25 December 2011

Ashwin Parameswaran on the tradeoff between short-term stability and long-term resilience

From this, rather long, blog post:

The puzzle:

Most monetary and fiscal interventions result in a rise in the financial markets, NGDP expectations and economic performance in the short run. Yet,

  • we are in the middle of a ‘great stagnation’ and have been for a few decades.
  • the frequency of crises seems to have risen dramatically in the last fifty years culminating in the environment since 2008 which is best described as a perpetual crisis.
  • each recovery seems to be weaker than the previous one and requires an increased injection of stimulus to achieve results that were easily achieved by a simple rate cut not that long ago.

... Similarly, when a central bank protects incumbent banks against liquidity risk, the banks choose to hold progressively more illiquid portfolios. When central banks provide incumbent banks with cheap funding in times of crisis to prevent failure and creditor losses, the banks choose to take on more leverage. ... Of course, in economic systems when agents actively intend to arbitrage such commitments by central banks, it is simply a form of moral hazard. But such an adaptation can easily occur via the natural selective forces at work in an economy – those who fail to take advantage of the Greenspan/Bernanke put simply go bust or get fired. ...

some of you may raise the following objection: so what if the new state is pathological? Maybe capitalism with its inherent instability is itself pathological. And once the safety nets of the Greenspan/Bernanke put, lender-of-last-resort programs and too-big-to-fail bailouts are put in place why would we need or want to remove them? If we simply medicate the economy ad infinitum, can we not avoid collapse ad infinitum?

This argument however is flawed.

  • The ability of economic players to reorganise to maximise the rents extracted from central banking and state commitments far exceeds the the resources available to the state and the central bank. ... as Minsky and many others have documented, the pace of financial innovation over the last half-century has meant that banks and financialised corporates have all the tools they need to circumvent regulations and maximise rent extraction.
  • Minsky noted that "A high-investment, high-profit strategy for full employment – even with the underpinning of an active fiscal policy and an aware Federal Reserve system – leads to an increasingly unstable financial system, and an increasingly unstable economic performance. Within a short span of time, the policy problem cycles among preventing a deep depression, getting a stagnant economy moving again, reining in an inflation, and offsetting a credit squeeze or crunch."

...The structural malformation of the economic system due to the application of increasing levels of stimulus to the task of stabilisation means that the economy has lost the ability to generate the endogenous growth and innovation that it could before it was so actively stabilised. The system has now been homogenised and is entirely dependent upon constant stimulus. ...