ZIRP keeps velocity of money down?

If so, then the potential for negative feedback loops is high for, as growth
falls, the ex-post returns on the ‘financial borrowings’ will not be as high
as expected. And if, for whatever reason, interest rates then start to rise
(as they have lately been doing) then in a world in which the amount of
debt remains fixed, falling returns combined with rising servicing costs,
will mean that ‘somebody’ will have to eat an adjustment. That somebody
can be ‘capital’ (through a debt restructuring) though, more often than
not, the first port of call will be ‘labor’. Financial pressures will lead to
people being fired while remaining employees will be on the receiving
end of what was nothing but an attempt to get rich without working, by
capturing an undue rent created by the wrong cost of capital.

In other words, excessively low real rates seem to lead to rent seekers
(those close to the issue of new money) gorging themselves by bidding
on other people’s businesses and, then turning around when these assets
do not perform as expected and firing the employees. If this is the case,
then because zero interest rates trigger capital and labor misallocation,
we could perhaps conclude that they also end up being responsible for
a lower structural growth rate and a higher level of uncertainty for the
workforce (hence a fall in consumption, consumer confidence, birth
rates, etc.). This is how well-meaning central bankers and their zero
interest rate policies end up generating higher structural unemployment
rates, falling median incomes, and a huge increase in part time jobs.

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AfrikaansAlbanianArabicArmenianAzerbaijaniBasqueBelarusianBengaliBosnianBulgarianCatalanCebuanoChichewaChinese (Simplified)Chinese (Traditional)CroatianCzechDanishDutchEnglishEsperantoEstonianFilipinoFinnishFrenchGalicianGeorgianGermanGreekGujaratiHaitian CreoleHausaHebrewHindiHmongHungarianIcelandicIgboIndonesianIrishItalianJapaneseJavaneseKannadaKazakhKhmerKoreanLaoLatinLatvianLithuanianMacedonianMalagasyMalayMalayalamMalteseMaoriMarathiMongolianMyanmar (Burmese)NepaliNorwegianPersianPolishPortuguesePunjabiRomanianRussianSerbianSesothoSinhalaSlovakSlovenianSomaliSpanishSundaneseSwahiliSwedishTajikTamilTeluguThaiTurkishUkrainianUrduUzbekVietnameseWelshYiddishYorubaZulu

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Options : History : Help : Feedback

Math for Economists, The ideal economic system

In the early 1990s I know that I went through a number of books and articles on the mathematics of feedback processes, Cedric, but my memory has never been very good and I cannot remember titles. You might want to do searches on words like “reflexivity”, “feedback”, and “pro-cyclical” and see what you get. One suggestion however: if you are interested in this topic mainly because you want to improve your understanding of finance and economics, you probably should focus on trying to understand as intuitively as possible the basic mathematics of how these things work, and not worry too much about taking the mathematics too far. Usually, as these feedback processes occur in the real world, we simply don’t have data with high enough levels of precision for us to do very sophisticated modelling and, more importantly, the ways these processes occur can be so complex and with so many moving parts that it is hard enough just to see all the relevant mechanisms, let alone model them accurately. But once you get the basic intuition of how feedback mechanisms work, both positive feedback in which volatility is exacerbated and negative feedback in which it is muted, you will start to see them everywhere.

My second suggestion is on how you incorporate them into your thinking. We know that increasing or reducing volatility affects value, partly because we value stability, of course, but also because there are “breaking points” at which the changes in value are discontinuous. To put it in a less abstract example, if I have assets and debt, and the value of one or both sides of my balance sheet is volatile, the range of outcomes when my assets are worth more than my liabilities might be very different from the range of outcomes when my assets are worth less than my liabilities. As you know almost any time there is a sharp discontinuity, which I call “a kink in the payout curve” in my classes, you can probably find one or more implied options buried in there. This means that you can model the impact of volatility on changes in value by using basic option theory, although once again these are complex “options” with many moving parts (and usually with no specified expiry date) and so there is little additional value in applying option theory much beyond the basics.

If you train yourself to identify feedback mechanisms and implied options, I promise you will find them everywhere, and they will, I think, profoundly improve your ability to understand the economy as a system. Because so few economists seem to think this way, it will be to your great advantage if you do and you can find yourself making predictions that seem crazy to most people but almost inevitable to you. But the key, and this is probably true much more widely, is to get a deep and intuitive understanding of the basics (feedback loops, options, and probability theory) and not worry too much about knowing the advanced stuff. This may seem like a strange thing to say, but it is much, much easier to find people who understand the advanced stuff than it is to find people who understand the basic stuff intuitively.

I am not sure you can design “just right” growth. Perhaps you can in principle design a system of incentives such that businesses and individuals are more likely to take advantage of existing resources in the most productive way, and this must include financing mechanisms and property rights that maximize the social value of intellectual and physical property while at the same time maximizing incentives to create more productive intellectual and physical property. Some people argue that this means effectively creating the ideal Adam-Smith economy of an infinite number of competitive agents who are free to innovate, none of whom, including the government, are important enough to create institutional distortions. But you quickly realize that these are mutually contradictory goals: Eliminate all institutional distortions and you eliminate the ability to enforce property rights, and while this might increase the value of the some or most of the existing stock of assets, it would also probably reduce the future value of assets by, among other things, reducing innovation and investment aimed at improving capital stock. Eliminate all institutional distortions and you also eliminate rules that prevent businesses from lying or otherwise taking advantage of credibility generated by someone else, and if you reply that requiring total transparency might solve this problem, then you need an agent powerful enough to enforce transparency. Eliminate all institutional distortions and you make it impossible, or at least much harder, to protect commonwealth assets or to invest in projects that create externalities that are greater than the ability to capture those externalities — for example it is hard to capture the full social value of creating a first-rate primary education system, or enforcing an optimal pricing structure in any industry with returns to scale.

But once you agree that certain institutional distortions are good for long term value creation then you face the problem that the economy is a dynamic system with strong learning capacity, so that even if you could design the optimal set of institutional distortions, it would almost immediately become sub-optimal as the economy adapted and developed. This brings us back to Minsky when we think of the financial sector. The optimal financial sector must allow for enough value destruction to impose discipline, but not too much, and as the economy evolves from the agricultural economy of mid-19th-century California or the industrial economy of mid-19th Century New York to the information economy of early 21st century California or the creative/design economy of early 21st Century New York, is it even conceivable that the financial system that created the optimal amount of value destruction for the former will also create the optimal amount for the latter?

I will not even pretend that I know the answer, but remember that while there are clearly advantages to economic stability, and we know the many ways in which economic and financial instability can be extremely damaging to wealth creation, on the other hand in the past two centuries the periods of greatest technological innovation were almost always also periods of financial excess, asset bubbles, and foolish capital misallocation, and there is some evidence that from the Renaissance onwards, the fastest growing countries and regions in Europe and North America were never those that enjoyed the most stable financial sectors or even the most stable currency systems, but were in fact countries or regions that were relatively poorly served by their financial and monetary systems (for example few have been able to explain why the US was the most astonishingly productive country in a period of great economic advances for Europe and North America even though the US probably had the most unstable financial sector of any major rich country and a currency system that barely functioned to maintain the value of savings, and this outperforming economy and under-performing financial and monetary system held even against British colonies that were similarly endowed socially, legally, culturally, and physically, like Canada and Australia).