Money, Banking, and Financial Markets

Understand the principles, understand the future

People use a variety of statistics to gauge how the economy is doing. It is fairly straightforward to measure nominal GDP, so the challenge of estimating real economic growth arises from the need for accurate measures of prices. Price measurement also is key for inflation-targeting central bankers, who need a number as a guide and for public accountability. To be credible, that number must be based on an index constructed using established scientific methods.

Reflecting a set of well-known (and nearly insurmountable) difficulties, measured inflation has an upward bias. That is, the inflation numbers that statistical agencies report are consistently higher than the theoretical construct we would like to compute. As a consequence of this upward bias in inflation measurement, our estimates of growth in real output and real incomes are systematically too low.

The big question today is whether the bias in inflation measurement, and hence the bias in the measurement of growth, has increased in recent years. As Martin Feldstein describes in detail, the answer to this question is important, as it affects how we collectively view long-run progress. If published statistics show sluggish real growth, as well as slow growth in real wages and incomes, then people may be unduly pessimistic. A worsening bias would add to that pessimism.

In practice, however, careful recent analysis suggests that inflation measurement bias has not changed much since the early 2000s….

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

To read the full article, click the headline.
Further commentary, click here.

Welcome to ...

... the site where you can learn about finance and economics. We provide commentary on events in the news and on questions of more lasting interest. Because the financial system is constantly evolving, our analysis is informed by a set of core principles: understand the principles, understand the future. The opening excerpts of our two most recent posts appear above. For prior posts, click on the Commentary link to the left, or on the month-by-month Archives to the right. Alternatively, if you are interested in a specific topic, use the tags.

The site also provides material related to our textbook, Money, Banking and Financial Markets, 5th edition, 2017. The Five Core Principles on which the book is based are highlighted here. In addition, Cecchetti and Schoenholtz 5e systematically integrates the use of economic and financial data from FRED, the online database provided by the Federal Reserve Bank of St. Louis. Click on FRED Lessons on the left to access help on how to use this incredible resource.

Steve Cecchetti and Kim Schoenholtz

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