What I Read: “SCIENCE!”-Articles mk. II

Here’s the second issue of what I hope to make a regular ‘feature’ on my blog – next to my favorite tweets and maybe favorite articles. Topics this time: Modern Monetary Theory, Modern Monetary Realism, Monetary Circuit Theory and ESBies.

1. “Understanding the Modern Monetary System” by Cullen O. Roche (2011).

Short Summary: This is a paper that tries to update/modify Modern Monetary Theory (MMT) to a more ‘realistic’ approach: Modern Monetary Realism. The difference lies not in the ‘core’ – both contain the fiat money system basics (currency issuing, accounting identities etc.) – but in the policy recommendations deduced from each theory. By doing so it is able to support right-wing/conservative policies: “lower taxes, reducing (or ending[!]) the FED’s role […] and focusing on efficiency of government […]” [4], as well es left-wing views: public purpose [whatever that means?], government deficits, tighter bank regulations and a focus on optimizing resource utilization (hence full employment)” [ibid.].

Comment: Reading this really gets one thinking. I’m far from smart/knowledgable enough but the tackled issues seem to make sense, i.e.: banks are only capital constrained and never reserve constrained, that bond-buying is not necessary to finance the states’ deficits. The problem – of course – is that many countries have independent central banks. The countries redesigned the gold-standard via the mandates’ given to the central banks. MMT can only provide answers to a rather small subsets of countries. The difficulty persuading countries to abolish/change existing institutions will prove too much for such a small economic school of thought. However, I do highly recommend that you take a look at it is full of interesting insights. Some have even described it as the red pill of modern macroeconomics.

Further Reading: via FT Alphaville here is John Carney. Intro: Modern Monetary Theory – a primer. FAZit with a short historical note on MMT (in German). Washington Post on Galbraith and the drag of a balance surplus.

2. “Instability in Financial Markets: Sources and Remedies” by Steve Keen (2012).

Short Summary: The paper was presented at this year’s INET-Conference in Berlin and takes a Minskian perspective on the financial crisis and markets. The difference from ‘mainstream’ economics is: (1) a stable economy will breed instability through false expectations (building on J. Schumpeter and I. Fischer) and (2) endogenous money expansion through banks; investment is NOT financed by savings, but by the issuing of loans. Furthermore, (3) banks are not reserve constrained but capital constrained.

After a boom goes bust, the problem is that “the debts incurred to purchase assets [during the boom, J.F.], and the cash flows generated by them” [6] drastically diverge and the holders can’t service their debt obligations anymore. The solution to this problem then is either (1) an asset price deflation, or (2) a price inflation. While the second option is a self-correcting mechanisms that leads to low growth and high inflation, the first option is a self-reinforcing one. Here the crisis will lead to a depression, as long as the government doesn’t intervene.

To spot bubbles Minsky differentiates between “price level of ‘current goods'” and the “price level of assets” [10]. Whereas prices of ‘current goods’ change through a mechanism of cost pressure and changes to markups, asset prices are influenced via expected cash flows. In the short and medium term the price increase will diverge, in the long run they should not (see Fig. 6).

As a remedy against bubbles, Prof. Keene, proposes two solutions: (1) Jubilee Shares and (2) Property Income Limited Leverage. They are supposed to “reduce the appeal of leveraged speculation on asset prices, without at the same time choking off demand for debt for either legitimate investment or unavoidable borrowing” [18].

Comment: Prof. Keen provides another explanation and analysis of the financial crisis and markets that is not ‘bound’ by mainstream economics. I particularly like the inclusion of banks and debt-creation and how they effect pre-crisis development. The Minskian ‘calm before the storm’-part and the asset price deflation reminded me of Richard Koo’s balance-sheet recession, where companies don’t spend because they have to pay off debt with their cash flows after an asset-bubble-burst. This also affects their future behavior as they hoard cash, because they’re afraid that it’ll happen again, which leads to a calm period until all is forgotten and the cycle begins anew.

While the analysis is interesting and – as far as I can tell – valid, the remedies don’t convince me. This might be because Keen doesn’t focus on them in this paper and limits the presentation of his ideas to roughly a page. There are not many economists that accept his analysis (see his argument vs Paul Krugman) and so it might be better to focus on persuading people that his analysis is correct.

Further Reading: Video of Steve Keen in Berlin, Finanzen.net interviews Keen (in German). Steve Keen’s blog.

3. “European Safe Bonds (ESBies)” by Brunnermeier et al (2011).

Short Summary: Here’s another proposal how to save the eurozone from imminent collapse. Like Eurobonds the authors want to address the “lack of safe assets”-problem that is currently haunting the EZ. Safe assets are important as pension funds and banks are required to hold them for regulatory reasons, as well as central banks to conduct conventional monetary policy. Therefor safe assets must be: liquid, have a minimal risk of default, and is denominated in a currency with a stable inflation [2]. The last twelve years all sovereign bonds were treated as equally safe assets, but that is not the case. What follows is the need for a European Safe Bonds or ESBies issued by a European Debt Agency. They are “composed of a senior tranche on a portfolio of sovereign bonds of the different European states eld by that agency and potentially further guaranteed through a credit enhancement” [4].

The authors then name eight benefits: the asset is safe and can capture a ‘safe haven’ premium, the mispricing of European sovereign bonds would disappear, the causal mechanism from sovereign crisis to banks would be cut, ECB has an easier way to conduct conventional monetary policy, some countries would get some funding relief without the risk of moral hazard, no higher taxation necessary (therefore there’s no election risk for the government), no Treaty change necessary, and data on the an euro risk-free yield curve. They then go on how to choose the portfolio weights and how the ESBies should be implemented. At the end they also provide an overview of the alternatives (EFSF, Eurobonds, blue/red bonds, synthetic Eurobonds) to ESBies: how do they differ? Where might be the advantages? Where might be the disadvantages? I will spare you the technicalities, if you are interested you can read it yourself.

Comment: With the big buzz about Eurobonds it is nice to read another very thoughtful proposal. The authors are aware of the political and bureaucratic difficulties most alternatives face and try to circumvent them with ESBies. The whole article is not as easy to read, because of some more complex issues they raise, but their main point is well articulated and makes sense. While most other proposals seem to lack political feasibility (and might be against the German constitution) and realism (fiscal union, political union, etc.) this could be a first step towards solving the european currency crisis.

Further Reading: Sichere Anleihen für Europa, the blue-bond, red-bond proposal, Tyler Cowen on blue bonds. red bonds.


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