Why Isn’t the Fed Tougher on Banks?

By Kindred Winecoff

I am live at The Washington Post‘s political science blog The Monkey Cage, writing about some of my recent research on the global financial system. One key bit:

[T]his result conforms to a simple logic: if you task central banks with financial stability, they will partially tailor monetary policy to make it so. If banks know that their central bankers have their interests in mind, they will behave with less prudence. It makes perfect sense why this would be the case. So long as banks do not violate their statutory capital requirements there is little that central banks can do to prevent this behavior even if they wished to do so. Economists refer to situations in which actors are able to shift the risk generated by their actions onto others as “moral hazard.” It is one of the greatest economic problems, which can cause entire markets to fail. Isn’t that what’s happening in this situation?

Read the rest here. The underlying research is available on my website here.

The Wizard of Oz Is an Anti-Finance Manifesto

By Kindred Winecoff

Somewhat apropos of my previous post is the following anecdote, which I’ve read a number of times and have always forgotten. I’m pasting it here for posterity’s sake. It is from Daniel Little’s review of David Graeber’s Debt: The First 5,000 Years:

There are many startling facts and descriptions that Graeber produces as he tells his story of the development of the ideologies of money, credit, and debt.  One of the most interesting to me has to do with The Wonderful Wizard of Oz.

L. Frank Baum’s book The Wonderful Wizard of Oz, which appeared in 1900, is widely recognized to be a parable for the Populist campaign of William Jennings Bryan, who twice ran for president on the Free Silver platform — vowing to replace the gold standard with a bimetallic system that would allow the free creation of silver money alongside gold. … According to the Populist reading, the Wicked Witches of the East and West represent the East and West Coast bankers (promoters of and benefactors from the tight money supply), the Scarecrow represented the farmers (who didn’t have the brains to avoid the debt trap), the Tin Woodsman was the industrial proletariat (who didn’t have the heart to act in solidarity with the farmers), the Cowardly Lion represented the political class (who didn’t have the courage to intervene). … “Oz” is of course the standard abbreviation for “ounce.” (52)

The symbolism of the “yellow brick road” needs no elaboration.

UPDATE: As was been pointed out by Thomas in the comments, this was discussed long ago in the Journal of Political Economy.

Understanding the Preferences of Finance

By Kindred Winecoff

Paul Krugman [1, 2] and Steve Randy Waldman are having an interesting exchange on why the wealthy support tighter monetary policy despite the fact that expansionary economic policy is good for them. This is often expressed as an aversion to lower central bank interest rates, quantitative easing programs, or other activist monetary actions. Krugman sums up the puzzle nicely:

I get why creditors should hate inflation, but aggressive monetary responses to the Lesser Depression have been good for asset prices, and hence for the wealthy. Why, then, the vociferous protests?

Krugman believes that this is false consciousness: “rentiers” oppose policies that benefit them because they adhere to a model of the world — in which loose monetary policy will lead to runaway inflation that will erode the value of their capital — that does not apply in our current circumstances. (Krugman does not mention that one reason why rentiers might believe this is because Keynesians like Krugman have been advocating for higher inflation partially for this reason for some time.) Waldman portrays this as simple risk-aversion: expansionary monetary policy will change something, and because recent circumstances have been favorable to rentiers that something is likely to negatively impact their station.

I prefer Kaleckian accounts that emphasize the general relationship between capital and labor. In Kalecki’s world, full employment gives bargaining power to workers because they have easy exit options. Conversely, underemployment gives bargaining power to capital. I believe that both Krugman and Waldman are sympathetic to this framework as well.

But I want to highlight another possibility that situates the U.S. macroeconomy within the context of the world economy. The simple Mundell-Fleming macroeconomic model, when combined with a Ricardo-Viner sectoral approach, tells us that when international capital mobility is high (as it is today) financial capital benefits from an exchange rate that is high and stable, while fixed capital and labor benefit from monetary policy flexibility and (often) a lower exchange rate. This relationship is discussed in detail in Jeffry Frieden’s 1991 International Organization article “Invested interests: the politics of national economic policies in a world of global finance”, from which the table below is taken:



The section of the article that begins on pg. 442 is especially relevant. There are several things to note. First, the preferences of financial capital diverge from those of fixed capital, which are divided in turn by whether it is engaged in export-oriented, import-competing, or nontradeable production. Second, the preferences of labor within these sectors will tend to side with capital within the same sector, and oppose capital (and labor) in other sectors. Third, the interests of financial capital will diverge from everyone else.

Why is this? Frieden notes that the interests of capital depend on how strongly tied that capital is for its specific current use. Financial capital is much more liquid and adaptable than an industrial plant. It can be deployed globally while fixed capital is must remain local. For this reason, exchange rate movements create an additional source of risk: a depreciation will negatively impact the value of local assets vis a vis foreign assets, while an appreciation will negatively impact the value of foreign assets vis a vis local assets. The point is that any exchange rate movement from the status quo will benefit some and negatively impact other status quo investments, which is why the interests of fixed capital are divided. But for financial capital, exchange rate movements are always bad for their status quo portfolio, at least inasmuch as an alternative portfolio created that anticipated the future exchange rate movement could have been constructed.

Why should finance support a higher exchange rate level in addition to low volatility when capital is mobile globally? Because, all else equal, a higher value in the local currency will increase purchasing power globally. This is particularly true if you have easy access to that currency via one’s central bank. It is probably true that U.S. banks have had greater access to dollar liquidity over the past five years than at any point in economic history; given that, they would prefer those dollars to be more valuable in exchange rather than less.

Frieden notes in his article that the distributional implications of the battle over exchange rate stability and interest rate levels would be especially severe among the European countries that were then debating joining a common currency, with finance preferring a high and stable exchange rate and low monetary policy flexibility. I would suggest that this expectation has been borne out exceptionally well, as the ECB has engaged in quite restrictive monetary actions despite suffering from a regional economic collapse that has few historical parallels. The story is a bit different for the U.S. because of its n-1 privileges, but it is unclear whether anyone in the U.S. — financial firms or even the Federal Reserve — really understands this. Even still the basic story works: high and stable exchange rates are better for finance capital than low and volatile exchange rates.

So from the perspective of financial capital the great risk of expansionary monetary policy is that it will impact exchange rates rather than interest rates, growth, employment, or even asset prices. Thus the Krugman-Waldman puzzle is not a puzzle at all. Financial capital wants restrictive monetary policy because it benefits them more than the alternatives.

The Persistence of American Financial Power

By Kindred Winecoff

The Financial Times asks whether American financial prominence will endure. These articles recur with far too much frequency, in particular every time there’s a policy impasse. I have an essay (with the excellent Sarah Bauerle Danzman) on that topic in the most recent issue of Symposium explaining why the answer is “yes”. One key bit:

These [conventional] assessments see power as a result of the internal attributes of national economies: large economies with attractive financial sectors have power, while weaker ones do not. Accordingly, the U.S. decline in the share of global trade and income, and its domestic financial instability, should diminish its influence. But this focus fails to consider the ways in which the global financial network is, in fact, a complex and adaptive system. Power within this system does not depend solely on domestic attributes, but on the distribution of financial relationships that exists globally. In other words, the most well-connected economies, not just the biggest, are the most powerful. By extension, change within this structure does not follow a linear process, and economies that are initially more advantaged will continue to grow as the system develops.

The difference between these two approaches is significant. When we conceptualize the international financial system as a network, we see that the U.S. has become more central since 2007, not less. Rather than shift from West-to-East, global financial actors have responded to crisis by reorganizing around American capital to a remarkable extent. This is partially due to proactive responses to the crisis by policymakers such as the Federal Reserve, but it is also the result of factors outside the U.S. Above all, American capital markets remain attractive because complex networks contain strong path dependencies, which reinforce the core position of prominent countries while keeping potential challengers in the periphery. That is to say, policymakers and market players were limited in the decisions they could take because of factors that had already been locked in. As a result, the structure of the global financial system keeps the U.S. at the core and will continue to do so unless the entire network is fragmented, as it was during the 1930s when Great Britain lost its dominance.

Read the whole thing.

For those not familiar, Symposium is an exciting new magazine. It has aspirations to fill part of the void left by the dearly-missed Lingua Franca. It’s an excellent way to publicize research in a way palatable to the public. Working with them was an excellent experience, and I’d strongly recommend folks subscribe as well as considering them as a future outlet for their work.