Crisis Note 2009-3: This is Not an Economic Crisis; This is an Economics Crisis
(Work in progress)
This note was started in 2008; however, I have not had the time to finish my research.
Beside graphs, I also need to dig up the data to corroborate my thesis.
To solve the crisis and put the world on a stable footing for the future, we must first understand the problems with Economics and its applications (especially to monetary policy), before we can fix the global economy. The various Central Banks of the world have shown no indication that they understand the root cause of the global crisis and, being baffled, have been muddling along with a variety of experiments.
Unfortunately for the world, the people in charge of this crisis are all professional economists, and are incapable of declaring themselves obsolete. What they are on is a sure path to failure and the conversion of a global crisis to a global disaster.
Let me first enumerate what this crisis is NOT:
This crisis is not:
- a subprime crisis
- a liquidity crisis
- a banking crisis
- a deficit financing crisis
- an wage crisis
- a housing crisis
- a CDO crisis
- a MBS crisis
- a credit crisis
- a leverage crisis
- a toxic asset crisis
- a Wall Street crisis
- a failure of the efficient markets theories
- a failure of bank regulation
- a failure of consumer protection
- caused by predatory lending
What we need is a clean sheet understanding of economics. What follows next is a brief review of Macro 101. I will then expand this to cover the state of the world before the crisis, and make it clear as to what caused this crisis.
I'm lifting some stuff from http://en.wikipedia.org/wiki/IS/LM_model, and more from some Macroeconomics textbooks.
The horizontal axis (labeled Y) represents real GDP. The vertical axis represents nominal interest rates (labeled i).
The IS (Investment and Savings) curve shows the level of real GDP for each level of interest rates. Lower interest rates lead to more investment and less savings, leading to greater GDP, thus the IS curve is downwards sloping.
The LM curve represents the role of finance and money, and plots interest rates against the quantity of cash balances. ("Liquidity preference and Money supply equilibrium"). It represents the willingness to hold cash instead of securities. The LM curve is upward sloping. As GDP increases, and interest rates increase, so does the demand for cash.
Shifts to the IS curve:
- Increase in Marginal propensity to save - an increase will reduce the multiplier and move the IS curve to the left. (Interest rate changes impact saving and investment behavior – higher interest rates encourage savings, lower interest rates encourage investment. )
- Business and Consumer Confidence - greater optimism leads to more spending for any given interest rate, shifting the IS curve to the right.
- Real Money Demand - increases shift the LM curve up and to the left.
- Responsiveness of money demand to interest rates: changes the slope of the LM curve. Small responsiveness makes the LM curve be more vertical; large responsiveness makes it more horizontal.
- Increasing money supply, and the money multiplier
- Reducing propensity to save
- increasing risk taking and investing (done by lowering interest rates).
This white paper is excellent. I consider it mandatory reading.
Here’s a summary – :
- Central banks derive their power from the fact that they are monopoly providers of “high powered” money (base money). THIS IS IMPORTANT TO REMEMBER.
- Central banks choose the price (rate) at which they lend high powered money to the private sector.
- This official rate is transmitted to other market rates via the banking system to varying degrees, and impacts assets prices and expectations, as well as the exchange rate.
- These changes in turn effect spending, savings, and investment behavior, which impacts the demand for goods and services.
- Monetary policy works via its influence on aggregate demand in the economy. Monetary policy thus determines the general price level, and the value of money ie the purchasing power of money. (Inflation is thus a monetary phenomenon. )
- Changes in the policy rate lead to changes in behavior of both individuals and firms, which when added u p over the whole economy generate changes in aggregate spending.
- Total domestic expenditure in the economy is equal to the sum of private consumption expenditure, government consumption expenditure and investment spending. This, plus the balance of trade (net exports) is equal to GDP.
- Monetary policy changes affect output and inflation, as well as inflation expectations. - Inflation expectations influence the level of real interest rates and so determine the impact of any specific nominal interest rate. They also influence price and money wage setting, and so feed into actual inflation in subsequent periods.
- Money supply plays a role in the transmission mechanism of policy, but is not a policy instrument nor a target, as the central bank has an inflation target, and uses monetary aggregates as indicators only.
- There is a positive relationship between monetary aggregates and the general level of prices. - “Monetary growth persistently in excess of that warranted by growth in the real economy will inevitably be the reflection of an interest rate policy that is insistent with stable inflation. So control of inflation always ultimately implies control of the monetary growth rate. However, the relationship between the monetary aggregates and nominal GDP ..appears to be insufficiently stable (partly owing to financial innovation) for the monetary aggregates to provide a robust indicator of likely future inflation developments in the near term.”
– Examples include declines in bank lending caused by losses of capital on bad loans: a credit crunch.
In IS-LM model tems, the slope of the IS curve is vertical – ie changes in interest rates have no effect on GDP.
Risks to quantitative easing are considered to be that banks will still refuse to lend, or that the policy will be too effective and lead to hyperinflation.
Interest rate parity is an economics concept, expressed as a basic algebraic identity that relates interest rates and exchange rates. Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return.
Looked at differently, interest rate parity says that the spot price and the forward or futures price of a currency incorporate any interest rate differentials between the two currencies - the cost of carry or financing offsets any potential arbitrate.
So why is all this basic economics in a Crisis Note?
Lets postulate a 2 economy world – Country A & Counrty B.