Thursday 31 July 2014
Chaos in Basel: European Monetary Policy (Pt. II)
In a
recent report, the BIS have claimed that the recovery that is being made by the
European economy needs to be dampened so as not to re-enter a grossly
over-inflationary period of growth. A journalist for The Economist magazine
going by ‘R.A.’ reported: ‘Though the BIS's diagnoses of the
global economy's ills have evolved over time its policy recommendations have
not. In its latest annual report, it argues that what the world needs now is
higher interest rates.’[i]
The BIS has fears that although the economies of the Europe have and will
benefit from lower bank rates as it allows them greater domestic potential for
consumption and investment, it is important to not just keep inflation low,
now, but to keep it manageable in the future. R.A. did not take kindly to this
and deftly countered by first picking some misconceptions that may have arisen
from the reports, and then - seemingly unknowingly- discussing some of The
International Monetary Fund’s (IMF’s)
Managing Director Christine Lagarde’s fears from January this year.
Firstly R.A. set about drawing a clear distinction between ‘loose’ and ‘tight’
monetary policy. Loose refers to when central banks expand the money supply and
increase the flow of money in the economy through increasing demand- this can
be either ‘aggressive’ or ‘passive’. From this, R.A. concludes that European
Monetary policy is as yet to be classed as truly loose as there has been no
QE/OMO thus far; ‘It's not the loosest possible policy if there are plenty more
arrows in the quiver.’1 He asserts that before the policy for Europe
tightens it must be loosened to allow for restructuring. Despite seemingly
being opposed to the BIS and their suggestions, the two perspectives seem to
have found a point of synthesis- the financial sector and economy alike needs
restructuring. The difference lies in how they both suggest this should occur:
where the BIS suggests that a contraction would force firms to adapt to the
additional pressures of higher interest, making them more prudent. On the other
hand, R.A. argues that ‘intense private-sector competition… and more inflation’
is still needed to avoid a return to abnormal economic conditions. Both of
these suggestions seem plausible, with the European Central Bank (ECB)
suggesting stress-tests[ii]
for large commercial banks, but also encouraging loose monetary policy.
In another article, in The Financial Times, Chris
Giles[iii]
wrote of the OECD and their bid to get the European Central Bank (ECB) to slash
base rates, and also broaden trade to allow for greater structural reforms ‘to
boost productivity and create jobs through… domestic and international
competition in both advanced and emerging economies.’ This position strongly
supports that of R.A. from the abovementioned piece. Giles’ brings a more
quantitative perspective to this issue, quoting the OECD’s findings on how the
real GDP growth of the Eurozone is improving, but not completely out of the
reach of negative figures (see Fig. 1). In addition to validating the
stipulation made by R.A. Giles is able to expand the on argument by referring
to the possible loss of economic capacity in the medium-to-long-term. There are
a number of possible causes for this: long-term unemployment and a widespread
loss of transferrable skills; falls in foreign and domestic investment due to a
loss of confidence; and even an increase in inefficiency in investment due to a
lack of use of the mechanisms and infrastructure for such an extended period.
All of the above analysis from this range of
sources and from the macro-economic theory discussed points towards a middle
path between the two solutions suggested that errs slightly on the side of
loose monetary policy decisions. Had either perspective showed a greater depth
of analysis of the other, they would have been much stronger, providing a
deeper discussion. In spite of this, the strength of the arguments put forward
by R.A. and Giles are far more convincing those of the BIS especially
considering even some of the strongest recoveries that have been seen in
developed western countries still are somewhat fragile.
Kavi Chauhan-08/07/2014
[i]
R.A. (2014), Dead economies blow no
bubbles. The Economist, London.
[ii]
B. Moshinsky, J.Black, A. Speciale (2014), ECB
Haggles on Pain to Inflict in Bank Health Check, Bloomberg News, Brussels
and Frankfurt.
[iii]
C. Giles, (2014), OECD urges European
Central Banks to loosen monetary policy. The Financial Times, London.
Chaos in Basel: European Monetary Policy (Pt. I)
Over
the past months, Europe has faced a number of broad ranging problems from
fighting the pull of the ‘ogre’[i] that is deflation, to the
juggling act between the needs of the driving economies, and the less developed
ones, which has become more pertinent than ever before in this delicate
recovery period. There are a number of differing views on how to solve the
problems faced by central banks around Europe, and there are disputes about
this at all levels of society from individuals to huge institutions such as the
Bank of International Settlements (BIS) and the Organisation for Economic
Co-operation and Development (OECD).
There
are, in this debate two main schools of thought: expansionary and
contractionary. Expansionary monetary policy aims to increase Aggregate Demand
(AD) and induce demand-pull inflation. These changes are affected through a
number of processes, the first of which is the most commonly discussed- base
rates. If base rates are reduced, the amount that households have to pay on
variable-rate mortgages and other simple necessities falls, raising Real
Disposable Incomes (RDIs), and thus consumption (C). The base rate reduction
would be able to increase levels of investment (I) as firms can borrow more
cheaply and also use their increased levels of retained profits that would be
gained from reduced amortization rates. To supplement this increase in the
velocity of money in the economy, further expansionary policies would include Quantitative
Easing (QE) (or Open Market Operations (OMO) as it is referred to in the
Americas). QE is a method by which the Central Bank can expand the Money Supply
(MS) for their currency through asset purchases (i.e. bonds) which injects
money into commercial lenders providing more liquidity and thus reducing
lending costs, encouraging growth. This could even develop into operations akin
to the ‘Helicopter Drop’ wherein the ‘middle-men’ (high street banks) are
completely avoided and the population are simply given money to spend, inducing
further demand-pull inflation. In the long-run, there are other, additional
effects of cheaper borrowing and increased liquidity in the market- the most
prominent of which is the expansion of the potential output of the economy
(i.e. Aggregate Supply (AS)). The expansion in AS could be caused by the
falling price of investment as a result of the aforementioned processes, which
translates as a reduction in the cost of factors of production.
There
are also numerous effects on exchange rates and net-exports that can be traced
back to changes in monetary policy; an expansion in the money supply will
increase the value of the Euro (EUR) in its bilateral exchanges with major
financial partners due to the high relative inflation. In ‘normal’ cases, where
the Marshall-Lerner condition applies, this could lead to a deterioration of
the current account and thus causing ‘demand-pull disinflation’,
counterbalancing the effects of the initial inflation. In other cases, however,
the Marshall-Lerner condition does not apply as in the UK where over 40% of
food is imported, and the financial services and chemical products exported are
of such high quality and so ingrained in foreign production processes that both
exports and imports have very inelastic Price Elasticity’s of Demand (PEDs).
Here, what is essentially a price increase for imports, and a reduction for
exports, will lead to the current account position improving quite
considerably, leading to an expansion of AD and demand-pull inflation. For the
EU, fortunately, the net-exports are not as large a part of the economy as they
are for the UK meaning that the inflation rate will be somewhat rebalanced,
without large negative implications for the employment and national income (Y)
when expansionary monetary policy is introduced.
What does the rise of the Bitcoin imply for the future of Central Banking? (Pt. V)
The next step that investment bank would have to take to
legitimize Bitcoin would be to regulate the securities valued and derived from
Bitcoin- without this, specific, structure of conduct, the market for
Bitcoin-based derivatives would spiral into the same destructive chaos that
consumed both the derivatives market in its infancy, and subprime-mortgage
market in its adolescent years. If Bitcoin securities are not managed or
overseen by an authoritative body- not necessarily the SEC- their volatility
will lead to eventual collapse, in the same vain as the dystopian, lawless
market, the above paragraph aims to avoid. An extension of this regulation
could be to introduce Reserve Requirement Ratios (RRRs) and discount or base
rates for Bitcoin lenders, to allow for greater control over this currency.
The penultimate method
by which the likes of Mr. Carney and the Mrs. Yellen would need to adapt to the
rise of the Bitcoin would be to accrue liquid reserves of the Bitcoin so that
they would be able to respond with shocks to the ‘foreign’ bilateral exchange
rates between their own currency and Bitcoin. In the same way that the huge
reserves of USDs in China, to support its pegged exchange rate, it may be
necessary for the Federal Reserve (Fed) and the BoE to attain Bitcoin reserves
to guarantee a reasonable amount of stability. Without this further
amalgamation of Bitcoin with Central Banks’ domestic currencies, Bitcoin will
become disenfranchised, and excluded from global markets, and may be abandoned
entirely. The accumulation of Central Reserves will also help to restrain the
almost inevitable process of deflation that will occur in the Bitcoin system.
The above step
leads, logically –as was hinted at in the closing sentences- to the final step
that Central Banks would have to take to acclimatize to Bitcoin. Managing
monetary stimulus through the procedures, such as Open Market Operations, in
Bitcoin, would be the final step that Central Banks would need to take to be
able to meet their goals, outlined in the opening paragraph. The Central Banks
would have to manage deflation possibly through the use of ‘Bitcoin bonds’
which it could trade with commercial lenders to increase liquidity, when
necessary.
The above mentioned
alterations to the relationship between Bitcoins and Central Banks would lead
to a very unfortunate problem for Bitcoin followers, and acolytes of ‘Satoshi
Nakamoto’. The Bitcoin, through these changes would essentially become the USD,
or the GBP, or the Euro, or the Hong Kong Dollar, or any other internationally
traded currency- the only difference being that it has no domicile. Another
unfortunate truth that supporters simply must come to terms with is that the
Bitcoin is a currency that is almost destined to fail, as it relies so heavily
on its rapid uptake and use that long-term, serious investments will plainly
not be made. This view was supported by another case involving Mt. Gox wherein
the price of Bitcoin fell by over 800USD within the space of a month (see Fig.
3). Despite this problem supposedly being with Mt. Gox, previously the world
leading Bitcoin exchange, alone, many other Bitcoin exchanges have faced drops
by as much as 200USD.
The only real thing that Central Banks of the world
need to do to contain Bitcoin is wait. In a recent Financial Times analysis
column[i],
Mark Williams (former Federal Reserve risk
examiner and a finance lecturer at Boston University’s School of Management)
highlighted that: Bitcoin is unregulated, and is decentralized, and thus cannot
properly develop without the fundamental structure of it being changed. The
article reads that even the most established currencies require an entire team
of highly skilled individuals to be managed, and that no algorithm that
contemporary computers can run will be able to replace this. Even if the
problem of the cap of the number of Bitcoins was solved; there would still be
countless other struggles that would arise, due to the irrationality that is a
fundamental part of human nature.
Kavi Chauhan- 05/02/2014
[i]
M. Williams (2014), A dangerous mistake lies at Bitcoin’s
intellectual core. The Financial
Times.
What does the rise of the Bitcoin imply for the future of Central Banking? (Pt. IV)
In rebuttal to
this, there is the perspective that the almost inherent volatility of this
currency will ward of any and all serious investors, as well as the public-
Fig. 3 shows how quickly an ‘investment’ in Bitcoin can turn sour (in almost
half a month, Bitcoins value fell by over 50%). Many commentators have
reiterated this point- encapsulated when, in an interview with The Financial
Times, Barry Silbert (founder of the Bitcoin Investment Trust) said:
‘For Bitcoin to move to the mainstream there
has to be a high level of trust [and] a higher level of consumer-investor
protection’[i]
To compound this,
there is a huge flaw associated with the storage of Bitcoins that simply
ignores the idea of human error- if a Bitcoin holder forgets their password to
their Bitcoin ‘wallet’ they will have literally no other means of accessing
them. Now, it can be said that the same applies for the storage of cash- it is
much more difficult to lose $7.5million in notes and coins than it is in Bitcoins,
as Mr. James Howells proved late last year in his desperate attempt to find a
hard-drive upon which he had the details of 7,500 Bitcoins, worth approximately
$7.5m at the time of reporting[ii] This then implies that any of the above
evaluation of how badly Bitcoins could damage Central Banking is almost null
and void. Although the aforementioned parties may be involved with Bitcoin to a lesser extent, there will still be collateral damage from the Bitcoins
wider uptake, if Bitcoin is taken up as some suggest it will be.
Despite this, some
still believe that the Bitcoin will stabilise- if one entertains this notion,
it is possible to have a much broader and more colourful discussion in much
greater depth. If the Bitcoin were to stabilise and act as a fully-fledged
currency, in its own right, there would be a significant threat to the Central
Banks of the world. The proliferation of the idea of a fully decentralised
currency would mean that monetary policy, one of the main anti-inflationary
tools available to Governments, would no longer be accessible. This would
almost comprehensively block Central Banks from performing any and all of their
abovementioned primary functions, provided their power remain unchanged in
spite of industrial changes. Due to the organic evolution of regulation, and
finance as an entity, this is very unlikely to happen- to answer the
above question in short, the Bitcoin, in the long-run, may indeed change our
systems, but the negative effect on Central Banking will be negligible. Governor
Carney has shown this, perfectly, when he adjusted the Bank’s stance on Forward
Guidance. Before entering the monetary structure the UK knows today, it has
worked using the European-exchange Rate Mechanism (ERM), the Gold Standard, and
varying other degrees of Bank of England (BoE) independence.
For the Central Banks of the world to adapt, however, there
are four key steps that must be taken so ensure their survival, they will have
to: begin regulation and monitor transactions that take place under Bitcoin;
manage Bitcoin loans and securities (as perhaps an extension of the Securities
Exchange Commission); begin accruing liquid Bitcoin reserves; and finally
control monetary injection and stimulus to avoid deflationary spirals. Once
these have been discussed, an unfortunate truth will no doubt yield its ugly
head.
The first of these four steps may prove to be difficult as
many see the main attraction of Bitcoin to be its anonymity and
confidentiality, as has been shown with the recent ‘Silk Road’ trial:
‘Silk Road... a
“sprawling black-market bazaar” used by drug dealers ... to distribute hundreds
of kilograms of illegal drugs and launder hundreds of millions of dollars’[iii]
Ross William Ulbricht ran this multimillion dollar
enterprise and allowing drug dealers all over America and the world to exchange
products, using Bitcoins and the alias ‘Dread Pirate Roberts’. He has recently
been charged on four counts: operating a narcotics-trafficking scheme; money
laundering conspiracy; computer hacking; and operating a continuing criminal
enterprise. This could culminate in a final sentence of a minimum of 30 years.
This, however, is just one case out possibly hundreds or thousands that have
simply not been uncovered, yet. To stop the proliferation of these types of
enterprise, it is necessary to begin integrating regulation slowly to this
market- if we suddenly impose huge regulations, consumers may simply stop using
Bitcoins, even if they are not partaking in the more sinister side of the
currency. By tackling the problem of Tor –a global network of volunteer relays
making it almost impossible to trace someone’s whereabouts or online activity-
Central Banks will be able to make major headway on breaking down the ‘Dark
Web’. This sudden abandonment of a currency, almost fully ingrained in our
society -as is the case with this model- would lead to a widespread collapse of
businesses that rely upon it, not too dissimilar to the collapse of the Gold
Standard.
Fig. 3
[i]
S. Foley (2014), Bitcoin enters a new
phase. The Financial Times- FT World.
[ii]
Unknown (2013), James Howells searches
for hard drive worth £4-worth of Bitcoins stored. BBC News- South East
Wales.
[iii]
P. Hurtado (2014), Silk Road’s Ulbricht
Gets Trial Date in Online Drug Case. Bloomberg Technology.
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