Alternative Currencies for Effective Monetary Policy

I recently wrote about alternate currencies as a solution to the financial crisis, specifically to the ineffectiveness of monetary policy at the zero interest rate bound. Well it looks like Greg Mankiw (independently) agrees with me which is quite exciting. When currencies loose value over time the Fed could lower its rate to less than zero (e.g. you give me $100 today, I’ll give you $98 in a year) and still find people who would be willing to lend at those terms:

Reduce the return to holding money below zero. Imagine that the Fed were to announce that, one year from today, it would pick a digit from 0 to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

It definitely is an unorthodox solution that would be difficult to implement in practice but it’s also novel and interesting and it helps us understand why certain solutions work and others don’t:

I understand that this plan is not entirely practical. But you have to give the student credit for thinking out of the box. And his plan does address a fundamental problem facing the economy right now: Given the fall in wealth, increases in risk premiums, and problems in the banking system, the interest rate consistent with full employment might well be negative.

One key challenge to coming up with good solutions to problems is understanding why things are the way they currently are and what an ideal solution would have to accomplish. Coming up with good ideas that don’t quite cut it is an excellent learning process for getting closer to the optimal solution.

Update: The Economist talks about Switzerland charging foreigners a fee to keep their money there in the 1970s – effectively imposing a negative interest rate (this would have to be a percentage of the assets kept there instead of a lump sum).

Incredible Shortsightedness

The US economy is reeling and we are all worried, many of us have lost their jobs or know several people who have. There are good economic arguments for trying to keep as much as possible of the economic stimulus inside the country (to maximize the impact of each dollar spent) while avoiding new protectionism that might spark a trade war. With all of us so focused on the domestic economy it is easy to forget that things are also happening in the rest of the world and that they aren’t that different from what we are going through here (and many of the problems like speculative investment in Eastern Europe are not at all the US fault).

However, if the current crisis has taught us anything, it is that nations are interlinked. The economic decoupling was a myth and the economic crisis is hurting everyone and endangering many US foreign policy priorities, including the recovery of Iraq. Because of this I was extremely shocked to see the following shortsightedness from Richard Posner:

I think the big foundations, such as the Gates foundation (the biggest), should be strongly urged to redirect their extensive foreign charity to the United States at this time of depression. I am not suggesting that his projects should “Buy American,” in the sense of buying U.S. products to give to foreign recipients of his charities. The point is rather that charity should begin at home when home is suffering.

I agree that in these tough times all of us who have steady incomes should help less fortunate ones by donating more to local charities. But taking away funding from the developing world would both be immoral and counter productive. These countries are already suffering immensely from a crisis that they did not create, the World Bank’s Chief Economist for Africa expects up to 700,000 additional infant deaths in Africa because of the crisis and an increase in conflict and decrease in governance quality. Ted Miguel and Ray Fisman have shown how economic shocks greatly increase the likelihood of civil wars and the same is true for a rapid fall in natural resource prices. Offering aid and then withdrawing it can be much worse than not giving anything in the first place. This decade has taught us that failing states, from Afghanistan, to Pakistan, to Somalia are real security problems, not just for their neighbors but also for the West.

If the Gates Foundation and others like it suddenly stopped funding projects in developing countries countless projects that have come to depend on their funds (many of which were started because of it) would have to shut down and it would take a long time for them to recover once the money becomes available again. The cutting of funds would worsen the impact of the crisis in affected countries, increase the time it will take for the global economy to recover, endanger long term research into tropical diseases, and produce a (potentially protectionist) backlash against the United States that we really don’t need right now.

This crisis and the way we get out of it is a chance for the US to show its leadership and creativity in the face of tough problems and together we can achieve that. If you as an individual want to help those less fortunate than you consider making a loan on Kiva or donating to a US charity.

Update: As Lauren pointed out in the comments you can also contribute by spending your time solving important problems and make a career out of making the world a better place.

Update 2: Richard Posner wrote another post supporting the elimination of tax deductions for charitable donations to foreign countries while Gary Becker (on the same blog) had a more nuanced opinion. Posner also maintains that we should regulate such giving which as an entrepreneur leaves me just flabbergasted. Many innovative non-profits started by young upstarts with great ideas such as Kiva, Forge, Face Aids, and Unite for Sight would never have been started under this plan and the world would be worse off for it. Let’s foster entrepreneurship in all sectors of the economy, not limit it without good reason.

Adhoc Rescues, Global Coordination, and the Superclass

I just finished Superclass and while it initially sounded like exactly the kind of book I don’t like to read, after hearing Rothkopf in person and seeing Chris Blattman recommend it (in a hilarious post titled ‘Midway Down the Intellectual Food Chain) I decided to get the audio book. It was definitely entertaining and pretty interesting at times but definitely not a must-read. I was, however, struck by a conversation Rothkopf  had with Timothy Geithner (remember him?) on how he helped resolve a crisis in the derivatives market (the book doesn’t give any further information) that I think really captures the way many complicated (and extremely urgent) problems are addressed in our increasingly complex world:

What we did is, we got the fourteen major firms in a room down the hall here with their primary supervisors [..] and we said to them “You guys have got to fix this problem, tell us how you are going to fix it and we will work out some basic regime to work out there are no free riders to give you comfort so you know that if you move individually, everybody else will move with you” and there is nothing written, no guidance, no regulation, no formal process, [...]

These fourteen firms he continued, accounted for something like 90% of the all the activity in this market. The Fed, the SEC, the FSA, the Swiss and the Germans were there, and hose were the principals, each firm brought three people, they had an executive committee of four firms that had almost weekly a conference call among the four firms. And the best thing about the process was that it was efficient, there was nothing written except letters from the firm laying out their commitments, there’s no formal mechanism we could have used to force this on anybody so we had to invent it.

You have to have a borderless collaborative process, it does not mean it has to be universal every jurisdiction or every institution it just needs a critical mass of the right players it is a much more concentrated world, if you focus on the limited number of the ten to twenty large institutions that have some global reach, then you can do a lot.

Geithner is right, the world is becoming increasingly international but there are very few effective (and quick acting) international governing bodies and these adhoc meetings work very well. You don’t need to be a believer in World Government to realize that closer international coordination on finance and the economy (if nothing else) will be important in the future. The problem with doing things on an adhoc basis by getting the most powerful people and organizations in one room is that the concerns of the wider populace will be underrepresented (or not represented at all). The hurried actions of the US Treasury and Federal Reserve during the failure/bailout of Bear Stearns, AIG, and Lehman Brothers showed that personal contacts and informal meetings can help ensure quick action in an unforeseen crisis but they also show the dangers and resulting unfairness of the outcomes reached in such meetings. In the years ahead we will have to figure out how to build more effective coordinating (and potentially regulating) bodies on both the national and international scale. That should be a fun challenge.

The Extent of the Crisis

From the Economist:

In Germany December’s machine-tool orders were 40% lower than a year earlier. Half of China’s 9,000 or so toy exporters have gone bust. Taiwan’s shipments of notebook computers fell by a third in the month of January. The number of cars being assembled in America was 60% below January 2008.

Yes these numbers are among the extremes and other industries aren’t faring quite as badly but the core point is that this is an international crisis and it will have serious impact everywhere – goodbye to fantasies of decoupling. A Fistful of Euros has had excellent coverage of how the crisis is affecting European and other countries, things are looking bad in Russia, Ukraine, Japan, Ireland, Latvia, and pretty much everywhere else.

A quick note on monetary policy

In yesterday’s post on why I am seriously starting to worry about the US economy and our plans for fixing it I said that monetary policy had with some exceptions run out of power. I want to elaborate a little bit on what I meant by this after stumbling upon two succinct paragraphs that give an overview of the problem in this post by Edward Hugh. First,  the problem:

Keynes argued that monetary policy ran the risk of becoming impotent in stimulating demand and raising spending since interest rates were already at their lowest possible level. Essentially he argued that increasing the monetary base by buying short-term government bonds is irrelevant at zero interest rates since money and short-term government bonds become effectively perfect substitutes.

As I said in my last post, however, there are still some things that can be done and while the Fed cannot lower short term interest rates any further it can still influence long term interest rates:

This (monetary policy impotence) argument has been challenged to some extent of late, most notably by Ben Bernanke, who argues that while the central bank may lose policy leverage over short term interest rates, by buying longer term instruments (10 or 30 year bonds) the bank may influence rates further up the yield curve.

This basically means that while short term interest rates have effectively reached zero the Federal Reserve can buy longer term bonds and thereby lower the interest rates on those, and incentivizing banks to shift their money to loan on which they can earn higher yields. This is extremely similar to what is generally known as Quantitive Easing (and unneccessarily complicated sounding term for a relatively simple concept).

Unfortunately even this won’t help too much in the situation that we are currently faced with since it does not address the underlying problem but it is something that other central banks such as the ECB should keep in mind. Some other possible actions a central bank could take are explained in this paper by Gauti Eggertson of the IMF that I have just started reading.