He thinks that each school has a piece of the answer, and no one has the whole of it. This fits nicely with Hegel's dialectical approach to the development of knowledge, btw, as well as science as a work in progress.
Read it at The Money View
Heterodoxy and The Economist
by Perry Mehrling
UPDATE: JKH comments:
Wed, 01/04/2012 - 6:33am.
Neo-chartalism is strong on accounting and monetary operations, but weak on risk.
Regarding the former, base money is the problem with orthodoxy. Base money in the form of reserves is almost meaningless. Banks do not lend on the basis of reserves. They lend on the basis of capital. Failure to understand this is a profound general problem within the economics profession. In particular, it’s been a problem for its comprehension of QE.
Regarding the latter, the effect of QE is not additional purchasing power. Purchasing power is available already by collateralizing the instruments that might not have been removed from the market. This is not a perfect offset, but it is an important caveat.
The true effect of QE is to take risk out of the market. That is a stabilizing factor in terms of risk management viewed broadly. And it allows resetting of the private market risk taking function. Neo-chartalists don’t seem to acknowledge any of this. They focus on the fact that removing risk from the market removes expected return, and consider that a drain of income rather than a removal of risk. That’s the wrong way to look at.
11 comments:
So what? Is Hegel's view of knowledge development valid?
It is the basis of the scientific method, which holds that knowledge is cumulative and tentative. No one has the ocean in their bucket, and anyone who thinks they do is an ideologue and perhaps even a fanatic.
Moreover, the introduction of new paradigms revolutionize old ways of the thinking that underlie entire worldviews. Does anyone really thing that people five hundred years from now won't look back at us and scratch their heads about our funny ideas about reality? Or have a good laugh over it.
This is if humanity survives its present condition in which its power is outrunning its knowledge of how to use it safely.
JKH put a comment in over there....
Resp,
Thanks, Matt. I'll put it up here.
What is the removal of risk? Don't we all agree the debt is risk free?
QE increased liquidity by changing the composition and terms of bank assets from securities to reserves. There is interest rate risk associated even with tsys and some of the assets were not tsys, which may also have carried default risk.
As someone in banking and therefore having to deal with risk management on a daily basis this is a big deal to JKH.
I am not sure what Warren, who owns a bank, has to say about it.
At first I had the same question: How is fiat money is less risky than deault free treasury bonds?
But yes, as I think Tom says, maybe JKH is referring the risk inherent in locking up your money (until bond matures) rather than default risk.. so to speak?
In normal times, from a macro perspective QE still seems like a complete non-event, because your money is never really locked up - you can always sell your bonds (or using them as collateral for a new loan).
But maybe in times of crisis, people may want to run away from bonds and go into "money" instead.. so bond prices fall? And bond holders therefore face considerable losses? Which enforces the slump in aggregate demand?
(When the Fed buys private assets that can actually default, it's obviously a different matter.)
I do have some difficulties grasping this.. Thoughts?
Would be interesting to hear JKH - or Warren - or Scott Fullwiler - comment.
I made that comment very quickly so it was a bit sloppy.
First, I’m thinking of QE in the broadest sense – being an expansion of reserves on the right hand side of the balance sheet and an expansion of assets on the left.
Thinking about risk in the broadest terms, you have such categories as credit risk, liquidity risk, interest rate risk, and foreign exchange risk. All of these elements are involved one way or another when the Fed intervenes so broadly in the market. Some of the earlier programs involved more credit risk for example.
In the case of their treasury purchases, there is certainly an element of interest rate risk. People may not think there’s much interest rate risk these days due to the environment, but it exists as a risk, and different portfolio managers have different views on it. Bill Gross was famously wrong on his call of course.
One of the interesting things about interest rate risk in this environment is that marked to market risk (or present value risk) increases dramatically, the lower rates go, for a given absolute move in interest rates. That’s because lower rates increase the “duration” measure of bond risk. The low rate of discount used in the PV formula makes the longer term cash flows of a bonds super sensitive to very small interest rate moves.
Anyway, you can assess the amount of interest rate risk that’s been taken out of the market by doing a detailed analysis of what the interest rate risk might be on the Fed’s balance sheet, not only in present value terms, but in running interest margin terms. It’s a very complicated exercise and I won’t get into it here. But basically you have the Fed now running a massive “short funding” position on its balance sheet, due to the longer duration of its assets against the immediate interest rate sensitivity of many of its liabilities – i.e. the reserves that are priced essentially off the Fed funds target according to the interest on reserves. While the risk of increases in the Fed funds rate may seem benign now, it may not be the case at some point in the future.
But the most important aspect is the duration risk that’s been removed from the market, since much of that would be marked to market had it remained in street portfolios, where as I say it becomes super sensitive to even small interest rate moves when rates in general are so close to the zero bound.
Cont’d ...
....
But my point really was about risk in broad terms. The Fed has removed risk from market portfolios, other things equal, and these market portfolios would have required equity capital allocation to bear such risk – and that includes equity capital allocated to support interest rate risk. So it makes a difference. And there have been issues in credit risk earlier on, etc. And one of the important points here is that the Fed indeed has the capacity to remove gargantuan amounts of risk from the market, if it chooses, simply due to the (MMT) insight that it can fiat that transfer of risk with ease. And it can do this without having to worry about marked-to-market risk, because in all cases it has the inherent balance sheet strength to hold out until maturity of its assets. And it doesn’t really use marked to market accounting for its bonds portfolios, for the most part, for that reason. And finally, when MMT makes the point that the Fed is removing interest income from the market, we should just bear in mind that there is a “risk/return trade off” involved. It’s also removing risk from the market. And the pricing of the transactions reflects that risk. And the additional income the Fed has earned so far, while being income that has been removed from the market, is income that compensates the Fed for the risk it has removed from the market. And it was the sellers to the Fed that sought the removal of that risk from their portfolios.
The other thing I’d like to say is that my comment was quick and sloppy in a way (and this one is also quick), but to make a point. I do believe MMT is incredibly strong (as a competitor for academia) in its understanding of the monetary system and the banking system, and that’s critical to its essence – as per recent discussions. My own personal view that MMT is “weak” in risk (and I might have added, weak in capital, in the sense that bank capital allocation is inextricably linked to risk management) is exactly that – a personal view on where MMT’s unusual strength in monetary operations and the subject of reserve management isn’t particularly well balanced with the other essential technical banking functions of risk management and capital management. But I’d also like to say that I didn’t give MMT fair comparison against either MM or Austrian in that sense. If anything, MMT is probably still much better than those two in these areas of risk and capital management – and Warren Mosler is up to speed on this stuff of course, although I’m not sure how closely familiar he is with large bank operations in these areas. Finally, you can measure the relative strength of MMT in monetary operations against the other two schools only if you go off the charts to do so, because there is just no comparison - and the subject matter is critically important to understanding economics more generally, in my view.
Ah.. thanks, I understand this way better now!
JKH,
Good comments! I replied to your comment at Perry Merhrling's (still awaiting moderation) before realizing there was a discussion and more detail here.
I largely agree with you here, but with two points I'd emphasize:
1. My personal view is that MMT is neutral on risk rather than weak on risk, and that individuals MMT authors treat risk in different individual ways (but maybe I've missed something)
2. I agree that the Fed's QE takes away interest rate risk from the private sector, but I think given the portfolio preference aspect of endogenous money that the effect is almost entirely borne by the financial sector, with the loss being a direct reduction in the net interest margin of the entire private financial sector (banks and non-banks). Whether this is "helpful" probably depends on the regulatory environment (how much forbearance is in play), the capital raising environment (something you allude to), and how this change in maturity transformation is shared between banks and non-bank financials.
My understanding is that after QE the non-financial private sector actually ends up with a slightly riskier asset composition (i.e., less treasuries relative to assets with credit risk) as it strives to regain its preferred portfolio duration mix.
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