Islandiatiko albisteak

Olafur Margeirsson

@IcelandicEcon

One of those with a PhD in economics. Write about the Icelandic economy. Fan of realistic economics. Writing a book on #MMT in Iceland!

(i) Sarrerako lana:

Olafur Margeirsson‏ @IcelandicEcon1

First Patreon post in English: “Iceland’s sectoral balances and growth of tourism#MMT #sectoralbalances https://www.patreon.com/posts/13232825 

2017 uzt. 23

(ii) Doktorego tesia:

Financial Instability and Foreign Direct Investment2

Ondorioak:

6.1 Policy implications of this work

On 24th of November, 2005, Halldór Ásgrímsson, then the prime minister of Iceland, established a committee. The committee had the purpose of discussing the possibilities of building Iceland up as an international financial centre. The committee was headed by Sigurdur Einarsson, then the chairman of the board of directors of Kaupthing Bank, Iceland’s largest bank, but later found guilty of market manipulation, receiving a prison sentence of five years (Ríkisútvarpið, 2013). The committee’s report was published in October 2006

(Forsætisráðuneyti, 2006). It recommended some reforms that were to move Iceland closer to becoming an international financial centre. Two years later, the economy crashed and the financial system was wiped out. It was rebuilt only on the grounds of an exigency legislation (laws no. 125/2008, normally referenced to as “The Emergency Act”) that allowed, amongst other things, the Icelandic Financial Supervisory Authority to force banks into liquidation and the government to establish new banks on the ashes of the old, bankrupt ones. The Central Bank raised capital controls and took over the intermediation of international payments to and from Iceland.

Less than six years after the collapse of the Icelandic banking system, in June 2014, Aldo Musacchio, Associate Professor of Business Administration at Harvard Business School, argued that Iceland (Jónsson, 2014) … should try to follow into the footsteps of states such as Hong Kong and Singapore. It would be a good idea to make use of the experience and the knowledge which [Icelanders] have gained in the field of finance after the collapse of the banks in the fall of 2008 to open up the economy for foreign investors and turn it into an international financial centre.

(…)

As noted in the introduction to this work, Iceland has been an inspiration to me. One reason might be that Icelanders were, before 2008, stricken exceptionally blind by euphoria that nothing could cast a shadow on. Words of warnings were ridiculed. Infamous are the examples of Þorgerður Katrín Gunnarsdóttir and Árni Mathiesen before the crash in 2008. In 2006, when the Icelandic banks faced criticism regarding their business model from international finance professionals, including Richard Thomas of Merrill Lynch, Gunnarsdóttir asked, as the minister of education and a member of the Icelandic parliament, if Thomas “did not need a refresher course [in economics]” (Vísir, 2008c).

Mathiesen, as the minister of finance and a member of parliament, asked, in March 2007, the opposition, who tried to echo the words of warning from abroad: “Boys, can’t you see the party?” (Alþingi, 2007). A year and a half later, the party was over.

Steingrímur Hermannsson, then the minister of foreign affairs and a member of the Icelandic parliament, commented back in 1987 that “in this small economic society of ours [Iceland], which is far from being in equilibrium, those holy laws of economics do not apply” (KB, 1987). Those words have been repeatedly ridiculed since then. They have been interpreted such that Iceland is conceived as being “special” and so unique that the “holy laws of economics do not apply.”

But of course the laws of economics must apply in Iceland, like any other economy. Otherwise, they are not laws in the first place. And Iceland is just an economy, like any other. Hermannsson’s words are an oxymoron at best and nationalistic at worst. But Hermannsson must be given credit. He was referring to the laws of laissez faire economics: “[m]onetary policy based on laissez-faire economics will take everything here to Hell if it is not stopped” (ibid). Twenty-one year later, the economy, under the helmsmanship of liberal economic theories, arrived to Hell.

To Minsky, like post-Keynesians, the laws of laissez-faire economics were not laws in the first place. The economy was not destined to tend to a stable equilibrium but to unstable disequilibria. With the passing of time, a “stable” economy would endogenously develop trends towards ever increasingly fragile financial structures. The time would come that the system would, endogenously, break under the build-up of leverage and debt and a financial panic would be the result. Contrary to laissez-faire economics, “stability is destabilising” and the government had a role: to stabilise markets and solve “the policy problem”.

Minsky built his theory of endogenous financial instability on a diverse set of economists that preceded him. Schumpeter was his doctoral supervisor and he understood, like post-Keynesians, how money is endogenously created by the banking system and how endogenous money finances economic activity without any ex-ante savings. Fisher’s debt deflation theory explained how too much debt can force a deflation in prices to take place, which will have a feedback back onto the overburden of debt so that a vicious cycle sets in. Kalecki’s principle of increasing risk helped understanding how an interest rate increase can develop, endogenously, in the financial system as the leverage builds up.

The increase in interest rates can then act as the snowball that turns into the avalanche of debt deflation.

But it was Keynes who provided the shoulders of a giant that the FIH stands on. It was Keynes’s approach to economics, relying on uncertainty, money, and human behaviour, that provided the most influential theories behind Minsky’s formulation of the FIH. Keynes was so influential to Minsky that he saw it worthwhile to write a book, named after Keynes himself, about his theories and how they had been misunderstood by the mainstream.

Admittedly, because Minsky’s theories are constructed on Keynes’s, it can be hard to see where the line between them is to be drawn. This work, which to a large extent rests on Minsky’s theories, can consequently be interpreted as being an offspring of Keynes’s theories rather than his intellectual son. As an example, the last chapter of this work builds a monetary system which, it is argued, helps solving the “policy problem”, as Minsky described it. But it can just as well be interpreted as a continuation of Keynes’s ideas for Keynes “regard[ed] monetary policy as an important policy to prevent recession and public works as most relevant to the cure of recession” (Chick & Tily, 2014, p. 2). That is exactly what the OERS, along with Keynes’s public debt management, does. It uses monetary policy (quantitative and qualitative credit controls) to prevent recessions and keep the economy permanently in a “quasi boom”. Public works, such as an Employer of Last Resort program, act as a failsafe – the cure to recessions – in case the monetary policy fails, for one reason or the other, to prevent them.

Reorganising the way monetary policy is done may seem radical to some. But the dominant monetary-policy regime of the day, i.e. inflation targeting, has been tested. And it failed the test. Today, it is generally accepted that keeping inflation down is not enough to secure financial stability (Bank of International Settlements, 2014). Central banks have therefore had to improvise and the idea of “Inflation Targeting Plus” has, essentially, resurfaced.(173) According to these ideas, inflation targeting must be accompanied with something else, such as direct interventions on the exchange rate market or more proactive government finances. Changing interest rates to suffocate inflation and let the market do the rest is not enough. But the problem goes deeper than that. Monetary policy based on an inflation target and conducted by changing interest rates seemed to have defeated high inflation when it was gradually adopted in the late 1980s and 1990s. But that success can be ascribed to nothing else than luck: it was the lack of economic shocks that created the Great Moderation and not inflation targeting (Beckworth, 2014; Cecchetti & Ehrmann, 1999). And one cannot ignore the fact that the Great Moderation preceded the Great Recession without monetary policy based on inflation targeting having much to say about it: monetary policy based on inflation targeting did not prevent the Great Recession, thereby failing to fulfil the purpose of monetary policy as Keynes saw it.

(173) The term has also been called “Augmented Inflation Targeting” and “Inflation Targeting 2.0” (Baldwin & Gros, 2013). No exact definition of the term seems to exist but Baldwin and Gros highlight that it “involves financial stability considerations – even when that means coordinating with other domestic institutions, regulators, and so on”. This, of course, breaks the “linchpin” of the trust that the inflation target itself rests on: central-bank independence. There is therefore a certain internal conflict in “Inflation Targeting Plus”. A mention of the exact term, considerably before the Great Recession, is in Holub (2004). But the idea is older. As an example, Bofinger and Wollmershäuser (2003) discuss the role, or the lack thereof, of exchange rate interventions in a macro model where the monetary policy is based on inflation targeting. They then introduce exchange rate interventions as complementary to inflation targeting via policy rate changes and note that despite central banks declaring their target being inflation and their policy tool being interest rate changes, they frequently intervene in the exchange rate market. Goldstein (2002, p. 1) discusses “”managed floating plus,” where the “plus” is shorthand for a framework that includes inflation targeting and aggressive measures to reduce currency mismatching.” But the policy tool is still interest rate changes.

So just as interest rate changes superseded the idea of conducting monetary policy on the basis of growth of the money supply, the “experiment” that inflation targeting is may have reached its end (Beckworth, 2014). Something else must come instead. “Inflation Targeting Plus” is one suggestion. Another suggestion is the OERS, supported by the tested, and successful, method of managing the public debt a la Keynes.

The switchover from the Great Moderation to the Great Recession would have been impossible within the OERS. First, credit controls would have stopped the debt build-up. Credit fuelled asset bubbles would have been few and small. Second, interest rates would have been more stable, supporting the financial structure of the economy instead of being the source of instability via changes in the interest burden. Third, money manager capitalism would have been attenuated and its destabilising effects, at least the part arising from international capital flows, euthanised within the OERS. Fourth, deficit spending, in case of monetary policy being incapable of preventing the recession from beginning, would have been targeted directly towards public works and full-employment schemes. Consequently, unemployment would have been kept at bay. So even if the recession would have taken place it would have been immediately stopped in its tracks: if the prevention would have failed, the cure would have followed.

The policy implications of this work are not to shut down or fight international economic activity, even if foreign direct investment, like other international capital flows, can have a negative impact on financial stability. Far from it! The policy implications are that the institutional structure of the monetary system should be restructured, yet without shutting down globalisation. International economic activities such as foreign direct investment programs can yield positive results. Nevertheless, they should not be carried out in the blind faith of free markets and wishful thinking regarding ergodic trends in the economy towards stable equilibrium. Rather, the economy should be recognised for what it is: a chaotic non-equilibrium system with endogenous processes that tend to unstable equilibria, as Minsky and post-Keynesians have argued. As such, the policy implications of this work are to reorganise the institutional framework of the monetary system such that the possible positive effects of international economic activities, such as foreign direct investment, can be enjoyed to the fullest without putting financial stability at risk. The OERS is a theoretical contribution in that direction, based on observations of how the world works.

6.2 Where from here: the next steps in research

There are still aspects of financial instability to be understood. The approach here has been from the macroeconomic side. But the organisational setup of the financial system matters as well. For banks have two roles in the economy.

The first is the lending function: to screen potential borrowers and create credit.

The second is the payment function: to intermediate payments and thereby grease the process of commerce. But the first function – the lending function – can make banks fail while the second function – the payment function – relies on them not failing. Therefore, banks’ roles in the economy are inherently misaligned (R. J. Phillips, 2014).

Studying financial stability and its maintenance must also be done from the organisational point of view of the payment system. This is not done in this work and could be a welcomed expansion of it. Again, Iceland’s experience in 2008 is inspirational. Iceland’s payment system was and is channelled through the central bank which operates as the system’s settlement institution. This is the reason why Icelandic debit and credit cards continued to function normally despite the banks going bankrupt in 2008: the payments are settled in central bank money. In contrast, payments with debit and credit cards are settled with commercial bank money in the United Kingdom (Dent & Dison, 2012). That organisation would have been catastrophic had it been the implemented one in Iceland in 2008: commercial bank money became worthless and illegible as a means of payment as the banks went bankrupt. The problem of banking institutions being too-big-to-fail is closely connected to this organisational structure of the payment system. To end too-big-to-fail, banks cannot be allowed to be an indispensible part of the ultimate settlement process of the payment system. Setting the OERS up in a stock-flow consistent framework and rigorously testing it to various types of endogenous and external shocks (a build-up in leverage, a credit-supply shock, a fall in productivity, changes in consumer preferences, changes in foreign interest rates, etc., etc.) would be very informative and speed the development of the system.

Finally, the OERS is likely to receive criticism. That natural criticism must, of course, pass the tests of being relevant and “strive to explain the real world as observed empirically”. It should not be built on “imaginary models” and be irrelevant to real-world economic analysis. Judging on the severity of that criticism the system may have to be amended and developed further. That work, as this has hopefully been, must always be carried out with the aim of post-Keynesian economics in mind:

…to provide a clear understanding of how the economy works, by relating economic analysis to real economic problems. 


Iruzkinak (1)

  • joseba

    *ENGLISH* (in https://www.patreon.com/olafurmargeirsson)

    Hey there!

    So, I’m Icelandic and I started this site to finance my passion for writing about economic theory and issues, in particular post-Keynesian and Modern Monetary Theory, with a focus on Iceland. 

    I’ve been blogging about the Icelandic economy since 2009, both in Icelandic and English. I did this alongside my PhD studies in Economics, which I finished in 2014 (check out my thesis here). Thanks to my blogging and other contributions in the media, my message is slowly getting through. I was voted by the Icelandic parliament as an Alternate Member on the Supervisory Board of Central Bank of Iceland. I also happily support the Binzagr Institute for Sustainable Prosperity as one of their scholars. 

    Now, besides articles written here that focus on the Icelandic economy, I’m writing a short book for the ordinary Icelandic person. This book will focus on MMT, post-Keynesian economics in general and how policies based on these principles could help the Icelandic economy.

    I do plan to blog in English about the Icelandic economy as well and I hope this website will become source of info for you on what’s going on there. In time, I also plan to translate the book if I manage to finance that work.

    Don’t hesitate to contact me if you’ve got questions about the Icelandic economy! And if you’ve got $1-$50 dollars to spare, I’d certainly appreciate your assistance! If you support my by $5 a month, I’ll send you a copy of the book, when I’ve finished it, anywhere in the world!

    Cheers!
    Olaf

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