The Behavioural Impossibility Theorem

It’s been a few years since I’ve posted here but here goes…

Many non-economists (and economists alike) seem to think that behavioural economics is the new and important big thing in economics. I’m writing this blog post for myself as a quick reference I can send to people on why I think behavioural economics is fundamentally limited, but it might be interesting to others. The fundamental limitation I will describe is what I call `The Behavioural Impossibility Theorem’. David K. Levine has a great and accessible discussion here too.

The Impossibility Theorem of Behavioural Economics is the simple insight that a behavioural theory of beliefs cannot simultaneously be believed and true. Or, more strictly, a behavioural economic theory cannot be acted upon and be true. The only theories that can be both acted upon and true at the same time are those that satisfy rational expectations (RE).

Why is this the case? Consider an example of forecasting a stock-market crash. Suppose there were a theory that could accurately predict that the stock market was mis-priced and that there would be a crash in a week. This theory can only be true if it is not widely believed or acted upon. If it were believed, then everyone would short the stock market and asset prices would fall today rather than in a week. Thus the theory now becomes false.

Such a theory would be predicated on a systematic flaw in agents’ reasoning. When agents correct the reasoning by adopting the theory they then disprove the theory they now believe. By contrast, in a rational expectations theory, agents necessarily reason as best they can. They do not have perfect foresight or anything like that, but rather, they agree on on an underlying probability distribution for events which is optimal. In this world, the only possible shocks to the stock market that can occur are those which are essentially unpredictable (or predictable only at great cost of things like information acquisition or skill).

Mathematically this idea can be described as follows (ignore this italic text if you don’t want the math). Consider a mathematical space, X, where theories describing the world are objects of the space and agents’ beliefs are functions on the space, f. Since the economy is composed of peoples’ actions following their beliefs, the belief functions map to real world outcomes, Y, i.e

f:X \to Y.

In particular, f is a bijection from beliefs, X, to outcomes, Y. Formally you might have to appropriately condense the belief space into equivalence classes blah blah but that’s by-the-by. Since the bijection exists, beliefs and outcomes can be considered isomorphic spaces, so X=Y. In this space, behavioural theories are never fixed points i.e f(a) \neq a \in X. Only rational expectations theories are fixed points, i.e f(a^*)=a^*. Fixed points are the theories which can be both true and believed.

This is why I, and many others, think that RE theories are the most beautiful and likely to endure. They embrace the intrinsic randomness of human civilization. Much commentary focuses on Economists’ inability to forecast the financial crisis of 2008, but that’s the whole point! If Economists could forecast such a thing then it would signal a much deeper disfunction in our economy and our theories. Rational expectations is the truest embrace of randomness. It is our abyss in which to float, as Professor Mark Fabian would perhaps phrase it.

Note that Rational Expectations is also not efficiency. Perhaps the stock market is mis-priced, and that everyone knows it is but that there are short-sale constraints.* Then the stock market is mispriced, everyone knows that, but the mispricing persists for a while due to frictions. This is why economists like frictional explanations for things (including informational frictions).

David K. Levine nicely analogises economists’ RE theory to the Heisenberg uncertainty principle in physics. The Heisenberg uncertainty principle arises because the physicists’ very act of measuring a quantum system disturbs the quantum system in an unpredictable way. The same thing happens to economists. The act of generating a theory which is acted upon changes people’s behaviour and potentially disturbs the theory. Luckily, economists have Rational Expectations where physicists don’t!

*Actually, short-sale constraints cannot keep the price elevated in a world of pure RE, so the example is technically wrong (you need belief dispersion). I think the example is instructive nonetheless so I’ll keep it.

The Strength of Strong Form

The Efficient-market hypothesis, developed by Eugene Fama, is probably one of the most contested topics in the history of financial economics. Both on an empiric and theoretical basis economists, traders and media pundits often claim to have the truth that either supports or undermines the observations of Fama dating back to the 1960s. The EMH states that asset market prices reflect all available information and hence obey a ‘random walk’ on a ‘fat-tailed’ distribution.

But when financial economists say ‘reflect all available information’ what exactly do they mean? There are 3 possible interpretations:

Weak form- traded assets reflect all past public information.
Semi-strong form- traded assets reflect all past information but also adjust instantaneously to reflect all present public information.
Strong form- traded assets, in addition to having the properties of semi-strong form also reflect current and past ‘insider information’.
To most people, if one of the above forms is the most plausible it is either the weak or the semi-strong. By my intuition at least, it seems implausible that markets are able to completely price information that cannot even be acted on by most agents. Eugene Fama himself describes access to information on a continuum, where at first the cost is quite flat before quickly skewing off to infinity as more information is obtained on the margin. Hence, by his own admissions it may seem that ‘insider information’ is too costly to attain for most agents.

Nevertheless, Fama and others in favour of the EMH insist that more statistical evidence was found in favour of the strong strand of EMH than for the weaker forms. How can this be? I am by no means well-trained enough to devour the reams of statistical evidence on both sides of the debate and hence will refrain from offering a general opinion on whether the EMH is inherently flawed or a beautiful prophecy; but I will attempt to explain how the Strong-Form of the EMH has more going for it than is commonly assumed. In fact, it seems that Strong-Form is to be expected from some classic financial economics theorems which expose the vulnerabilities of using ‘economic intuitions’ alone. Contrary to popular belief, in this vein a “strong-form” of the EMH is probably more consistent with highly volatile markets than the weaker versions.

The clue to understanding why the ‘strong-form’ may be empirically sound comes from an unlikely source. Nothing really needs to be said about investors obtaining fundamental information for themselves. Rather, it has something to do with the effect that asset trading itself has on the dispersion of information.

A formal and somewhat abstract way of thinking about price information dispersal throughout a market comes from the No-trade theorem. Informally, this theorem states that under conditions whereby the market is composed completely of rational traders (no-noise) and operating at an efficient equilibrium there is no scope to profit off of private information. This is because given that all traders are rational with acknowledgement of collective rationality, any attempt to initiate a trade will reveal the private agent’s informational advantage and hence change market expectations in line with that. Consequently, all insider information is automatically reflected in prices as if it were public information.

Note that the assumptions behind the No-trade theorem are obviously not met by reality, and that theorems themselves are only strictly true when their assumptions are met. However, when thinking about information diffusion in an economy notice the game theoretic nature of asset trading in the hyper-rational world of the No-trade theorem.

Implicitly there is some strategic interaction, where each agent attempts to anticipate the motives of the others, and due to strict rationality ends up concluding that their own information is less accurate. If any forms of the EMH are to be taken seriously then there is the inevitable recognition roughly speaking the market will be at some kind of ‘perceived’ efficient equilibrium with noise traders not having the financial capital to issue the largest trades.

Hence, whilst the assumptions of the No-trade theorem are not completely met even when the EMH holds, the No-trade theorem still provides a context for understanding how Strong-Form may actually be more plausible than expected.

The idea is that using Fama’s model of an information-cost continuum, only agents with access to substantial capital have the capacity or incentive to actually obtain that information and then trade on it. Following this, the trade using insider information is likely to be quite large, often issued by a known Hedge Fund which can ‘lever’ the information up to the hilt. The fact that the private information holder is only likely to exist if they are agents with an ability to trade large volumes implies that they are often sophisticated agents whose valuations are more likely to be perceived as fundamental rather than noise by the rest of the market. Thus, using the game theoretic analysis from the No-trade theorem it would be quite rational for other agents to reprice their own valuations in line with the offer/bid by the private information holder.

It can be expected that in a world of fast paced traders trailing behemoth funds there is little to be gained from trading on insider information which serves as a signal more than anything else. Practically, it may even be in the public’s interest to permit insider trading where there is scope to maintain the information-cost continuum (via an excise tax perhaps); seeing as it can signal an efficient pricing mechanism.

Furthermore, the existence of these ‘game theoretic’ patterns whereby smaller traders attempt to piggy-back off the information of more sophisticated ones in a world of Strong-Form EMH could also be more prone to volatility of the sort first identified by Mandelbrot. In this context, the ‘fat tails’ of financial markets can represent the cascading of less sophisticated agents attempting to bid immediately after large sophisticated ‘shock trades’. In turn, quick readjustments may be the realisations that high-frequency ‘trailing’ is often misplaced since large trades may simply reflect internal dynamics of the leading firm. This fits the observable facts that shocks are often random, and readjustments follow seemingly unimportant information.

Note, that none of the above discussion is bullet-proof financial theory, nor is it an exposition of the strength of the EMH. Rather, I have attempted to explain practically how insider information can be priced effectively in markets, and how it is linked to seemingly unexplainable volatility that may otherwise be used as evidence for irrationality.

Formalising ‘Trickle Down’ Economics

Note I am not an advocate of trickle down, I just want to make the definition meaningful. I apologise for the slap dash structure.

Looking at the Wikipedia definition of trickle down economics one can get a broad sense of the kind of policies that it might imply. My contention is that the term is just a euphemism used by left-wing audiences, with little actual substance in its current popular usage. I propose an alternative interpretation here which is more in line with the original conception.

When people normally think of trickle down they think of things like tax cuts on the rich, financial deregulation and union busting. Tracing back to 1896 the term was popularised by a Presidential candidate as being “you just legislate to make the well-to-do prosperous, that their prosperity will leak through on those below.”

This is a purely rhetorical point, but it is possible to think about how this framework can work from a technical economic perspective. There are a few ways. From a supply-side point of view we might just think of deregulation. But this is not really ‘trickle down’. It already has a term- deregulation.

The notion of ‘trickle down’ that I would understand from the 1896 definition is one where we conceptualise that by funding the business and wealthy interests we can boost economic growth for all. Deregulation may or may not be in the interests of businesses, so it’s not a useful way of thinking of it.

So let’s think about this formally. Why would helping rich people boost economic growth? Milton Friedman in a famous video described the argument as being “When you give money to a rich entrepreneur, they’ll put it back into the business and create investment and jobs for all. By contrast if you give it to a poor person, they will tend to consume rather than invest”.
This idea can be made more rigorous as follows. Rich people and businesses have a lower marginal propensity to consume. Therefore they have a higher propensity to save. Under standard macro assumptions, these savings in turn go through the financial sector to create investment. Thus by allowing the rich to retain more income you can grow the economy faster for long term benefit to everyone, at the cost of short term consumption. The point is that you try and take from agents that spend, and give to agents that save to boost the pool of savings. In turn you boost the pool of investment.

The precise mechanisms which lead to this can be found in an intro macroeconomics textbook if the reader is interested.

I contend that this is the most meaningful way to approach the definition of trickle down. Don’t think of it as a bunch of policies with uncertain impacts on the rich. That is just pure political rhetoric with no meaning. Think of it as a framework to grow the economy by affording businesses and the rich more opportunities.
Now that we are thinking of trickle down in a more formal and precise framework, what are some examples.

Let’s look at Reaganism. Is that trickle down? I contend that it is NOT. Reagan’s economic reforms involved large scale financial deregulation. One impact of this was to allow the US economy to borrow more from international capital markets. This in turn via some technical trade theory forced a current account deficit on the US economy. This borrowing surge overall probably lowered the total pool of investment in the US and dramatically lowered savings rates. (Interest rates would have stayed roughly the same though.). Hence yes while in some ways the rich benefited from these policies, the impact on US business profits is uncertain. We can look at this some more, but I think I have illustrated my point.

Now let’s look at China and Germany. In a certain sense these two economies have similar structure, but China would be the one to focus on here. Both via a large swathe of economic policies give huge implicit subsidies to business. Things like energy subsidies, infrastructure spending and currency devaluation take money from consumers and give money to businesses. The result is a strong pool of savings that have created highly industrial economies. Consequently we get faster (though distorted) growth, and a widening of income inequality. Note that both these economies are very different from Reagan’s conceptualisation of the ideal US economy. They both have high regulation. But it is this regulation that captures the ‘trickle down’ effect at its most potent.

If we look at trickle down this way, then in a sense it definitely does lead to fast growth. Japan, China, Germany, the UK, Taiwan, South Korea all used a form of high regulation trickle down to reach record levels of growth, though with large negative consequences. This is not to say that ‘trickle down’ is good in any normative sense. I don’t really have a view on that, as the morality is extremely complex. But it certainly seems like it works from a ‘boosting growth’ perspective if we have a formal definition.

The point of this rant is to give a shitty rhetorical tactic some substance, and address a pet peeve of mine. Helping business interests actually does boost growth in developing nations, and the left cannot simply ignore this inconvenience.

Explaining Slow Growth: Turning Away from the Stale “Lessons from Japan”

For the past 3 years, macroeconomists and central bankers have grappled fiercely over the topic of developed market economic stagnation, pending a true recovery from the financial implosions of 2008. Many influential “macro guys” and financial analysts now see stark similarities with the Japanese post 1990 experience and the current forecasts given for much of the developed world. Paul Krugman in a recent Op—Ed piece in his New York Times Blog for example stated emphatically that “Nowadays, we are all Japan”, whilst Richard Koo’s (highly informative) “The Holy Grail of Macroeconomics: Lessons from Japan” attempted to empirically relate the current financial position of the US to that of Japan during the lost decade. Nevertheless, I see a number of structural differences between the Japanese economy leading up to 1990 and the other indebted developed markets of today.

Essentially, if China’s economic model is a mirror of Japan’s, and thus awaits an equally daunting “Long Landing” as is expected (See Pettis, China Financial Markets), then surely the U.S and Europe who run a functionally obverse economic model shouldn’t intuitively be in the midst of a Japanese styled slump. To my mind, much of the debate amongst the macroeconomists misses this point and is therefore muddled and wonky. To my mind, a viable opponent to the Japanese analysis, is one based upon the international Balance of Payments (BoP).

I have long found it curious and odd, that even at the height of sub-prime lending in the U.S combined with excessively low interest rates after 2001, that the U.S economy remained on its long term average growth path. Surely the asset bubble and leveraging cycle should have propelled growth. Similarly, the 3 rounds of QE in the post-crisis era should have also stimulated growth and investment. (I share the opinion of Richard Koo in the idea that the US financial sector, contrary to popular sentiment is indeed healthy) One explanation for lacklustre growth is that the US economy has lost much of its comparative advantage, and that without constant monetary pump priming growth would be even slower. Another idea is that of Richard Koo and those of the Japan school, who now believe that the U.S economy is caught in a fierce deleveraging cycle that may take decades to resolve. And yet both of these theories, as intuitive as they may be, are muddled by inconsistent empirical evidence and strange contradictions.

What if however, the U.S and European economies were plagued by a very different type of problem? One which monetary pump-priming and asset bubbles could not solve. What if, the U.S and peripheral European demand over the past 20 years had simply been bled out by distortions in the external account? In this case, the US crisis was driven by external trade policies, and not, by a statist investment orgy as in Japan.

This situation at first glance seems to be supported by simple facts and intuition. The persistent current account deficits of developed markets, specifically the US, to my mind have caused both the inflated asset prices leading up to 2008, and also the below trend equilibrium (rather than actual) growth rates experienced since roughly 1997.

The late nineties were indeed a tumultuous period, and can be seen hence, as crucial to the development of instability within the US financial system. In 1997-8 a few things happened:

  1. East-Asian financial markets, stunned by a sequence of currency devaluations, began to run targeted trade surpluses.
  2. The US capital inflows soared (functionally the equivalent of a rising trade deficit that balanced the East-Asian surpluses)
  3. Lending and credit within the US expanded, funnelled largely into real estate.
  4. Housing prices and volumes began their ominous ascent.

The East-Asian surpluses then, can be seen to have (either directly or indirectly) penetrated the American trade account. Consequently, East-Asian markets served to change the composition of the American economy. The U.S tradable sector, due to financial repression and increasing savings in East-Asia, was beaten to a pulp and workers quickly made redundant. With a contracting tradable sector, the only possible way to redeploy labour is through a surge in foreign-financed debt which expands domestic consumption and investment. In addition, when the economy is balancing away from the tradeable sector most investment becomes speculative and in this case was inevitably funnelled towards the increasingly liquid real estate sector.

Therefore, the capital inflows (functionally current account deficits) can be seen to have both slowed equilibrium growth, as productive workers were redeployed and fired, and simultaneously fuelling a speculative binge. (The impending crisis’ magnitude was of course also amplified by the irresponsible lending techniques rampant within US financial markets which increased the probability of insolvency).

Even to this day, East-Asian capital exports have continued to increase, with China probably consuming a mere 35% of production (GDP) in comparison to the US’ 72% and Europe’s 65% (Rough estimates). The effect of such Underconsumption on the national savings rate is immense and if the US is to bear the brunt of the resultant capital inflows and Chinese production overload (As the PBoC reserve account holdings of USD implies it does) then it means the U .S is being bled white through the gaping hole in the external account.

With the financial crisis having largely capped the private sector’s willingness to further leverage-up and accumulate debt, there thus remains only one natural way for the U.S economy to absorb foreign excess capacity- unemployment and slower growth. Of course also there are a few politically unlikely ways too though. The US could become competitive through devaluation, higher VAT tax or equivalent, labour market reforms, tariffs etc. But the point is that China and East-Asia have purposely pushed their surplus savings onto the US. The US must absorb this excess by either more consumption, more investment (both imply less savings) or by intervening in trade and stopping the central bank purchases of so many treasuries (remember for every net $1 of Treasuries that are bought by foreigners, that is by economic law $1 added to the trade deficit). Since debt financed consumption and investment is not really an option without significant fiscal stimulus from the public sector (the private sector seems unwilling to leverage up further) and intervening in trade is politically unlikely the only other way to reduce savings is to reduce production by an amount more than the reduction in consumption. ie unemployment. This is basically an accounting necessity

Spain is an exaggerated version and perhaps a better example to see why. Spain can’t devalue due to it’s Eurozone membership. It also has a very limited capacity to load up on leverage (Look at sovereign bond risk premiums and the imploding banking sector) and so if Germany’s surplus continues to be pushed onto it, what can the Spanish administration do? All it can do is lower domestic savings by jacking up unemployment or try to become competitive and push it’s own savings out onto the rest of the world. (Like a Vampire state, sucking away at foreign demand to keep employment high). Coincidentally, the quickest way to regain competitiveness without intervening in trade is to grind down wages via unemployment. This is referred to the “internal devaluation” mode of recovery.

It is in this context that the anomalous predicament of the U.S and other developed markets is neither surprising nor complex. Unemployment will remain high until the trade interventions in surplus nations are eliminated, and the deficit ones are allowed to compete on an equal basis. In a situation where demand is being haemorrhaged to foreigners, fiscal stimulus will also need to be focused on innovative investments and cannot be allowed to stimulate consumption as is optimal Japan. In this world we must draw very different conclusions from those of the 90s.

The Redundancy of Supply-Side Economics in Abe’s Japan

Great expectations surrounded the announcement of Shinzo Abe’s economic revolution in Japan to pull the economy out of its 20 year slump. The revolution involved a huge overhaul of public policy, with a three-pronged attack on the macroeconomic conditions beleaguering the nation.

The first prong, a tsunami of monetary stimulus and cheap credit released by the Bank of Japan’s new governor Haruhiko Kuroda was designed to end the deflationary spiral. The second was a similarly immense fiscal stimulus package worth $116 billion designed to offset lacklustre investment from the private sector. But it was the third arrow, a series of supply-side reforms, that was perceived to be key to improving the competitiveness of Japanese firms and bolster long-term growth.

At best, these supply-side measures will prove to be only mildly stimulative to the Japanese economy if it begins to recover from its 20 year slump. By contrast, if the economy falls into another recession and the continued deregulation of Japanese labour markets is pursued aggressively, the result could be damaging.

 So let’s star our analysis by looking at the channels through which labour market reforms increase productivity. The first channel allows low-productivity sectors and unprofitable enterprises to shed labour more easily. The second channel is then designed to allow firms to hire workers more easily, and consequently pick up the previously fired workers. Therefore, in a healthy economy, structural reform redistributes labour from unproductive employment towards productive employment.

In conditions of economic malaise however, the second channel operates rather weakly. It is easy to see why. When aggregate demand is depressed even productive firms may be saturating the market with unsellable produce and as a result, they are hardly likely to increase employment until aggregate demand recovers. Thus, only the first channel operates at full capacity, and labour is fired at increasing rates. Synthesising these two channels in dampened economic conditions therefore results in heightened levels of unemployment, whilst aggregate demand is depressed even further.

If Abe’s supply-side plan is to recognise any success in this case it will have to hope that the effects of monetary and fiscal stimulus hit the economy before the labour market deregulations do. But even in this event (which admittedly is the more likely one), the third arrow of growth will inevitably fail to boost growth substantially.

The fact of the matter is that Japan’s crisis is one of a huge debt-deflation overhang, and one of depressed demand. That is; it is cyclical in nature, not structural. The huge time-frame and multitude of bogus recoveries would seem to imply that the recession is not a normal one, and the implication is correct; the problems are odd. But the peculiarity of the problems does not make them structural.

In an economy suffering from supply-side malaise, firms are unable to compete internationally and produce anything of meaningful values. In this situation, the current account deficit will rise due to domestic inefficiencies (since domestic production will be unable to compete with imports, and exports will falter).When the current account deficit rises, the currency devalues by the natural mechanisms. When the currency devalues imported inflation will rise. And when inflation rises the central bank will attempt to remedy the problem via contractionary monetary policy. Thus an economy suffering from supply-side inefficiencies should be characterised by having:

  • A deficit on the current account.
  • A weak currency
  • High levels of inflation
  • Contractionary monetary policy

These symptoms validate the experience of the USA in the 1970s, when it suffered from stagflation. Indeed, the problems in that situation were supply-side, and the required response was microeconomic in nature. But 1970s America is very different to 2000s Japan.

The Japanese economy for the past 20 years has shared none of the symptoms of stagflation. It has enjoyed persistent current account surpluses, a strong currency (the government has had to step in on numerous occasions to weaken the Yen in the past 20 years), persistent deflation and the most expansive monetary policy seen in history.

This should all point to the fact that Japanese firms are highly competitive on an international-scale. Whilst many academic economists may not realise this reality, one merely has to look in their own home to validate the reality. Japan’s firms are at the forefront of global innovation, and export their products vigorously to western households and businesses.

If Japan’s economy thus does not suffer from supply-side ails, and an economy stifled by over regulation then Shinzo Abe’s measures will be largely fruitless. If the demand-side stimulus measures hit the economy fast, the microeconomic reforms will be redundant. If however, implementation of the fiscal and monetary attacks wavers, the microeconomic reforms could cripple the situation and prolong the pain even further.

The reality stabs policymakers in the face every day. Japan’s problems are demand-side, failing to recognise this jeopardises the livelihood of millions of people.

A Quick Note on Quantitative Easing- The Portfolio Composition is More Important than the Reserve Levels.

So I was recently engaged in a debate with a close friend of mine over what the repercussions of continued Quantitative Easing (QE) would be, and what the inflationary effects of QE would be. The debate began with agreement, with both of us acknowledging that the current program was largely ineffectual due to the huge amount of excess reserves in the US financial system. Differences did soon become apparent however when my friend expressed his concern over the inflationary effects of the program if it went on indefinitely. This was because of the difficulties of retracting the program if it were allowed to go on for too long. Retracting $2 trillion dollars is easier than retracting $20 trillion. With the reserves just sitting there in huge excess, surely Bernanke could taper the constant injections, but leave the money already there as is. Money at the moment is just sitting in the system floating about, so what’s the point of putting more in if it just makes the retraction harder? Surely the huge monetary base would keep liquidity high and interest rates low across the board. There is so much excess, why do we need more? Stop the program, leave the reserves there, and lending growth should be unchanged. The analogy is “If the shops can’t sell 10 apples, giving them 100 isn’t going to help them sell any more if the price doesn’t change”. And in other words again, people seem to think that as the money multiplier declines banks ‘park’ their money with the Fed, and do not ‘Lend it out’

This line of thinking however overlooks the actual mechanisms that drive the operations behind QE, and its theoretical framework. The fact is that QE works to drive specifically Long-term interest rates down with the purchase of Long-term assets. The answer lies in the fact that banks have strict portfolio norms that they follow, and that reserves don’t simply get “lent out”.

So let’s briefly address the “Lending-Out Misconception” first. This common misconception holds that when commercial banks hold too much cash in their reserve accounts with the central bank, they can expand their lending operations. They simply lend out this extra cash to the private sector and real economy. This is simply not true. The commercial bank has no actual control over reserve levels, and the link is indirect. (see for more http://www.standardandpoors.com/spf/upload/Ratings_US/Repeat_After_Me_8_14_13.pdf)

So, on to the more substantial point. If it’s reserves that matter and if there are excess reserves, what is the point of pushing even more into the system? The money is not being used as it is!

The point however is that it’s not the reserves nor the liquidity that expand lending. Rather, lending comes from individual banks changing their portfolio composition. In reality, when the Fed implements QE, what it does is buy long-term securities (henceforth simplified to be mortgages). Buying these mortgages helps to increase lending activity, not because the banks now have money in their checking accounts that they can lend out, but rather because banks strive to have a consistent level of long-term assets and liabilities relative to short term ones. When the Fed buys mortgages off of a bank. The bank will find itself with a more cash assets, and less mortgage assets. It’s portfolio’s composition will have changed. In order to address this the bank will strive to correct the portfolio and buy up mortgage contracts and assets off of the private sector. It will then credit the private sector with cash. Hence, when the Fed buys mortgages off of the banks, portfolio corrections means that it is really accumulating them off of the private sector. The private sector will then find itself with excess cash and the money should theoretically be invested or used.

Where the ‘flow’ of QE becomes important is in distorting the banking sector’s portfolio. As it stands, the banks are not inclined to correct their portfolios, and lending rates are not rising. But corrections back to normality DO nevertheless happen slowly, and the more balance sheets become liquid with cash exceeding mortgages, the more the banks will strive to correct their balance sheets, buying up mortgages off of the private sector.

Thus, QE works through the norms of the financial sector, and no matter how redundant inflating the monetary base through reserves may seem, it incentivises lending expansion regardless. Why are banks not so keen to rebalance their distorted portfolios? Is this situation permanent? The answer is a resounding no to the latter. Banks simply do not want to rebalance their portfolios because the returns on long-term assets have not been deemed valuable enough relative to those of highly liquid assets at the moment. In addition, the 0.25% interest rate payment that the Fed gives the sector for excess reserves provides an incentive to keep the asset compositions highly liquid. This means keeping the portfolios at above equilibrium levels of liquidity. That doesn’t mean that banks will completely disregard the portfolio norms however. Indeed, the more the Fed increases the liquidity of the balance sheets, the more the banks will strive to accumulate mortgages off of the private sector. Thus the private sector’s holdings of loanable funds increases, and interest rates fall.


*Disclaimer: I think I’m wrong

Understanding Sovereign Bonds- Foreign Financing of Fiscal Deficits

The rise of Neo-Mercantilism’s export-led growth in countries such as China and Japan has brought a host of Balance of Payments (BoP) and Sovereign Debt problems to the fore. These problems are paramount to the international economy, but experts and policymakers alike demonstrate ignorance of the mechanisms behind the BoP through counterproductive proposals.

Sovereign Debt Markets and the Balance of Payments are one of the most counterintuitive and complex themes that policymakers face, fallacies are therefore riddled throughout the public debate. Not even the US Secretary of State Hillary Clinton is immune to frequent blunders when engaging in the sphere of international macroeconomics. In February, 2009 for example she made a famous imploration to China that they continue their purchases of US treasuries. This simple (and fallacious) request to the Jintao administration received almost no academic criticism; despite the detrimental effect that the Secretary of State’s policy goals would have on the US economy. An analysis of Chinese purchases of US dollar-assets is therefore required in order to address the unforeseen issues associated with foreign financing of sovereign bonds.

There are two main problems with Clinton’s imploration to the Chinese- namely the nondiscretionary nature the Bank of China’s treasury purchases, and the manner in which these purchases fail to alleviate fiscal deficit serviceability.

Firstly, the Bank of China (BoC), and Chinese Sovereign Wealth Funds do not simply decide to purchase huge quantities of US dollar-assets (in the form of bonds for now) based on whimsical choices of investment hubs. The decisions are not arbitrary; they are natural. The Bank of China’s decision to keep the RMB devalued means that they acquire huge foreign exchange reserves primarily in the form of US dollars. These dollars must be invested somewhere, and the only two markets large enough to absorb this influx of liquidity are the Eurozone and the US. Of these two options the US financial sector’s development and reputation of a safer investment location makes it the obvious choice.

Even if the Chinese decided to shift their exchange reserves to the Eurozone, they would have to undergo huge and costly transactions changing their accumulated dollars to Euros, in the process making huge losses in arbitrage as the dollars were devalued. It is clear with this in mind that Clinton’s beggary to the Chinese was completely ineffectual. The only way the Secretary of State could get her wish of increased foreign purchases of dollar-assets would be through the BoC devaluing the RMB even more, acquiring more reserves, before shoving them back into the bloated US treasuries market.

This leads us to the second (and far more important) fallacy underlying the Secretary of State’s understanding of foreign financing. The only way for China to unilaterally increase its purchase of US bonds would be to increase the volume of its capital exports to the US, thereby forcing a larger current account surplus as well (By definition the quantity of capital that is imported or exported is equal to the quantity of goods that are imported or exported respectively). The influx of demand for dollars would inflate the value of the currency, increasing the trade deficit by an even larger amount, and consumption on imports would boom leading to an even more indebted household sector.

In addition, interest rates on bonds would be largely unaffected and the government’s debt would become no more serviceable than before. This is due to the fact that with an appreciation of the dollar, many tradable sector firms would be adversely affected, and workers would be made redundant quite quickly. As a consequence, the US fiscal deficit would rise in a quantity roughly equal to the initial influx of Chinese bond purchases which caused the appreciation or by contrast the US would have endure higher levels of unemployment (The change in the capital deficit will be exactly equal to the trade deficit).

The point is that the Obama administration would have to issue an amount of bonds roughly equal to or in excess (A few economists have tried to calculate the exact relationship with little success) of the amount purchased by the Chinese. The influx of supply would equal the influx of demand, and the price (in the form of interest) would have no net effect. The difference for the American economy would be that both the current account deficit and the fiscal deficit would have grown. Americans, in essence, would be forced into an even larger imbalance between consumption and production.

Hillary Clinton’s imploration to the Chinese in this light is clearly opposed to American interests, and yet the entire economics profession remained largely apathetic to her announcements. Today, the profession continues to be mute when confronted by similar policies that flout textbook macroeconomics.