Knowing and Making

Models and Agents hints at the Fed increasing the interest rate it pays on banks' excess reserves. Is that a good idea? Given that banks seem to be building up those reserves instead of lending them out, paying more (or any) interest would just encourage them. Instead, I suggest a small tweak in the other direction. Charge banks a negative interest rate to hold their reserves - even as small as 0.1%. While rational calculation implies that the difference between 0 and -0.1 is virtually no difference at all, the real world doesn't necessarily work that way. Behavioural experiments clearly show a phenomenon called loss aversion  where people are asymmetric in their valuation of profits and losses. They will typically give up twice as much to prevent a £1 loss as they would to make a £1 profit. In this case, I would bet that loss aversion will kick in and encourage the banks to lend into the private sector instead of having their money drain away to the central bank. Even if ban...

I've had an article published today in VoxEU: Models of bounded rationality and the credit environment : Responses to the recession should not be based on unrealistic expectations of rational behaviour. We now know enough about real, flawed human psychology to be able to take some account of it in policy setting. Mark Thoma has linked to it and there are some interesting responses in the comments to his posting.

Roger Farmer has taken up my suggestion that central banks should make equity investments . OK, chances are he didn't get it from me - but his proposal is somewhat similar to mine. I explain my suggestion in more detail below. Farmer's article has provoked much comment on economics blogs – as befits an unorthodox proposal. Although there are understandable objections to it, it is at heart a sound idea. Most of the responses which argue against the idea use one of two grounds. First, that equity price targeting is not the government’s job. Second, that market indices are not a good way to pick the equities to be purchased (Farmer’s suggestion of the S&P 500 index would privilege those 500 companies at the expense of smaller firms outside the index). For these reasons I would also argue against the proposal in the form that Farmer makes it, but recognise the fundamental reasoning behind it. With a slightly different emphasis, the logic becomes much more compelling. The reaso...

" The crisis is caused by excessive debt " " You can't borrow your way to prosperity " (video) " We need a recession to clean up the rot " " We have borrowed prosperity from our grandchildren - transferring consumption through time" Economic illiteracy , all of it. We can only consume today what we can produce today. Was your iPod made in a factory built in 2016? Monetary transfers (i.e. debt) cannot create new goods or services. You cannot transfer consumption from the future. But it is a common fallacy to think you can. There are three kernels of truth in this viewpoint, and some of them give us a clue to the real answer: Individuals can transfer consumption from the future to the present by borrowing money from other individuals. But there is an entry on the other side of this ledger - the lender is transferring their own consumption from present to future. The net effect on the whole system is nil. Countries can do the same - if America...

So Jaguar might be "rescued" by the UK government. Robert Peston gives a summary of some of the arguments. Even more quickly, here they are: The company is not able to refinance its loans, but is still fundamentally a good business 15,000 people are employed by Jaguar and up to 60,000 second-order jobs are dependent on it It is one of the remaining UK-based manufacturers with substantial ongoing R&D But: It is owned by Tata, the (profitable) Indian multinational There's a risk of moral hazard - if Tata can get finance for its UK operations like this, why wouldn't other companies do it and use their scarce private funds elsewhere? There is no doubt that Peter Mandelson is aware of these arguments - he makes it pretty clear in the interview with Robert Peston. What other criteria or safeguards might he use to make sure that public money is genuinely providing a public good which would not be financed by the private sector; and that it gets a positive return? Sugge...

Alistair Darling has announced £4bn in money from the European Investment Bank to help small firms access credit over the next four years. I wrote a few weeks ago about the economic justifications for this and those comments still stand. However, I'm surprised - and impressed - with how fast the government has moved. The money is apparently already available, through Barclays. Barclays of course is one of the banks which did not require public capital earlier this month and so, arguably, was not subject to the condition of making funds available at 2007 levels - though it has strengthened its balance sheet with additional private equity. Even before this announcement Barclays has certainly been making some credit available over the last couple of months without unusually onerous conditions. So if anything this could be a better than usual time for creditworthy businesses to raise funds. Not what you would expect given the headlines in the financial press. Could this be, paradoxic...

In 2000, the IMF added up the reported trade balances for every country in the world and discovered that total world imports were $172 billion greater than total exports. Discounting the prospect that aliens are using their unfair price advantage (presumably they are not subject to payroll taxes) to steal our jobs, the idea that the world as a whole could run a trade deficit is of course absurd. However, the idea is resurfacing in much recent comment about the world financial crisis. Even the excellent Martin Wolf is talking about "a growing crisis of insolvency" and this is becoming a common theme: we thought we had an illiquidity problem, but now we find it's an insolvency problem. Well, it's not. Insolvency is the inability to pay debts as they fall due. The total amount of debt in the world is zero - every debt is owed by one party to another party, in equal amounts. Just like the total trade balance of the world is zero, the world does not have any debt and there...

"Finance is the web of intermediation binding economic agents to one another, across both space and time." Martin Wolf in his FT column on 30th September . It's interesting to consider how bankruptcies or insolvency of financial players can cause a recession. After all, a debt has two sides - and if it is uncollectable, the money hasn't disappeared - it's just been transferred to one party at the expense of another. If Lehman Brothers goes bust because it can't collect $40bn of debts, then presumably the debtors (or their employees, or suppliers, or the people they bought their houses from) have gained $40bn; Lehman shareholders have lost $10bn and Lehman creditors have lost $30bn. At first glance, the economy is no worse off. Indeed even the creditors aren't as distraught as they appear, because some of them now have a claim to pursue against the lucky debtors. And that's true, insofar as money is an asset in itself. The total amount of money in the e...

A suggestion for Barack Obama's team: if John McCain doesn't show up for the debate this evening , why not get Warren Buffett onstage with Obama to explain the crisis and talk through pragmatic solutions for it? I'm sure he can take the evening off from sorting out Goldman Sachs. Virtually nobody is trusted more by the public on these matters than Buffett, and he's already endorsed and advised Obama during the campaign. It might be pretty good for Obama's image as a safe pair of hands.

From the FT today : "Towards the end of the week several rivals said they had dropped internal restrictions on approaching Morgan Stanley clients when it became clear how much potential custom was available." Why on earth do investment banks have "internal restrictions" on approaching each other's clients? I appreciate that they would end up spending lots of time chasing new leads and winning new clients only to lose existing business to the other banks who start poaching their clients. They would probably end up reducing fees and increasing sales budgets without expanding the market much, just pinching share from each other. Maybe not an ideal result for the banks. But in any other industry that's called a cartel. Why should investment banks be exempt from competition law? If the public is taking the opportunity to get some reforms in return for its $700bn, this could be one to throw in. p.s. As usual, Martin Wolf's take on the issue is pretty sound.