Excessive public debt and financial repression

January 2, 2014

The central government debt ratio in the advanced economies has reached a 200-year high watermark. Other levels of government debt, unfunded pension and health care liabilities, and a huge external debt stocks add to scale and complexity of the problem. A historical analysis of Carmen Reinhart and Kenneth Rogoff suggests that developed countries, like emerging markets, are prone to taking recourse to aggressive financial repression and even debt restructuring.

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Concerns about bank assets’ risk weights

December 21, 2013

Hagendorff and Vallascas argue that the risk weights used to calculate banks’ capital adequacy fall significantly short of true portfolio risks. Capital arbitrage may have undermined Basel II capital regulation and could do the same for Basel III in the future.

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How fear of disaster affects financial markets

December 14, 2013

Fear of economic disasters, such as depressions, is more frequent than their actual occurrence. People tend to perceive a growing risk of disaster as they see economic conditions deteriorate. A new Federal Reserve paper illustrates that this pro-cyclicality of fears can trigger fluctuations in equity prices that go well beyond the actual changes in economic conditions, consistent with actual historical experience. Disaster fears also can make asset returns partly predictable.

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The importance of central bank collateral frameworks

December 11, 2013

A new ECB paper illustrates the power of a central bank’s collateral framework as a policy tool. The collateral framework influences overall monetary conditions, helps preserving financial stability, and functions even at the zero lower bound for policy rates. Liquidity regulation can be an important complement, since by themselves generous collateral buffers might invite moral hazard and encourage excessive reliance on short-term funding.

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How to reduce excessive public debt

November 25, 2013

An empirical IMF paper suggests that public debt reduction can support medium-term growth, if it is focused on cuts in non-investment spending. Such benign fiscal consolidation is less likely, however, when the private sector is credit constrained and fails to benefit from lower public borrowing, as has been the case after the 2008 financial crisis. In this case more balanced and gradual fiscal adjustment may be required to mitigate the negative growth effect.

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A brief history of monetary policy and asset price booms

November 20, 2013

A new NBER paper reminds us of historical episodes when loose monetary policy contributed to asset price booms and busts. The paper also provides econometric evidence that low policy rates usually support asset prices. This history may not dissuade central banks from running highly accommodative policies at present, but explains the importance of accompanying macro-prudential measures.

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Understanding the U.S. monetary policy framework

November 10, 2013

A new staff paper summarizes the Federal Reserve’s policy framework, as it evolved in the face of the zero lower bound for interest rates. The framework is predicated on the principles of excess stimulus, history dependence, economic conditionality, and credible communication. Its main tools are interest rate forward guidance and asset purchases. A higher inflation target or a nominal income level target is under discussion. The integration of monetary and macro-prudential policies has progressed.

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How easy G3 monetary policy spills over into East Asia

November 2, 2013

A recent BIS paper illustrates the consequences of highly accommodative monetary policy in the G3 for East Asia. These include lower policy rates than warranted by domestic conditions, lower bond yields and appreciation pressure on currencies. Importantly, easy G3 monetary conditions stimulate Asian foreign currency borrowing in many forms, including letters of credit, forward selling of foreign currencies and international bond issuance.

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Some stylized facts of FX liquidity

October 28, 2013

A paper of the University of St. Gallen shows that foreign exchange liquidity has been highly correlated across currency pairs, apparently more so than in equity markets. Liquidity correlation has been strongest in developed FX markets and particularly in volatile currency pairs. Bond and equity markets seem to have a bearing on systematic FX liquidity. Feedback loops between market illiquidity and funding constraints can escalate into fire sales. Riskier currency pairs, and particularly those related to carry trades, are more susceptible to liquidity shocks.

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A theory of safe asset shortage

October 21, 2013

Ricardo Caballero and Emmanuel Farhi from MIT and Harvard propose an interesting and relevant formal model of safe asset shortage. While safe asset supply is constrained by the fiscal capacity of sovereigns and financial innovation, demand may be in a secular ascent (driven for example by collateralization and population aging). The resulting shortfall can result in a structural drag on economic growth and impair the effectiveness of fiscal and monetary policies, with some resemblance to the Keynesian liquidity trap.

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