do not currently finance real economy activities. 

Hmm..Very interesting and lots of ideas in this short paper…

Sitikantha Pattanaik, Binod B. Bhoi and Harendra Kumar Behera in this RBI article analyse whether the growth in RBI balance sheet during the pandemic led to inflation today:

The global surge in inflation since the second half of 2021 has reignited interest in assessing the role of post-pandemic balance sheet policies of central banks in fuelling inflation, against the backdrop of the missing inflation puzzle that was encountered after the global financial crisis (GFC). This article explains the link between RBI’s balance sheet size, growth in monetary aggregates and inflation, and explores conditions under which excess money growth may not be inflationary. It finds that in the post-COVID period, the decline in income velocity of money and persistent negative output-gap warranted a larger than usual growth in monetary aggregates, without endangering the inflation outlook.

RBI’s Bulletin (Jun-2022) has several interesting research articles.

Michael Debabrata Patra, Joice John, Krishna Mohan Kushwaha and Indranil Bhattacharyya discuss whether yield curve tells us anything about Indian economy. Typically when yield curve is inverted meaning short term interest rates are higher than long term interest rates, one expects a recession.

So what does the yield curve say about Indian economy:

The government securities yield curve is widely regarded as a valuable predictor of future macroeconomic developments. Following the dynamic latent factor approach suitably modified to fit Indian conditions, this article uses a state space yield-macro model to show that in contrast to advanced economies, it is the level and curvature of the yield curve rather than its slope that contain useful information on market expectations about economic prospects and inflation expectations.

Highlights:

• • The government securities yield curve contains important clues on the likely behaviour of the economy.
  • The slope of the yield curve steepened with the onset of pandemic-related policy easing which has reversed in the recent policy tightening phase.
  • The curvature increased sharply during the pandemic-related easing and after the Union Budget announcement of a large market borrowing programme for 2021-22 till the announcement of G-SAP in April 2021.
  • The yield curve is indicating an improvement in long-term growth prospects and an upshift in ex ante inflation expectations. At the same time, the fact that the yield curve has become steeper and concave reconfirms expectations of tighter monetary policy in the period ahead.

Curvature is defined as 2*10 year yield – (3 months yield + 30 years yield).

RBI should also release data/code of the analysis.

Prof Rohit Azad of JNU in this HT article interlinks rising inflation to class conflict, as discussed by Polish economist Michal Kalecki.

TIm Sablik of Richmond Fed in this article looks at the question of whether dollar dominance will continue:

While there may not be a single obvious replacement for the dollar, that doesn’t mean that countries haven’t been diversifying into other currencies. The dollar’s share of global foreign exchange reserves fell to a 25-year low at the end of 2020, to 59 percent from 71 percent in 1999.

Serkan Arslanalp and Chima Simpson-Bell of the IMF and Barry Eichengreen of the University of California, Berkeley, referred to this development in a recent IMF working paper as “the stealth erosion of dollar dominance.” The dollar isn’t being replaced on bank balance sheets by another single currency like the euro or renminbi, they found. Rather, most of the shift away from dollars has been into dozens of smaller currencies. They cited a greater desire for portfolio diversification on the part of central banks as well as the falling cost of transacting in smaller currencies as factors that have contributed to this change. This has led some economists to speculate that we could be heading toward a “multipolar” world of many different competing currencies, which could have some advantages.

“Just like biodiversity makes for a more robust global ecology, a multipolar system will be more robust,” says Eichengreen. “In addition, an expanding global economy needs additional international liquidity to grease the wheels of globalization, and the U.S. can’t provide the requisite safe and liquid assets all by itself.”

New Triffin dilemma:

Indeed, many economists point to a new kind of Triffin dilemma as a greater risk to dollar supremacy than the use of sanctions. Just as the United States faced a crisis of confidence in its ability to back the dollars in circulation during the Bretton Woods era, economists have warned that it could face a similar challenge in the coming years to supply enough safe assets to meet global demand while simultaneously maintaining confidence in its ability to repay its debts. Having more options for safe assets to choose from in the form of different currencies could solve this problem, but not all economists agree that a multipolar system would necessarily be more stable. Competition among countries to grab the reserve currency crown could lead to coordination challenges and questions about which assets are truly safe.

Moreover, the transition from the dollar regime to its successor could be unstable. “One historical precedent is the coexistence of dollar and sterling during the interwar years,” the late Harvard University macroeconomist Emmanuel Farhi told Econ Focus in a 2019 interview. “It’s not a particularly happy precedent; it was a period of monetary instability. You saw frequent rebalancing of international portfolios into one reserve currency and out of another, which created a lot of volatility.”

History teaches that dominant currencies change infrequently and often over long transition periods. But crises can be the catalyst for those transitions, as was the case when the British pound’s centuries-long reign started to unravel after World War I. While almost no economist predicts that the dollar will be replaced soon, market confidence is fickle, and the types of crises that spark a changing of the reserve currency guard are inherently hard to predict.

Isabel Schnabel of the ECB in this speech discusses the major challenge for monetary policy in a monetary union is to remain united in diversity:

One illustrative symbol of this unity in diversity are our euro coins, with the map of Europe on one side and a country-specific symbol on the other. The euro unites us.

Yet, diversity also brings about challenges – and that is what I will talk about today.

The euro area consists of 19 – soon 20 – different countries, each with its own economic structure, societal governance and fiscal policy. The natural consequence is that shocks that hit the euro area, be it a financial crisis, a pandemic or a war, affect each euro area country differently.

Today’s inflation is a case in point. Harmonised consumer price inflation in the euro area as a whole is at a record high, reaching 8.1% in May according to the most recent flash estimate. But there are large and unprecedented differences across countries (Slide 2). In Estonia, for example, inflation stood at 20% in May, while it was less than 6% in Malta and France.

How countries produce and use energy accounts for a large part of these differences. But energy is only part of the story. The war, like the pandemic, has had differential effects on consumption, investment and fiscal policy, and hence on underlying price pressures.

The pandemic was a stark reminder that such differences can seriously impede the conduct of monetary policy. In the spring of 2020, concerns about some countries’ perceived lack of fiscal space to deal with the pandemic led to a sharp divergence of financing conditions across euro area economies, thereby severely disrupting the transmission of monetary policy.

I will argue that the vulnerability to such fragmentation risks will only disappear with fundamental changes to the euro area’s institutional architecture. Therefore, monetary policy needs, at times, to respond to market developments that undermine the smooth transmission of monetary policy.

That said, the progress we have made over the past years in strengthening the resilience of the currency union, on both the fiscal and the monetary side, has helped to reduce the likelihood that disruptive and self-fulfilling price spirals in government bond markets threaten the cohesion of the single currency.

Pamela Pogliani, Goetz von Peter and Philip Wooldridge in this BIS research discuss role of financial centres:

Financial centres that cater predominantly to non-residents account for an outsize share of cross-border financial activity. These so-called cross-border financial centres are typically located in small economies, in contrast to global financial centres located in large economies. Economies of scale and scope benefit global centres, but physical distance works against the tendency of financial activity to concentrate. So do regulation and taxation, which have set cross-border financial centres apart and propelled their rise. At the same time, these centres pose challenges to regulatory consistency across countries and complicate the analysis of capital flows. 

Edward Nelson in this Federal Reserve working paper looks at the causes of inflation in the 1970s:

The pickup in the U.S. inflation rate to its highest rates in forty years has led to renewed attention being given to the Great Inflation of the 1970s. This paper asks with regard to the Great Inflation: “How did it happen?”

The answer offered is the fact that, in both the United Kingdom and the United States, monetary policy and other policy instruments were guided by a faulty doctrine—a nonmonetary view of inflation that perceived the concerted restraint of aggregate demand as both ineffective and unnecessary for inflation control.

In the paper’s analysis, the difference in the economic policy doctrine in the 1970s from that prevailing in more recent decades is represented algebraically, with this representation backed up by documentation of policymakers’ views.

A key conclusion implied by the analysis is that the fact that a nonmonetary perspective on inflation is no longer prevalent in policy circles provides grounds for believing that monetary policy in the modern era is well positioned to prevent the recurrence of entrenched high inflation rates of the kind seen in the 1970s.