December 6, 2010


How central banks make decisions?
Federal Reserve has come under scathing criticism after its second round of quantitative easing. Fed members have explained their decision in various forums. This entire decision making process is complex and done under uncertain times. JAN QVIGSTAD of Norges Bank explains the nuances involved in decision making at central banks in a speech (On making good decisions, 9 Nov 2010).

How do central banks make decisions under uncertainty? First, they try and have as much information as possible on the economic environment and build possible scenarios and make decisions on the most likely scenario. Second, they simply do what others have done. Like in this crisis, we saw central banks cutting policy rates together. However, aping others does not work all the time as economic situation is different. He points to examples from Norway’s history when they copied UK’s devaluation in 1931 and 1949. It worked in 1931, but failed in 1949.

Qvigstad points that committees help make better decisions compared to individuals. This is shown by both general research and specific research on monetary policy committees (MPC) in central banking. However again groups are no guarantees for good decisions as there are chances that independent thinking gets lost in groups. The members may simply base their analysis based on what others have been saying.

Overall, decision making in central banks is done in a highly difficult environment and current economic uncertainty is only adding to the complexity.

Understanding the issue of Currency Wars
WILLIAM CLINE and JOHN WILLIAMSON have a nice paper on the topic (Currency Wars). The authors base their calculation on their concept of fundamental equilibrium exchange rate (FEER). A fundamental equilibrium exchange rate (FEER) is defined as an exchange rate that is expected to be indefinitely sustainable on the basis of existing policies. They first calculate what FEER should be and compare it with what it actually is. Based on this, much like the Big Mac index, they calculate the exchange rate misalignment.

The authors then plot the countries on the basis of FEER and intervention:
• There are countries that have intervened to prevent appreciation but FEER shows undervalued currency – China, Hong Kong, Malaysia, Singapore, Taiwan etc. The intervention is unjustifiable.
• There are countries that have intervened to prevent appreciation but FEER shows currency in equilibrium – Argentina, Indonesia, Korea etc. Again, intervention is unjustifiable.
• There are countries that have intervened to prevent appreciation but FEER shows currency overvalued- India, Japan, Brazil etc. Here, intervention is justifiable.
• Then you have countries whose currency is in equilibrium and overvalued but have not intervened – Euro-Area, Canada, Mexico, US, UK, NZ, Australia etc (mainly developed economies who have preferred not to intervene so far).

The authors then take the analysis further and use James Meade analysis and classify countries on the basis of whether they need internal balance or excess supply. Most advanced economies are suffering from excess supply and need more demand where as emerging economies need to balance internally. As China is a country with undervalued exchange rates and also needs internal balance, it can contribute to world economy by letting its currency appreciate.

Was the Fed completely clueless in the Great Depression?
Milton Friedman famously said that the Fed created the Great Depression. If the Fed had eased around that time, the depression could have been averted. Or it would not have been as severe as it finally became.

MARK CARLSON, KRIS JAMES MITCHENER and GARY RICHARDSON have written a superb paper (Arresting Banking Panics: Fed Liquidity Provision and the Forgotten Panic of 1929) which shows that the story is not fully true. They point to an event study around April 1929 just before the beginning of the great depression. State of Florida is known for its oranges and around 1929, the crop was impacted because of fruit fly infestation. As a result, a large percentage of orange crops were destroyed and the infection threatened to spread to other regions as well. The state government quarantined the crop. Congress also thought of compensating the farmers but did not do anything.

This led to concerns over the banking system. As all banks were highly exposed to orange farmers, the loan book started looking worrisome. On realising this, depositors started rushing to their banks to withdraw deposits. This led to panic and a bank run. Banks were squeezed for liquidity. There are two issues here.

First, the crisis moved from real economy to banks. Second, the insolvency of banks resulted into a liquidity crisis as well. So, unlike the current crisis, the flow was opposite. In the current crisis, crisis moved from finance to real; and liquidity crunch led to an insolvency crunch.

In the crisis, the role of the Atlanta Fed was seen as critical. It not just sensed the crisis but acted forcefully to reduce the panic. It shipped millions of dollars to prevent panic. The authors add that Atlanta Fed intervention stands out for two reasons. First, it suggests that prior to 1930, the Federal Reserve had the knowledge and experience to calm anxious depositors and bankers during a panic. Federal Reserve officials demonstrated that they could effectively leverage their discount window lending capability with public announcements. This challenge may have provided a further impetus for the strengthening of the Board of Governors during the financial reform acts of the 1930s.

Second, Florida banking panic illustrates how an insolvency shock (in this case the potential losses stemming from the destruction of the citrus crop) can induce runs on banks and a precipitate a liquidity crisis.

This exciting study shows that the Regional Feds were better placed to fight crisis in their own regions. It also shows Monetary policy is helpful in reducing liquidity panics like Atlanta Fed showed in 1929 and Fed has shown in this crisis. It was able to prevent banks from falling. But if the crisis worsens and spreads, monetary policy usefulness is limited. Once a highly leveraged economy is in a liquidity trap, just pumping in money does not help. Monetary policy has many options after rates fall to zero levels but are unlikely to be very effective.

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