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THE SOURCE OF MONETARY INSTABILITY
Robert Z. Aliber
I. INTRODUCTION
A. Nine Questions
B. Capsule International Monetary History 1970-2014
C. Cross Border Investment Flows and The Transfer Problem Process
D. The Scorecard--Primary Deficits and Secondary Deficits
E. Iceland--The Prototypical Case Study
E. Source of Instability-A Dysfunctional International Monetary Arrangement
F. Policy Issue #1 Revamping International Monetary Arrangements
G. Policy Issue #2 Regulating Domestic Banks
II. NINE QUESTIONS
A. Is A Banking Crisis An Act of God or A Predictable Event?
B. Why Do Banking Crises Occur In Waves?
C. Why Has Every Banking Crisis Been Preceded By An Economic Boom?
D. Why Have Banking Crisis Been So Frequent In the Last Thirty Years?
E. Why Have Banking Crisis Been So Severe In the Last Thirty Years?
F. Why Have Banking and Currency Crisis Occurred Together?
G. Are There Connections Between Successive Waves of Banking Crises?
H. Why Have There Been So Many Economic Booms and Busts?
I. Why Has Canada Not Had A Banking Crisis?
III. CAPSULE INTERNATIONAL MONETARY HISTORY--1970-2014
A. Four Waves of Banking Crises
B. Each Banking Crisis Followed a Boom
C. Most Booms Were Associated With Rapid Increases In Prices of Securities
D. Every Boom Followed From Rapid Increase In Supply of Credit
E. Every Boom Was Associated With Surge In Cross-Border Investment Inflows
F. Banking Crisis and Currency Crisis Largely Overlapping
G. Large Variability in Prices of Gold and of Petroleum
H. Large Variability in Market Prices of Currencies Relative To Long Run Average
I. Changes in Prices of Currencies Correlated with Changes in Prices of Securities
J. The U.S International Investment Position Morphed From the Largest
Creditor to Largest Debtor
K. Surges In Supply of International Reserve Assets
IV. CROSS BORDER INVESTMENT FLOWS AND THE TRANSFER PROBLEM
PROBLEM PROCES
A. Keynes' Transfer Problem
1. politicians set the level of reparations payments
2. gold must be continually re-cycled between France and Germany
3. necessary adjustments in Germany and France to ensure gold recycling
B. The Concept of Economic Absorption
1. When Investment Inflows Accelerate
2. When investment inflows slow
C. The Transfer Problem When A Currency Floats
1. A shock leads to surge in a country's capital account surplus
2. The invisible hands must ensure there is a comparable induced increase in
the country's current account deficit
a. the price of the country's currency increases
b. consumption spending increases
c. increase in household wealth drives consumption spending
d. Japan in the late 1980s experienced a decline in its capital account
deficit--hence Japan had to have an induced decline in its current account
surplus
V. PRIMARY DEFICITS AND SECONDARY DEFICITS
A. Definitions
1. PRIDEF=(EXP-INTPAY)>REVENUES
hence growth of indebtedness>int payments
2. SECDEF=(EXP-INTPAY)<REVENUES
B. THE DEFICIT MATRIX
Borrowers
PD SD
PD NW NE
Countries
SD SW SE
C. Inferences from the Data
1. A banking crisis occurs when borrowers can no longer finance a PD
2. A currency crisis occurs when a country can no finance a PD
3. Thus far no banking crisis has occurred when borrowers did not
have a PD
4. Some borrowers have transited from a PD to a SD without a crisis
VI. ICELAND--THE PROTOTYPICACAL CASE STUDY
A. The Uniqueness of Iceland
1. size
2. the banks were owned by thugs
3. massive increase in Iceland's capital account surplus
4. sharp increase in price of Icelandic krona
5. phenomenal surge in capital of Icelandic banks
6. massive increase in stock prices and household wealth
B. Primary Deficits in Iceland
1. Icelandic household borrowers had a primary deficit
2. Icelandic banks had primary deficits
3. Iceland the country had a primary deficit in its international payments
C. An Induced Increase in Iceland's Current Account Deficit Because of
1. the relative price effect
2. the relative income effect, following the surge in household wealth
D. What Was the "The Date of No Return"--That Date After Which a Banking
Crisis in Iceland was 99.44% Likely--Probability of a Banking Crisis is Higher,
1 .the larger the capital account surplus as a share of GDP
2. the higher the level of indebtedness as a share of GDP
3. the smaller the sensitivity of exports and imports to changes in the
price of the krona
E. Credit Flows After "The Date of No Return"
1. Why Did the Lenders Continue to Provide Credit to Icelandic Banks?
2. The Stance and Understanding of International Regulators
VII. THE DYSFUNCTIONAL INTERNATIONAL MONETARY ARRANGEMENT
A. What Is An International Monetary Constitution?--"The Rules of the Game"--
B. The Current International Monetary Constitution--the Claims of Friedman et al
1. is it better to adjust domestic prices and incomes and employment
so the parity can be retained, or to allow the prices of currencies to change?
2 smaller deviations of market prices of currencies from equilibrium prices
3 fewer currency crisis
4. each country would have greater insulation from external shocks
5. smaller demand for international reserve assets
C. The Pattern of Changes in the Prices of Currencies
1. Larger Deviations of Market Prices of Currencies
2. Cross Border Investment Flows Accelerate As Currencies Become
Overvalued
3. Changes in Prices of Currencies Are Correlated With Changes
in Prices of Securities
4. The Long Swings in the Prices of Currencies
5. Some currencies have fallen off steep cliffs (when the money inflow ends)
D. Why the Data Challenge the Claims of the Proponents
1. The Shortcoming of Their Model--A Goods Market and A Money Market
2. Monetary Shocks Have Been Much More Important than
Structural Shocks
VIII. THE POLICY CHOICES
A. The Current Policy Response Deals With Symptoms Rather than with Cause
1. Lehman could buy sub-prime mortgages only if it could sell its own IOUs
2. Credit Supply Follows from Investment Inflows and Monetary Policy
B. The Menu of Possible Changes in International Monetary Arrangements
1. A Monetary Union
2. An Amended Bretton Woods--wider bands and gliding parities
3. Tobin Taxes on Cross Border Flows
4. Macro Prudential Margin Requirements
C. Changes in Domestic Financial Regulation
1. Higher Capital Requirements
2. Living Wills
3. A Banking Crisis Ends When Authorities Indicate That they
Will Commit Capital to Prevent Failure
a. Bagehot and Illiquid Institutions
b. Bagehot and Insolvent Institutions
4. An Alternative Approach -Minimum Capital requirements--Government
becomes owner of failing institutions
a. one government agency provides too much credit
b a second government agency adopts regulations to
insulate economy from too much credit
IX. CONCLUSION-ANSWERS TO THE NINE QUESTIONS
A. The International Financial Arrangement is Dysfunctional
B. A Banking Crisis is a Predictable Event--Uncertain Timing
C. Banking Crisis Occur When Lenders Choke the Credit Supply
D. Cross border Investment Inflows Stimulate Economic Expansion,
But Are Too Rapid to be Sustained
E. Frequency of Banking Crises Reflects Large Variability in Cross Border
Investment Flows
F. Severity of Banking Crisis Reflects the Sharp Variability in Cross Border
Investment Flows
G. Banking and Currency Crisis Overlap Because Each Occurs
When Investment Inflows Slow
H. Links Between the Successive Waves of Banking Crises Reflects
the Variability of Cross Border Flows
I. Canada Has Avoided A Banking Crisis Because of Sluggish Foreign Demand
for Canadian Securities
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