13.4 Central Bank Independence #Notebook

13.4 Central Bank Independence #Notebook

In principle, Central Banks are independent of the dictates of government, the freedom to conduct monetary policies. And by experiences, as a country’s central bank becomes more independent, its average inflation rate drops. Many Latin American and African countries had very high rates of inflation when their central banks were ruled by dictators.

If a central bank has control of its own budget, as the Fed and ECB do, then the bank is quite independent because it is beholden to no one. 

The Fed is slightly less independent than the ECB because its existence is not constitutionally guaranteed. Congress could change or abolish the Fed by passing a law or it could override his veto. The ECB was formed by an international treaty, any changes to which must be ratified by all the signatories.

The Bank of Canada’s independence is limited by the Bank Act of 1967 made the government ultimately responsible for Canada’s monetary policy. 

Central bankers are tougher on inflation than governments, politicians, or the general populace because they represent bank, business, and creditor interests, all of which are hurt if prices rise quickly and unexpectedly. 

Businesses tend to dislike inflation because it increases uncertainty and makes long-term planning difficult. 

Many households are net debtors, they owe money to some financial institutions. Inflation will decrease the real burden of their debts. 

Politicians also tend to stand on the side of higher rather than lower inflation since they always writing checks to win their votes. In addition, increasing the money supply quickly or lowering the interest rate, can stimulate a short burst of economic growth that will make people happier and more willing to give returns.

After all, should everything be democratic? Would you want the armed forces run by majority vote? 

Another knock against independent central banks is that they are not very transparent. The Fed has long been infamous for its secrecy. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

Other Important Central Banks #Notebook

13.3 Other Important Central Banks #Notebook

The Maastricht Treaty created the European Central Bank (ECB), the central bank of the euro area.

The ECB was consciously modeled on the Fed and their structures are similar. However, the ECB is more decentralized than the Fed because the NCBs control their own budgets and conduct their own open market operations. 

The ECB does not regulate financial institutions, left the duty to each member's government. 

Other important central banks, the Bank of England, the Bank of Japan, and the Bank of Canada are unitary institutions with no districts. 

Despite the structural differences, the Bank of Japan implement monetary policy in ways very similar to the Fed and ECB.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

13.2 The Federal Reserve System’s Structure #Notebook

13.2 The Federal Reserve System’s Structure #Notebook

The Federal Reserve is composed of twelve district banks: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. 

The twelve district banks all have to do their duties.

Issue new Federal Reserve notes (FRNs) in place of worn currency.

Clear checks

Lend to banks within their districts.

Connect the Fed and the business community.

Collect data on regional business and economic conditions

Conduct monetary policy research

Evaluate bank merger and new activities applications

Examine bank holding companies and state-chartered member banks. 

The Fed’s headquarters is located in Washington, DC. Except for Boston and Philadelphia, each of those district banks also operates one or more branches. 

The districts don’t seem to be evenly balanced economically. Missouri is the only state with two federal reserve district banks. This was thought necessary to secure the votes of Missouri congressional representatives for the bill. 

Each Federal Reserve bank is owned by the commercial banks in its district, and they are chosen to join, own restricted shares in the Fed. 

The FRBNY (Federal Reserve Bank of New York)

The FRBNY (Federal Reserve Bank of New York) is the most important of the district banks because it also conducts open market operations, buying and selling government bonds on behalf of the Federal Reserve System, and doing International Settlements (BIS).

The FRBNY even safeguards tons of gold owned by the world’s major central banks. 

The FOMC is composed of the seven members of the Board of Governors. The FRBNY’s president is the only permanent member of the Federal Open Market Committee (FOMC).

The FOMC meets every six weeks or so to decide on monetary policy and open market operations.

Until recently, the Fed had only two other tools for implementing monetary policy, the discount rate that district banks lend directly to member banks and reserve requirements. 

The head of the Fed is appointed by the president of the United States, confirmed by the U.S. Senate.

The researchers provide the chairperson and the entire FOMC with new data, qualitative assessments of economic trends, and quantitative output from the latest and greatest macroeconomic models. 

Fed economists also help the district banks to investigate markets and competition conditions, and educational programs.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

13.1 America’s Central Banks #Notebook

13.1 America’s Central Banks #Notebook

Central banks generally charged with:

Controlling the money supply

Stabilizing the major prices

Improving economic output and employment

Regulating financial institutions

Stabilizing the economy

Providing a payments system

Central banks can be useful as an official systemwide lender of last resort, to increase the money supply or reduce the interest rates during a crisis period. 

Episodes in the history of the US convinced many Americans that the time had come to create a new central bank lest private financial institutions hold too much power. 

Financial Crisis in Greece and Ireland and What Is The Difference?

 Introduction

The financial crisis in Europe is also known as the European debt crisis or the European sovereign debt crisis. Many financial institutions, investors, or even the governments could not repay their debts. Many of the financial institutions collapse, and the governments in several European countries are running under tons of debts. The bond yield rose rapidly during that period and the fear was quickly spread. As the fear spreading, the bondholders tend to expect much more yield for the risk trade-off. After all, safety is very important while we consider our investment. 

The debt crisis began in 2008 and then spread to many European countries such as Portugal, Italy, Ireland, Greece, and Spain in 2009, and destroyed the confidence in European businesses, economies, and the credibility of the governments. Several Eurozone countries' bonds have been downgraded by rating agencies and became far more difficult to issue new bonds.

To restore the confidence, the International Monetary Fund (IMF) and the governments of European countries tried hard to prevent the collapse of the euro and financial contagion. And it was eventually controlled by making financial guarantees. However, the bonds are also built on guarantees, but they all default during the period. How can we know when does it will finally collapse again?

What Factors Led to The Present Financial Crisis in Greece and Ireland?

Greece 

Before the Global Financial Crisis of 2007-2008, the debt-to-GDP of Greece was pretty healthy and did not exceed 104%. As the financial crisis of 2008 hit the world's economy, many of the major industries of Greece like tourism suffered serious damage since tourism accounts for 18% of Greece’s GDP, and accounting for one-fifth of the workforce.(For a Sustainable Tourism Industry) That may explain why Greece has more international airports than most countries. 

As Greece's policymakers try to keep the economy functioning by government spending, the national debts increased accordingly. Since 2008, the debt to GDP of Greece was significantly soared. However, being a member of the Eurozone, Greece did not have autonomous monetary policy flexibility. But if Greece were to leave the euro, the economic and political consequences would be devastating. That means Greece has fewer tools to solve its own problems if they want to stay in the Eurozone. Moreover, Greece was hard to borrow money during this period since the markets have increased borrowing rates. Therefore, It was very difficult for Greece to finance its debt in early 2010 until the IMF's bailout. 

But the IMF's bailout was not for free, those loans are tied with several requirements and terms. Greece has to narrow the cost-competitiveness gap like wage reductions and head back to the original issue, the government spending. 

Ireland

Unlike Greece, the Irish sovereign debt crisis was not from government over-spending. It is caused by financing a property bubble. 

As we know that the Global Financial Crisis of 2007-2008 hit many countries around the world, of course, Ireland was not excluded. After the crisis, the unemployment rate in Ireland rose to 14% by 2010. Irish bank related industry had lost about billions of euros because of defaulted loans. These loans were borrowed mostly by property developers and homeowners to boom the property bubble and then burst around 2007. 

And no surprises, while the Irish government tries to save the economy and fix this issue, the national budget sank from surplus to deficit in 2010, the highest in the history of the eurozone. Moreover, a lot of depositors and bondholders cashed in during 2010 because with Ireland's credit rating falling rapidly, the guarantee was not credible enough. As we all learned how bankers making money by deposits, that kind of tremendous cash by depositors will be a devastating event.

Furthermore, yields on Irish Government debt rising rapidly was an inevitable path to go, because of the lack of confidence. Therefore, call out for help was a helpless choice. The Government went to seek assistance from the EU and IMF. Similar to Greece, money does not grow on trees, there are bailout agreements have to sign and compromise.

Summarise The Differences between The Greek and Irish

As the Global Financial Crisis of 2007-2008 hits, Greece's policymakers try to keep the economy functioning by government spending, and it is too much. 

Unlike Greece, the Irish sovereign debt crisis was not from government over-spending. It is caused by financing a property bubble. 

Finally, we are all humans, we always make mistakes. But why do we fall? So, we can learn to pick ourselves up. That's what we should do.

Reference

European debt crisis. (2020, October 02). Retrieved October 03, 2020, from https://en.wikipedia.org/wiki/European_debt_crisis

For a Sustainable Tourism Industry. (n.d.). Retrieved October 03, 2020, from https://www.mfa.gr/usa/en/about-greece/tourism/for-sustainable-tourism-industry.html

12.2 Asset Bubbles #Notebook

12.2 Asset Bubbles #Notebook

Low interest rates can cause bubbles by lowering the total cost of asset ownership. Interest rates and bond prices are inversely related. The PV formula, PV = FV/(1 + i)n

In colonial New York about the 1740s, interest rates on mortgages were generally 8%. In the late 1750s and early 1760s, they fell to about 4%, and expected revenues from land ownership increased by around 50%. 

What happened to real estate prices? 

The land was expected to create higher revenues.

The real estate prices rose significantly because it was cheaper to borrow money, and the total cost of real estate ownership was lower. 

Thinking of the land as a perpetuity and FV as the expected revenues arising from it:

PV = FV / i 

PV = £100 / .08 = £1,250 

PV = £100 / .04 = £2,500

The effect of new technology can increase FV, leading to a higher PV. 

Large increases in the demand for an asset occur when investors’ expectations of higher prices in the future.

In the Gordon growth model

Lower interest rates decrease k(required return) and new inventions increase g (constant growth rate).

 P = E × ( 1 + g ) / ( k – g )

If investors believe that P2 will be higher than P1, then a self-fulfilling cycle begins, repeats through P3 to Px.... 

In fact, the existence of an asset bubble when news about the price of an asset affects the economy, rather than the economy affecting the price of the asset.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

 

12.6 The Crisis of 2007–2008 #Notebook

12.6 The Crisis of 2007–2008 #Notebook

The financial crisis began in 2007 as a nonsystemic crisis linked to subprime mortgages, or risky loans. In 2008, the failure turned it into the most severe systemic crisis in the United States since the Great Depression.

Between January 2000 and 2006, Home prices rose rapidly as mortgage rates were low. Mortgages also became much easier to obtain. 

Traditionally, lenders verified that borrowers were employed or had a stable income from any sources. But it all changed with the widespread advent of securitization which bundling and selling mortgages to institutional investors. 

Then more complex derivatives were created...

Mortgage-backed securities(MBSs), Collateralized mortgage obligations (CMOs)....

MBSs afforded investors the portfolio diversification. 

CMOs allowed investors to pick the risk-return they desired. 

Securitization allowed mortgage lenders to specialize in making loans. 

Origination was much easier than lending because it required little or no capital, Originators had little incentive to screen good borrowers from bad and incentive to sign up anyone with a pulse.

At the height of the bubble, loans to no income, no job or assets borrowers were common...

Regulators allowed Fannie Mae and Freddie Mac, two giant stockholder-owned mortgage securitization companies whose debt was guaranteed by the federal government, to take on excessive risks and leverage themselves to the hilt.

As long as housing prices kept rising, overrated securities were not problems since they all count on selling the house.

By summer 2007, prices were falling quickly, triggered the wide-ranging defaults.

How about bond yields, September–October 2008?

Investors sold corporate bonds, especially the riskier Baa ones, forcing their prices down and yields up. 

In a classic, switch to bought Treasuries, especially short-term ones, the yields dropped from 1.69% to 0.3%.

Policymakers are now carefully trying to prevent a repeat performance or the next bubble.

One approach is by education, to teach investors about bubbles.

Another is by regulation, to keep the leverage to a minimum.

The third approach is to use monetary policy, higher interest rates, or tighter money supply.

However, each of these approaches has its pros and cons.

Education might make investors afraid to take on any risk. Tighter regulation and monetary policy might squelch wealth-creating industries.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.  

12.3 Financial Panics #Notebook

12.3 Financial Panics #Notebook

Financial panic occurs when leveraged financial intermediaries and investors must sell assets quickly to meet lenders’ calls, or ask for repayment. It happens when interest rates increase or when the value of collateral pledged sinks.

Calls may all come due to some bursting of an asset bubble, often triggered by an obvious shock, like a natural catastrophe or a huge failure.

During a panic, almost everybody must sell, so prices plummet, triggering more selling.

Panics often cause rapid deleveraging during a credit crunch....

Usually, highly leveraged investors cannot sell assets quickly enough, to “meet the call” and repay their loans. Banks and lenders begin to suffer defaults. As asymmetric information and uncertainty reign supreme, lenders restrict credit.

A negative bubble

When high interest rates, tight credit and expectations of lower asset prices in the future, asset values trend to go downward, even below the values indicated by underlying economic fundamentals. 

In New York in 1764, interest rates spiked from 6% to 12% and expected revenues from land plummeted by about 25%. What happened?

Obviously, it must drop because it was more expensive to borrow money. Thus, the total cost of real estate ownership will increase. In addition, the expectation of yield revenues from the land was lower.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

 

12.4 Lender of Last Resort #Notebook

12.4 Lender of Last Resort #Notebook

Financial panics and deleveraging can cause firms to reduce output and employment. 

Lenders often try to stop panics and deleveraging by adding liquidity or attempting to restore investor confidence. 

They add liquidity by increasing the money supply, reducing interest rates, and making loans to worthy borrowers.

They try to restore investor confidence by making upbeat statements or by implementing helpful policies.

During the darkest days of 1933, the U.S. federal government restored confidence in the banking system by creating the Federal Deposit Insurance Corporation.

A big event on October 19, 1987, in a single day, the S&P fell by 20%...

The macroeconomic outlook during the months leading up to the crash had become somewhat less certain. . . . 

A growing U.S. trade deficit and decline in the value of the dollar were leading to concerns about inflation and the need for higher interest rates in the U.S. as well. 

As prices dropped, fueling further selling....

To restore confidence, the most common form of lender of last resort today is the government central bank, the Federal Reserve....

The Federal Reserve Chairman Alan Greenspan restored confidence in the stock market by promising to make loans to banks exposed to brokers hurt by the steep decline in stock prices. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

12.5 Bailouts #Notebook

 12.5 Bailouts #Notebook

Bailouts restore the losses suffered by economic agents, usually with taxpayer money, outright grants, or purchase their equities, subsidized or government-guaranteed loans. 

However, it's politically controversial because it's usually unfair and increases moral hazard.

But, bailouts can be an effective way of mitigating further declines, if the massive deleveraging cannot stop.

During the Great Depression, the federal government used $500 million to capitalize on the Reconstruction Finance Corporation (RFC). 

In its initial phase, the RFC made some $2 billion in low-interest loans to troubled banks, railroads businesses, helped the economy to recover by keeping important companies afloat. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation.  Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.