Hawtreyan “Credit Deadlock” or Keynesian “Liquidity Trap”? Lessons for Japan from the Great Depression

This paper outlines the ideas of Ralph Hawtrey and Lauchlin Currie on the need for monetised fiscal deficit spending in 1930s USA to combat the deep depression into which the economy had been allowed to sink. In such exceptional circumstances of “credit deadlock” in which banks were afraid to lend and households and business afraid to borrow, the deadlock could best be broken through the spending of new money into circulation via large fiscal deficits. This complementarity of fiscal and monetary policy was shown to be essential, and as such indicates the potential power of monetary policy – in contrast to the Keynesian “liquidity trap” view that it is powerless This lesson was not learned by the Japanese authorities in their response to the asset price collapse of 1991-92, resulting in a lost decade as ballooning fiscal deficits were neutralised throughout the 1990s by unhelpfully tight monetary policy with the Bank of Japan refusing to monetise the deficits.

Understanding Liquidity and Credit Risks in the Financial Crisis

This paper develops a structured dynamic factor model for the spreads between London Interbank Offered Rate (LIBOR) and overnight index swap (OIS) rates for a panel of banks. Our model involves latent factors which reflect liquidity and credit risk. Our empirical results show that surges in the short term LIBOR-OIS spreads during the 2007-2009 fi nancial crisis were largely driven by liquidity risk. However, credit risk played a more signifi cant role in the longer term (twelve-month) LIBOR-OIS spread. The liquidity risk factors are more volatile than the credit risk factor. Most of the familiar events in the financial crisis are linked more to movements in liquidity risk than credit risk.

Transmission of macro-liquidity shocks to liquidity-sorted stock portfolios’ returns: The role of the financial crisis

This study examines the impact of macro-liquidity shocks on the returns of UK stock portfolios sorted on the basis of a series of micro-liquidity measures. The macro-liquidity shocks are extracted on the meeting days of the Bank of England Monetary Policy Committee relative to market expectations embedded in futures contracts on the 3-month LIBOR during the period June 1999- December 2009. We report definitive evidence that these shocks are transmitted to the cross-section of liquidity-sorted portfolios, with most liquid stocks playing a very active role. Our results emphatically document that the shocks-returns relationship has reversed its sign during the recent financial crisis; the standard inverse relationship between interest rate surprises and portfolios’ returns before the crisis has turned into positive during the crisis. This finding confirms the inability of interest rate cuts to boost returns in the shortrun during the crisis, because these were perceived by market participants as a signal of a deteriorating economic outlook.

Money and Liquidity

John Hardman Moore outlines his joint research with Nobu Kiyotaki on the macroeconomic questions to do with the nature of money and liquidity, and the interplay between the financial system and the aggregate economy.

Revealed cardinal preference

I prove that as long as we allow the marginal utility for money (lambda) to vary between purchases (similarly to the budget) then the quasi-linear and the ordinal budget-constrained models rationalize the same data. However, we know that lambda is approximately constant. I provide a simple constructive proof for the necessary and sufficient condition for the constant lambda rationalization, which I argue should replace the Generalized Axiom of Revealed Preference in empirical studies of consumer behavior. 'Go Cardinals!' It is the minimal requirement of any scientifi c theory that it is consistent with the data it is trying to explain. In the case of (Hicksian) consumer theory it was revealed preference -introduced by Samuelson (1938,1948) - that provided an empirical test to satisfy this need. At that time most of economic reasoning was done in terms of a competitive general equilibrium, a concept abstract enough so that it can be built on the ordinal preferences over baskets of goods - even if the extremely specialized ones of Arrow and Debreu. However, starting in the sixties, economics has moved beyond the 'invisible hand' explanation of how -even competitive- markets operate. A seemingly unavoidable step of this 'revolution' was that ever since, most economic research has been carried out in a partial equilibrium context. Now, the partial equilibrium approach does not mean that the rest of the markets are ignored, rather that they are held constant. In other words, there is a special commodity -call it money - that reflects the trade-offs of moving purchasing power across markets. As a result, the basic building block of consumer behavior in partial equilibrium is no longer the consumer's preferences over goods, rather her valuation of them, in terms of money. This new paradigm necessitates a new theory of revealed preference.

Stock Market Liquidity and Macro-Liquidity Shocks: Evidence from the 2007-2009 Financial Crisis

We develop an empirical framework that links micro-liquidity, macro-liquidity and stock prices. We provide evidence of a strong link between macro-liquidity shocks and the returns of UK stock portfolios constructed on the basis of micro-liquidity measures between 1999-2012. Specifically, macro-liquidity shocks, which are extracted on the meeting days of the Bank of England Monetary Policy Committee relative to market expectations embedded in 3-month LIBOR futures prices, are transmitted in a differential manner to the cross-section of liquidity-sorted portfolios, with liquid stocks playing the most active role. We also find that there is a significant increase in shares’ trading activity and a rather small increase in their trading cost on MPC meeting days. Finally, our results emphatically document that during the recent financial crisis the shocks-returns relationship has reversed its sign. Interest rate cuts during the crisis were perceived by market participants as a signal of deteriorating economic prospects and reinforced “flight to safety” trading.

Liquidity, moral hazard and bank crises

Bank crises, by interrupting liquidity provision, have been viewed as resulting in welfare losses. In a model of banking with moral hazard, we show that second best bank contracts that improve on autarky ex ante require costly crises to occur with positive probability at the interim stage. When bank payoffs are partially appropriable, either directly via imposition of fines or indirectly by the use of bank equity as a collateral, we argue that an appropriately designed ex-ante regime of policy intervention involving conditional monitoring can prevent bank crises.

The Effects of Experience on Preference Uncertainty: Theory and Empirics for Public and Quasi-Public Environmental Goods

This paper develop and estimates a model of demand estimation for environmental public goods which allows for consumers to learn about their preferences through consumption experiences. We develop a theoretical model of Bayesian updating, perform comparative statics over the model, and show how the theoretical model can be consistently incorporated into a reduced form econometric model. We then estimate the model using data collected for two environmental goods. We find that the predictions of the theoretical exercise that additional experience makes consumers more certain over their preferences in both mean and variance are supported in each case.

Expectations, Learning and Monetary Policy: An Overview of Recent Research

Expectations about the future are central for determination of current macroeconomic outcomes and the formulation of monetary policy. Recent literature has explored ways for supplementing the benchmark of rational expectations with explicit models of expectations formation that rely on econometric learning. Some apparently natural policy rules turn out to imply expectational instability of private agents’ learning. We use the standard New Keynesian model to illustrate this problem and survey the key results about interest-rate rules that deliver both uniqueness and stability of equilibrium under econometric learning. We then consider some practical concerns such as measurement errors in private expectations, observability of variables and learning of structural parameters required for policy. We also discuss some recent applications including policy design under perpetual learning, estimated models with learning, recurrent hyperinflations, and macroeconomic policy to combat liquidity traps and deflation.

The Global Dimension to Fiscal Sustainability

This paper examines the issue of fiscal sustainability in emerging market countries and industrial countries. We highlight the importance of the time series properties of the primary surplus and debt, and find evidence of a positive long run relationship. Consequently we emphasise, that especially for emerging markets, it is important to recognise the implications of global capital market shocks for fiscal sustainability, a relationship which has hitherto been ignored in the empirical literature. Using a factor model we demonstrate that the relationship between deficit and debt is conditional upon a global factor and we suggest that this global factor is related to world-wide liquidity. We also demonstrate that this acts as a constraint on emerging market economies’ fiscal policy.

Productivity, Preferences and UIP deviations in an Open Economy Business Cycle Model

We show that a flex-price two-sector open economy DSGE model can explain the poor degree of international risk sharing and exchange rate disconnect. We use a suite of model evaluation measures and examine the role of (i) traded and non-traded sectors; (ii) financial market incompleteness; (iii) preference shocks; (iv) deviations from UIP condition for the exchange rates; and (v) creditor status in net foreign assets. We find that there is a good case for both traded and non-traded productivity shocks as well as UIP deviations in explaining the puzzles.

A Salience Theory of Choice Errors

We study a psychologically based foundation for choice errors. The decision maker applies a preference ranking after forming a 'consideration set' prior to choosing an alternative. Membership of the consideration set is determined both by the alternative specific salience and by the rationality of the agent (his general propensity to consider all alternatives). The model turns out to include a logit formulation as a special case. In general, it has a rich set of implications both for exogenous parameters and for a situation in which alternatives can a¤ect their own salience (salience games). Such implications are relevant to assess the link between 'revealed' preferences and 'true' preferences: for example, less rational agents may paradoxically express their preference through choice more truthfully than more rational agents.

The Rise and Fall of the ABS Market

The nancial crisis has raised some concern about the quality of information available on some traded assets on the securities markets to market participants and regulators. Asset-backed securitization in general got partial blame for the paucity of liquidity on bank balance sheets and the consequent credit crunch. After the Asset-Backed Security (ABS) market fell to near inactivity in 2009, the US federal government's Term Asset-Backed Securities Loan Facility (TALF) provided backing and a boost to the issuance of asset-backed securitization. In this market condition, given the nature of ABS, it is di¢ cult for them not to be relatively illiquid, and this has resulted in unacceptable levels of market risk for most investors. Their liquidity before the crisis was driven by a market in continuous expansion, fed by Special Purpose Vehicle (SPV), Conduits, and other low capitalized term-transformation vehicles. Nowadays, the industry is concerned with the ongoing ABS reforms and how these will be implemented. This article reviews the ABS market in the last decade and the possible consequences of the recent regulatory proposals. It proposes a retention policy and the institution of a new nancial body to supervise the quality of the security in an ABS pool, its liquidity, and the model risk implied by the issuer's valuation model.

Why do UK banks securitize?

The eight years from 2000 to 2008 saw a rapid growth in the use of securitization by UK banks. We aim to identify the reasons that contributed to this rapid growth. The time period (2000 to 2010) covered by our study is noteworthy as it covers the pre- financial crisis credit-boom, the peak of the fi nancial crisis and its aftermath. In the wake of the financial crisis, many governments, regulators and political commentators have pointed an accusing finger at the securitization market - even in the absence of a detailed statistical and economic analysis. We contribute to the extant literature by performing such an analysis on UK banks, focussing principally on whether it is the need for liquidity (i.e. the funding of their balance sheets), or the desire to engage in regulatory capital arbitrage or the need for credit risk transfer that has led to UK banks securitizing their assets. We show that securitization has been signi ficantly driven by liquidity reasons. In addition, we observe a positive link between securitization and banks credit risk. We interpret these latter findings as evidence that UK banks which engaged in securitization did so, in part, to transfer credit risk and that, in comparison to UK banks which did not use securitization, they had more credit risk to transfer in the sense that they originated lower quality loans and held lower quality assets. We show that banks which issued more asset-backed securities before the financial crisis suffered more defaults after the financial crisis.

The determinants of sovereign bond yield spreads in the EMU

We use a panel of euro area countries to assess the determinants of long-term sovereign bond yield spreads over the period 1999.01-2010.12. We find that, unlike the period preceding the global financial crisis, European government bond yield spreads are wellexplained by macro- and fiscal fundamentals over the crisis period. We also find that the menu of macro and fiscal risks priced by markets has been significantly enriched since March 2009, including the risk of the crisis’ transmission among EMU member states, international risk and liquidity risk. Finally, we find that sovereign credit ratings are statistically significant in explaining spreads, yet compared to macro- and fiscal fundamentals their role is limited.