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31 октября 2012, 16:01

OMT: Slouching toward Eurobills?

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The Eurocrisis has many dimensions—bank solvency crisis, sovereign debt crisis, political unity crisis, and economic/unemployment crisis—but time after time it has been the liquidity crisis dimension driving events, and ECB response to the liquidity crisis driving institutional evolution.  The reason is simple.  Liquidity kills you quick.   Most people, probably, think that the real point of Outright Monetary Transactions is to support the price of sovereign debt, notwithstanding Draghi’s claim that it is about fixing a broken monetary transmission mechanism, since low policy rates seem not to be transmitted to low sovereign debt rates.  But maybe Draghi has more of a point than most people realize.  From a money view perspective, let’s consider the possible connection between proposed Outright Monetary Transactions and the ongoing problem of burgeoning Target 2 balances between surplus and deficit national central banks of Europe.     If there were Eurobills, balances could be settled periodically by transfer of assets, just as is done in the Federal Reserve System.   More precisely, if there were a System Open Market Account at the ECB, in which all of the national central banks held shares, settlement could be made by transfer of shares.   From this perspective, OMT can be seen as the first step toward a kind of system open market account, and the shares in that account would be a kind of first step toward a Eurobill.      We know that the Bundesbank is not happy that it has accumulated such large Target 2 balances, which are essentially unsecured claims against the Eurosystem as a whole.  We know also that the Bundesbank would be quite happy receiving German bonds as settlement for those claims, but that is not going to happen and everyone knows it.  So the question is whether Spanish sovereign bills would be acceptable, and it seems that maybe the answer is positive, especially if the sovereign commits to some kind of conditionality before hand.     Even better however if the Bundesbank could receive shares in a system open market account, representing a portfolio of the various assets held by the Eurosystem.  The point is not so much diversification as it is security.  In effect, these shares would be a kind of proto-Eurobill, maybe not yet traded in private money markets, but traded nonetheless in settlement between national central banks.  So maybe we should  be pushing for a package deal, not just Spanish OMT but also others (Italy and maybe also France), in order to begin creating a system open market account at the ECB. (See here for such a proposal).   If it works, OMT holds out the prospect to finally settle the Target 2 overhang.  Start with Spain.  Suppose that Rajoy asks for OMT.  Spanish banks sell Spanish bills to the ECB, use the proceeds to repay loans from their national central bank, which then uses the proceeds to repay Target 2 loans from the Eurosystem.  Hey presto, settlement.     But now the ECB has new Spanish bills as an asset, and new deposits as a liability, and both have to be booked at one of the national central banks.  Book them at the Bundesbank and the deposit liability cancels against the Target 2 repayment, leaving Spanish bills as an asset.  In effect, Target 2 balances are replaced by Spanish bills.  That's why the crux of the matter is whether the Bundesbank commits to accept Spanish bills.   The larger point of this post is the simple observation that the Bundesbank will more readily accept Spanish bills if in some sense these bills are the joint and several liability of all the European sovereignties.   If Spain, Italy, and France all went in for OMT together, and the resulting assets were segregated in a system open market account in which all national central banks held shares, we would be halfway there.   The unsecured liabilities of the Eurosystem, such as Target 2 balances, are already the joint and several liability of the national central banks which capitalize the ECB.  A system open market account in which national central banks hold shares is just a secured version of the same thing.  This is the sense in which Draghi’s OMT offers the prospect of a kind of backdoor Eurobill, essentially a secured clearinghouse certificate now, but possibly something more in the future.  

18 октября 2012, 00:54

Liquidity, Down the Drain

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China released quarterly GDP figures this week. Wen Jiabao emphasized the parts of the release that pointed toward stabilization, and one can certainly find some logic to that view. Stabilized or not, China's target of 7.5% growth marks a steep slowdown over recent growth rates. Other major economies, facing weak demand, currency crisis, and high unemployment, have pushed monetary policy to the hilt with various forms of central-bank balance sheet expansion—QE3 in the US, OMT (announced, not yet used) in the euro zone, and maintenance of a currency peg in Switzerland. What about China? The PBoC has certainly not been sitting still. Earlier this week it lent RMB 30bn ($5bn) to the money market, on the heels of a near-record injection of RMB 265bn ($42bn) into the Chinese money market earlier this month. This has come in the form of reverse repo operations: It is worth remembering what is the immediate effect of such injections on the financial system. In a contracting economy, borrowers are coming up short, unable to meet their maturing obligations as they come due (in China as in any financial capitalist economy). The strain falls onto the banks, who can absorb it when the shortfalls are small. When the shortfalls become too large to be absorbed by any one bank, the biggest bank around, the PBoC, can create new money to meet the strain, which is the economic substance of these short-term liquidity operations. They have been successful in pulling down overnight interest rates, but not at even slightly longer tenors, including the normal measure of Chinese interbank conditions, the seven-day repo rate. The RMB 265bn ($42bn) injection was enough to bring down the seven-day rate by just 3bp. One problem is that the reverse repo operations themselves have a fairly short term, and so they will have to be refinanced or unwound over the next few weeks, depending on whether the PBoC continues accommodation. The context of all of this is the question of whether China will be able to rebalance incomes in its economy away from investment and toward domestic consumption. If the current high level of investment is unsustainable, it will surely come to an end. Coming to an end means, practically speaking, that producers of capital goods (and inputs to those goods) will be coming up short at the end of the month. There is evidence, albeit anecdotal, on this score. In his latest newsletter, Michael Pettis points us to Bloomberg: Copper inventories at bonded warehouses in Shanghai probably climbed to a record as import premiums dropped to a four-month low, signaling demand in China may not be improving as much as expected after a summer lull. Other similar stories can be found. Simply put, as investment spending falls, industrial inputs like copper will go unsold. Inventories will pile up, and producers will find it hard to pay their bills. This will in turn bubble up as unmet obligations and, ultimately, liquidity strains in the banking system. There are two ways out: either chronic shortfalls leading to bankruptcies in the capital-goods sector and contraction of investment, or sufficiently rapid growth of consumption to rebalance the economy without allowing capital-good production to contract. The trouble for the PBoC is that, in the first case, the shortfalls are not going to go away in seven days or even in three months, so liquidity is no help; and in the second case, a major structural change needs to play out, so liquidity is still no help. China has avoided large-scale stimulus in the current cycle, perhaps looking ahead to the Party Congress and leadership change in November. So perhaps the PBoC, not entirely unlike the Fed, feels that monetary policy must be used, even if fiscal policy would be more appropriate under the circumstances. The Fed, the ECB, the SNB, and the PBoC have taken stock, and each has decided that large amounts of liquidity are called for. Rough seas ahead seems a safe prediction.

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03 октября 2012, 21:23

Ring-fencing Explained

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Everyone wants to ring-fence something, but they can’t agree on what:  Vickers, Liikanen, Volcker. In all proposals, the idea is to have bank capital separately allocated for some activity, and to prevent that capital from being exposed to any other activity.  Some people want to lock the wild animals in a cage to keep them away from us; some people want to lock the tame animals in a cage to keep them safe from the dangerous world outside. Vickers wants to ringfence retail banking, with the idea of trying to protect Main Street from the other more risky activities of banks.  Liikanen wants to ringfence all trading activities (i.e. Wall Street), apparently in the hope of keeping the rest of the bank safe from them.  And Volcker wants simply to ring fence the market-making aspect of trading, in order to separate it from so-called proprietary trading which exposes bank capital to price risk. All three proposals represent attempts to come to regulatory grips with the dramatic changes in the nature of banking over the last 30 years or so, changes that were revealed to the world by the global financial crisis that began in August 2007 and continues to this day. My own view is that we need to begin by thinking of banking more generally as dealing, and distinguish between money dealers who quote buy and sell prices for funds, and risk dealers who quote buy and sell prices for risk.   I think both of these activities need backstop, not just the money dealers, but different kinds of backstop since funding liquidity is a different thing from market liquidity. Further, in both cases, we need to distinguish between matched-book dealing and speculative dealing.  That’s essentially what Volcker is trying to do, but probably I get to this view from a different chain of logic.  The ideal of matched book is to have offsetting risk exposures that exactly net out; if you could really do this, you would not need any capital since you would be bearing no risk.  But there is one kind of risk that does not net out, and that is liquidity risk which is systemic.  The larger the scale of the matched book position, the larger the liquidity risk, even if all other risks net out.   Because of this, there is always an implicit liquidity put from matched book dealers, both money dealers and risk dealers, to the central bank.  My view is that we should make that liquidity put explicit, and then argue about the details, including how much it should cost. Speculative dealing is an entirely different animal, at least conceptually.  It is true that liquidity risk is involved, again in both money and risk dealing, but price risk is the big thing, so this is where you want there to be capital requirements, or other ways of ensuring that the taxpayer is not providing implicit capitalization.  Where does that leave me in terms of the proposals on the table? I don’t think it makes sense to try to ring fence either Main Street or Wall Street.  Shadow banking brought them together—money market funding of capital market borrowing—and the collapse of shadow banking has torn them apart.  We could of course simply adopt a regulatory structure that reads that experience as the verdict of history, and so strives to keep the two sides apart forever more.  My concern is that maybe that is just piling on, rather than constructively trying to imagine an ongoing engagement between the two, a market based credit system that is shorn of the worst elements of the shadow banking system. Europe is having its Glass-Steagall moment, and maybe they just have to go through it.  But the US has been there and done that.  I’m with Volcker that we need to try to distinguish matched-book market making from speculative position taking.   The former involves liquidity risk, and requires liquidity backstop, which should be forthcoming.  (Maybe we should actively try to concentrate it at central clearing counterparties?)  The latter involves price risk, and requires capital backstop, which should be demanded by counterparties in the first place, and by regulators protecting the public purse in the second place.

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19 сентября 2012, 23:51

QE3

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Last Thursday, the Fed announced its anticipated third round of balance-sheet expansion, at a fixed rate of about $40B per month "until [substantial] improvement [in unemployment] is achieved in a context of price stability". A relief, perhaps, to see some attempt at boosting the economy. But in a column that appears to praise Bernanke for doing something—anything—Martin Wolf still suspects the policy will fail to live up to hopes, and I am inclined to agree. How should we understand QE3? The Fed promises to buy MBS, and possibly other assets, at a fixed and steady pace until employment improves. The immediate effect is to absorb such assets from elsewhere in the financial system. This is, in the first instance, a boost to the liquidity of these securities: when a big-time buyer is out there, it will be easier to sell, and knowing that a big-time buyer will continue to be out there, others will be more likely to buy. Large-scale purchases (and $40B a month is quite large-scale) can also be expected to raise the price of the securities, and anticipation of such effects went immediately to the benefit of bank share prices, which spiked after the policy was announced. The existing supply is unlikely to be enough to meet the Fed's demand for too long, and so it will have to be met with new origination of the underlying mortgage loans. The Fed's statement says it aims to "put downward pressure on longer-term interest rates." What channel would make this work? The Fed could be hoping that its presence as a buyer will support new lending. If this new lending facilitates an increase in sales of new homes, equity withdrawals (or refinancing) to finance consumer demand, it could increase aggregate demand and GDP. In balance sheets, the channel looks like this: But this is quite an indirect way to generate demand. Narrowly, a spread already seems to be opening between rates faced by borrowers and MBS yields—the origination channel, so to speak, can not be counted on to transmit the asset purchases all the way to households. The yield on MBS rises, but rather than mortgage rates falling, originators are capturing a wider spread between the two rates. The rise in MBS prices, that is, leaks out as increased fees to the financial sector. At the highest level, finally, does QE3 get at what is keeping aggregate demand down? If the problem remains, still, overindebted households unwilling to increase their demand for newly produced goods and services, then this liquidity-providing operation will have very little effect. If there is too much debt out there, and it is to be reduced, someone will have to write that debt down against equity. This is not a feature of QE3 as announced. Special video feature This final observation on QE3 offers a passable segue to the ECB's announcement of outright monetary transactions earlier this month, and George Soros's plan to address eurozone sovereign indebtedness. After a conversation this morning, I decided to take the US, in words, and Perry took Europe, in a video:  

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30 июля 2012, 02:38

The fix was in

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In Friday's FT, former Morgan Stanley trader Douglas Keenan traces banks' LIBOR manipulations back to 1991, when he observed, from the futures desk, LIBOR fixings come in at levels different from where he new the market to be. "My naivety seemed to be humorous to my colleagues," he writes. There is an easy story in the Barclays LIBOR scandal, one with a good bit of truth to it: avaricious bankers manipulated their submissions to quasi-official benchmark rates, taking advantage of what had naively seemed a clean measure of interbank lending conditions. During the crisis, the same sort of manipulation was used to hide banks' weak financial positions. There is truth to this story, without question, and blame to go around. But that a bank would consider every action strategically, even its LIBOR submissions, and that at least some would misrepresent their submissions for profit, does not seem like a revelation. The story, however, also exposes some rather deeper truths about banking. To get there, some mechanics are necessary. To make a business taking deposits, a Jimmy Stewart bank must stand ready to exchange depositors' funds into cash and back, at the depositors' initiative. It gives up, that is, a measure of control over its own liabilities. On the other side of its balance sheet, it holds a portfolio of assets that, it hopes, will yield enough cash to meet depositors' demands with something left over. If ever such a bank cannot make good on its obligations, the central bank ensures the availability, at a price, of reserves. Such a guarantee of liquidity means that depositors can be sure that their bank will always be able to make payment on their behalf. Instead of putting principal on deposit with the bank, its customer might instead do something more fundamental. What it really wants is to forgo the floating payments it might earn on its cash in favor of receiving fixed payments. The bank can oblige by standing opposite the customer in an arrangement to simply swap the cash flows, fixed for floating, never mind the principal, which gets returned in full eventually anyway. The customer gives up the possibility that rates will rise for the certainty of receiving a fixed payment, and the bank accepts the fixed payment for a fee, and for the possibility that rates will fall. Such an exchange of cash flows, called an interest-rate swap, is the most basic instrument of banking. To make a business dealing in such swaps, a derivative bank must stand ready to swap with its customers from fixed into floating and back, at the customers' initiative. Sometimes the bank's trades will net out, leaving the bank with no exposure. More often, trades will not quite net out. The derivative bank can adjust its posted prices to help it achieve a net position that, it hopes, will yield enough cash to meet its swap obligations with something left over. Swaps (and much of this discussion applies no less to interest-rate futures) tally the floating side using a reference rate, BBA LIBOR and EBA EURIBOR being two of the main such rates. These rates are fixed each day based on surveys, opening the door to manipulation by false reporting. What is more, swap payments depend critically on the fixing of the reference rate on a single key day—the reset date—meaning the payoff to a well-timed manipulation could be large. When a swaps dealer is short of the reserves it needs to settle periodic payments on its swaps contracts, there may not be an easy recourse to the central bank. The dealer must rely on backstops from its banks, whether they are separate firms or different parts of the same universal bank. The swaps dealer could avoid reliance on these backstops, though, if it could exert some control over the reference rate. By making a market in swaps, it has sold liquidity to meet its clients' demand. By pushing the reference rate around, it creates a free supply of liquidity. Not perfect, because the LIBOR fixing depends on the submissions of many banks, and because the scope for manipulation was only a couple of basis points. And not even free, in the end, as Barclays has learned. But a good enough source of liquidity that it was done dozens of times. What felt to derivatives traders like a looming loss on their books appears at a higher level as a liquidity shortfall. For deposit-taking banks, a large system has been built up to prevent such shortfalls from ruining them. When the same business is done with derivatives, no such system exists. The rules for LIBOR submissions turned out to be the weak link, and so they broke down. If something new is to be installed as the reference for trillions of dollars' worth of derivatives, it might provide an opportunity to address this asymmetry.

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20 июня 2012, 04:14

Lethal Embrace? A Thought Experiment

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At the heart of the Eurocrisis lies a vicious circle where once there was a virtuous one.  Over the last week or two, the FT has been reflecting on the connection between the sovereign debt crisis and the bank crisis, conjoined twins (as George Soros has put it) of the current Eurocrisis.  See here, here, here. Historically, banks have stepped in to help sovereigns in their time of need, such as the stresses of war finance, by expanding their own balance sheets, offering bank liabilities (money) in exchange for sovereign debt that has no alternative ready market.  Contrariwise, sovereigns have stepped in to help banks in their time of need, offering central bank liabilities (reserve money) in exchange for bank debt to allay periodic liquidity crises, and sometimes going so far as to offer sovereign Treasury liabilities in exchange for bank equity issue that has no alternative ready market. The problem Europe now faces is that monetary union, a fait accompli, left in place the historical symbiosis between national banking systems and national sovereignties, as well as the pattern of thinking formed by generations of experience with that symbiosis.   As a consequence, when the crisis hit, national banking systems stepped in to help their national sovereigns, and national sovereigns stepped in to help their national banking systems.   Both thought they were doing the right thing, based on past experience.  But the consequence has been to transform isolated sovereign debt crises into systemic bank crises, and to transform isolated national bank crises into systemic sovereign debt crises.  What started as a problem of the periphery (the famous PIIGS) is now threatening the very core of Europe, both sovereigns and banks.  The ongoing run on Greece et al. is now threatening to become a run on Europe, both European sovereigns and the European banking system. The problem is that banking is no longer national, and neither is sovereignty. Calls for “fiscal union” are calls for replacing lost national sovereignty with something new, supra-national sovereignty.  The EFSF, and then the ESM, were supposed to be steps on the road toward a common European Treasury, and a common European sovereign debt (Eurobonds and Eurobills).  Maybe it could work, from an economic point of view, but by now it looks like too big a step to be achieved in the time available, from a political point of view.  Angela Merkel is not wrong when she says we are in a race between politics and the market, and we know which one of these is the hare and which one the tortoise. That is the background needed to understand properly the shift, in recent weeks, toward focus on “banking union” instead.  But old patterns of thinking still stand in the way.  If you think of banks and sovereigns as inherently symbiotic, then it is hard to conceive of banking union without fiscal union, and vice versa.   (See here the FT article today that finally inspired me to put my developing thoughts on the record.) Here is the main point.  History tells us that there is nothing inevitable about such a symbiosis.  Banking, indeed even international banking, existed long before the modern nation state.  The origin of the lender of last resort function of the modern national central bank is in the operation of private bankers’ banks.  (In the US, before the Fed there was J. P. Morgan.)  There is no logical, or economic, necessity for sovereign backstop of banking.   It follows that there is no logical, or economic, necessity for fiscal or political union to precede, or even coincide with, banking union. Of course today the balance sheets of European banks, including the ECB, are stuffed with sovereign debts of one kind or another, and that fact by itself makes it hard to think about banking union without fiscal union.  But let’s try, as a little thought experiment.   Let us imagine a special purpose vehicle, a private vehicle without supra-national backstop, which issues its own private securities of various types and uses the proceeds to buy sovereign debts of various types.   (For those who remember fall 2007, think of it as an analogue to the super-SIV idea, except that the assets are sovereign debts rather than tranches of securitized subprime mortgages.)   In this way, sovereign debt could be removed from the banking system and replaced with cash, which (suppose) banks use to repay liabilities so shrinking their balance sheets by the size of their debt holdings.   No doubt some banks would still be in trouble, but we can imagine banking union proceeding as the Europe-wide solution to that remaining trouble. But wait, you say, what about deposit insurance, currently national and so currently a second channel of lethal embrace?  But this is just another asset of the bank and another liability of the sovereign.   Since we are just thinking, let’s imagine that we place a market value on this asset and have the SPV buy it as well.   Note that, by making this implicit asset explicit, bank capital will be increased.  Even so, no doubt some banks would still be in trouble. The point of this thought experiment is to enable us to think separately about the sovereign debt crisis and the banking crisis, and to conceive of the possibility of addressing each separately.  At the end of the day we will be left with a range of private banks, some insolvent, some merely illiquid, and perhaps a few that are okay.  That is one side of the problem.  And we will be left with our SPV; that is the second side of the problem. But, most importantly, we will also have broken the lethal embrace.   Investors who are thinking about lending to private banks, or perhaps taking up a new equity issue or taking over the existing equity ownership, can form estimates of value without having to consider the fortunes of the bank separately from the fortunes of the sovereignty where that bank has its headquarters.  And investors thinking about lending to a sovereign, or perhaps taking up the securities issued by the SPV, can form estimates of value without having to consider the fortunes of the banking system that happens to be headquartered within the national boundaries of that sovereignty.  If we think the lethal embrace of banks and sovereigns is currently taking both down together, then breaking that lethal embrace should improve the fortunes of each separately.  It’s a win-win. Historically, the origin of the embrace between sovereigns and banks was pragmatic.  They did it because it was a win-win.  Today it looks like the win-win involves dissolving the embrace.  

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06 июня 2012, 23:00

Swexit - When will Switzerland exit the euro?

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Since September 2011, the Swiss National Bank has held a floor of 1.20 francs per euro. This floor has in practice been a peg, as the pressure has been in only one direction, downward (that is, in the direction of CHF appreciation). Image via FT Alphaville As funds fled the euro crisis last summer and fall, the Swissie appreciated, putting in jeopardy the competitiveness of Swiss exporters.  The SNB first intervened, first in an ad hoc way and then as a formal policy commitment. As long as the pressure is toward appreciation, this policy cannot run out of ammunition: the SNB can always meet the demand for francs against euros by creating new franc-denominated reserves to purchase euro-denominated assets. Before it runs out of ammunition, though, the policy could run up against other constraints, about which more below. By fixing the exchange rate, Switzerland was joining the euro, albeit in a limited way. A unified payment system is what knits together a monetary union. Within the eurozone proper, this role is played by TARGET2. A euro deposit in Athens is guaranteed to extinguish a euro of debt in Berlin, and that guarantee is backed by the operation of TARGET2. The national central banks allow claims among themselves to clear payment flows for the system as a whole. To hold fixed the exchange rate between the CHF-denominated Swiss banking system and the EUR-denominated eurozone, the SNB is in effect creating on its own balance sheet a payment system for the Swiss banking system, carrying correspondent balances for exchange against EUR for all its member banks. To achieve this, the SNB gives up the initiative in managing its balance sheet—it meets all demand for Swissies at 1.20 per euro. Here it is in balance sheets: When you look at it this way, you can see the other side of the transaction too: the SNB is facilitating the world's portfolio reallocation out of EUR and into CHF. Even fixed at 1.20 francs per euro, funds have been fleeing the euro area as the crisis heats up again. The SNB's policy means that any net flow results not in price adjustment, but in fluctuations in the size of its own balance sheet. This permits expansion of CHF-denominated claims for the entire Swiss system. Now we see that this expansion is not fast enough to prevent all price adjustment: via Zerohedge, the yield on 2-year Swiss government debt has now gone negative. By fixing the exchange rate, Switzerland has, in a way, unilaterally joined the euro. As a haven destination, Switzerland faces problems not unlike Germany's. Just as the Bundesbank's claims on TARGET2 swell, so too are the SNB's euro-denominated assets: From a speech by Hervé Hannoun of the BIS This entails some credit risk—if a peripheral country exits the euro, either central bank could take losses.  Switzerland has some choice about what EUR assets it buys, where TARGET2 requires Germany to accept claims on other eurozone national central banks (though after Jens Weidmann complained, maybe BuBa is getting collateral for its TARGET2 assets?). What if the SNB releases the peg? (Swexit is an unfortunate term, but it seems like the right one.) If the SNB abandons the peg, the Swissie will appreciate rapidly against the euro.  Even leaving aside the consequences for the Swiss trade account, this will mean an immediate loss on the central bank's asset portfolio. The SNB faces no liquidity constraint in CHF, so this is not immediately catastrophic, but prudent central bankers will want to avoid insolvency all the same. There is also the risk of speculative attacks. We cannot yet see the SNB's balance sheet as of May 31, but as conditions in e.g. Spain have worsened, it is likely that it has grown again after being mostly stable since the peg was introduced. If policy is credible, no one will risk loss by testing it, but as soon as doubts enter, the SNB will quickly have to absorb large speculative flows to defend the peg. Again, the SNB has the ammunition to do so, but it would be an uncomfortable situation. I won't hazard a forecast yet as to when the policy will come to an end. But Switzerland has put itself in an interesting and challenging position in the wider eurozone crisis, and Swexit will definitely come, sooner or later.

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22 мая 2012, 15:58

Maynard's Revenge: A Review

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    Below is a revised version of a talk I gave at the New School University, at a conference to launch Lance Taylor's latest book.  The date of the event was April 28, 2011, more than a year ago, and the delay in revision was entirely my fault--overcommitment and pressing deadlines on many fronts.  Sorry about that.  Lance Taylor, Maynard’s Revenge:  The Collapse of Free Market Macroeconomics (Harvard 2010). In the Preface, Lance tells us that he has written this book with two audiences in mind.  I think of myself as falling into his first group:  “people who are willing to put their feet up on the table, nose to the grindstone, and so on and think about how Keynes and his closest followers did macroeconomics.”  I love the image--both feet up and nose to the grindstone, at the same time!  I would like to stipulate that I read the book this morning sitting in my favorite easy chair (feet up), but starting at 5am sharp (grindstone). The central theme of the book is that Keynes and his fellow travelers or “OId Believers” (another pregnant image), were “correct about how to do macroeconomics”, which is to say they were methodologically on the right track.  The biggest thing they were right about was the importance of blending both history and equilibrium or “thinking in historical and logical time” (as Joan Robinson put it).  The reason this is so important is that the economy itself is a constantly changing and evolving entity, which means that individuals face epistemic problems of uncertainty, not just risk.  In a world like that, historico-institutional methods provide a kind of knowledge that mathematico-statistical methods simply cannot, knowledge to inform individual decisions but also social policy. Concretely, the way Keynes blended the two methodological approaches was by building his theoretical structure on the solid foundation of the National Income and Product Accounts, whose development he played some role in stimulating.  The accounting framework gives us a picture of the economy as a whole, and macroeconomic theories are essentially about how various elements of that accounting framework fit together, in a system of mutual causation.   Keynes little pamphlet “How to Pay for the War” is perhaps the epitome of this kind of approach. The Old Believers who built on Keynes used the same method, but with a progressively widening accounting basis, extending from NIPA to Flow of Funds  (Copeland 1952) and Wynne Godley’s Stock-Flow Consistent accounting (Ch. 5), and then on to global balance of payments and net foreign assets accounting (Ch. 8).  Corresponding to these extensions of the accounting basis are extensions of macroeconomic theory, most importantly extensions to money and finance in the work of Minsky and Kindleberger. The virtues of starting with the accounts  are never spelled out explicitly but they seem to be two.  First, the approach provides a tether that keeps our thinking in tight connection with the real world, but not too tight a tether since, and this is the second virtue, it permits (even encourages) a rather open theoretical space in which a range of insights can flourish simultaneously.   In this respect I note the repeated emphasis in Ch. 8 that we have a number of plausible stories about what determines exchange rates, so we must pick and choose among them which one yields the most insight at any particular moment.  Exchange rates are “overdetermined” by our theories, Lance says, and this seems to be the flip side of the fact that our theories are “underdetermined” by the underlying accounting frameworks.  The resulting open economics is a good thing. There is a lot to like about this approach to macro.  We need look no farther than Lance’s own work to appreciate its flexibility and utility.   His Structuralist Macroeconomics (1983) is clearly an attempt to find the right blend between historico-institutionalist and mathematico-statistical method, and it clearly works.  Indeed, I appreciate it more today that when I first encountered it.  I admit to not quite understanding what Lance was up to when I first came into contact with his work as a graduate student twenty five years ago.  Indeed, what Lance identifies as the characteristic methodological moves of Keynes seem to me more descriptive of Lance’s own work than of Keynes himself.  But Lance is certainly not the first person to look at Keynes and see himself!  (Minsky does much the same in his John Maynard Keynes.)  As a sometime historian of thought and intellectual biographer, if I were asked to characterize how Keynes did macro, I would put more emphasis on the man of affairs—both statesman (as Economic Consequences of the Peace) and speculator (as partner with Oswald “Foxy” Falk in the Syndicate)—learning by doing in the first place, and only later trying to formulate what he had learned in the language of academic economics, as a way of communicating to others.  Just so, I read the Tract on Monetary Reform not so much as a an attempt to build on the quantity theory tradition, and more as a struggle to express ideas that came from somewhere else using existing acceptable language.  Contra Lance, I also do not read Keynes as very much of a NIPA theorist—that’s another projection of Lance, who is clearly a real side macroeconomist in his bones.  Lance plots the price of goods against the price of assets and it is clear which he thinks is the more reliable index of economic reality; part of his difficulty with the exchange rate is that it is at the same time both a goods price (as PPP) and an asset price (as UIP).  Here is Lance at the end of the book, commenting on the road ahead after the crisis:  “The real policy challenge in this area is to build a firewall between finance and the real economy so as to shield the rest of us from the bankers’ excesses.”  Now, Keynes of course famously distinguished between speculation and enterprise in the General Theory, but I think he lived too much in the world of speculation ever to imagine that Lance’s firewall could hold.   Minsky’s financial Keynes is a projection of Minsky’s own theory onto the great man, but it captures a side of Keynes that is not visible if we see him through NIPA lenses.  Had the Flow of Funds accounts been available earlier, the course of macroeconomics might have been different—and that different course is still available to us. Lance’s Keynes is more Taylor than Keynes in another respect as well, namely his emphasis on the centrality of distributional concerns for macroeconomics.  Richard Goodwin’s celebrated predator-prey model of the class struggle is not very Keynesian, but it is very Taylorian.   Similarly, Lance’s lifelong concern to find a macroeconomics that is relevant for the problems of the Third World comes from a sense of the importance of distributional concerns between nations as well as between classes.   Keynes, by contrast, in his policy contributions was arguably more focused on prolonging and propping up what remained of the dying British Empire. But these are quibbles.  Keynes remains an attractive exemplar of how to do macroeconomics, and not just because of his repeated deep insights into the problems of his own day.  One of the main sources of attraction is by contrast with other economists, both before and after Keynes’ own day.  Lance does not have a high opinion, shall we say, of most of what passes for macroeconomics.  He sees it as either nothing more than playing games with models, or nothing less than apologetics for neoliberal political trends.  Modern finance in particular comes under sustained assault as “an intellectual elixir for deregulation and the proliferation of exotic financial instruments that led into the boom and crash.” From this perspective, the global financial crisis presents itself primarily as a reality check.  The world is not as free market macroeconomics would have us believe.  It is in fact more as structuralist macroeconomics would have us believe.  Maynard Keynes’ Revenge is also Lance Taylor’s Revenge.

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11 мая 2012, 20:24

Insights from Bagehot, for these Trying Times

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Here is a talk I gave recently at Wake Forest University.  It is pretty long, but you can page through the video (on the left) by paging through the powerpoint (on the right), and anyway the last twenty minutes are devoted to questions.  I couldn't figure out how to embed it in the blog, but the link will get you there.

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01 мая 2012, 17:25

Banks as creators of money

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In conversation recently, I was called upon to defend the claim that banks are in the business of creating and destroying private money. This has been for me a working hypothesis for so long that I was unable to respond effectively or cogently to the argument. My interlocutor followed up in e-mail with a Cowles Foundation paper by Tobin in support of her case. Here is my response to Tobin, hopefully better articulated than I managed on the fly. In this post, I'll stick to the theoretical claim (the practical context was bank capital requirements). I agree wholeheartedly with Tobin's dismissal of the mystique of "money"—the tradition of distinguishing sharply between those assets which are and those which are not "money," and accordingly between those institutions which emit "money" and those whose liabilities are not "money," but rather than enclosing the difficult word in quotes, I prefer to try to understand it. By all means let us not draw an abritrary line between money and non-money. But Tobin is wrong to conclude that there is nothing special about money at all. There is indeed something special about money. All of the traditional functions of money come down to the certainty that one will be able to get rid of it, at a reasonably certian price, for a reasonably long distance into the future. That certainty amounts to money's liquidity, and the institutional setup of the payment system—including commercial banks, the central bank, and deposit insurance—all exist to support it. It is costly to do so; liquidity is not a free good. This moneyness is not something that is inherent in the thing; it is present when institutions and individuals provide and maintain it. Participation in the payment system is an expression of a bank's willingness to trade at par deposit claims on itself with those on other banks. To do this is to guarantee the liquidity of the bank's deposit liabilities—if a depositor wishes to enter or exit a position in some bank's deposits, it can do so, in size, without moving the price from par (i.e., from one). The central bank supports this guarantee by ensuring banks' access to clearing balances for the processing of interbank payments; deposit insurance supports it by protecting banks from runs. Moneyness should, moreover, be viewed as a property which can be possessed in degrees. No arbitrary line should be drawn, but some things are more like money than others: federal funds are very money-like, T-bills less so, equity shares not so much at all. The degree depends on how deeply the liquidity of each type of claim is supported by the banking system. Asking whether the fact that their liabilities are monetary means that banks have priveleged access to funds, Tobin finds that [t]his advantage of checking accounts does not give banks absolute immunity from the competition of savings banks; it is a limited advantage that can be, at least in some part for many depositors, overcome by differences in yield. Tobin imagines banks raising funds by issuing various kinds of securities—checking deposits, savings deposits, bonds, shares—and competing on yield with other issuers to raise funds. But the differences among those liabilities are not to be found only in yields. They possess moneyness to varying degrees, and when the need is for liquidity, no yield is high enough to entice lenders. Yield and liquidity are not commensurate, especially in a crisis. Asking whether, in aggregate, an expansion of bank lending necessarily entails an expansion of deposits, he says that [i]t depends on whether somewhere in the chain of transactions initiated by the borrower's outlays are found depositors who wish to hold new deposits equal in amount to the new loan. That is, Tobin says, the deposit that a bank creates for its borrower is soon spent, and so this deposit cannot be said to fund the loan for that bank. Moreover, it can neither be said to fund the loan for the banking system as a whole, because deposits will be held only if someone wishes to hold them. On this point Tobin is simply wrong. He neglects to consider who has the initiative in deposit creation and destruction. A bank's role in the payment system, and the very reason that its deposit liabilities serve as money, is that they guarantee conversion of bank deposits at par, conversion into cash or conversion into deposits elsewhere in the system, at the initiative of the depositor. A borrower can exit a position in bank deposits in two ways—by selling them to a non-bank, for example by buying real goods, or by selling them to a bank, for example by buying bank bonds. The former does not destroy aggregate bank deposits, it just moves them from one bank's balance sheet to another's. The latter does destroy aggregate bank deposits, but only if some bank is willing to sell bonds. Thus deposit destruction can happen only at a bank's initiative. All this is to say that what is important about the fact that banks issue monetary liabilities is that those liabilities are liquid—that you can be sure that you can get rid of them at par—and that that liquidity is provided and guaranteed by the banks, supported (for commercial banks, anyway) by the Fed's guarantee of the payment system. Banks guarantee the liquidity of their deposit liabilities, not that of their other liabilities, so someone who wishes to hold them faces a market price, not guaranteed by anyone.

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26 апреля 2012, 15:37

The Clash of Economic Ideas: A Review

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When Paul Krugman paints John Maynard Keynes as a pioneering critic of dominant free-market economics, he exaggerates wildly, both about the rigidity of orthodoxy and about the pioneering character of Keynes’ critique.  So says Larry White in his book The Clash of Economic Ideas and, speaking as a sometime historian of economic thought, I am inclined to agree.   It's less black and white than Krugman makes it out to be. And yet, White organizes his own book along similar black and white lines as an account of Manichean struggle between advocates of capitalism versus socialism, free markets versus government planning, spontaneous order versus deliberate design, and the Mont Pelerin Society versus the Fabian Society.  It is a struggle epitomized by the clash between Hayek and Keynes, and readers learn quickly that White is always rooting for Hayek, and for Hayek’s adoptive ancestry Carl Menger and Adam Smith.  This is a book with a definite point of view. Indeed, the best that can be said on the other side for Keynes is that he, along with his Fabian fellow-travelers, was an unwitting dupe of the real enemy of freedom, Vladimir Ilyich Lenin.  The worst that can be hinted is that Keynes may himself have been one of those enemies of freedom whose skill in wielding political power allow them to get ahead in a system where political power controls everything (p. 166, 277).  For White, following Hayek, The Road to Serfdom is a veritable sheet of ice, a slippery slope that can easily sweep the unwitting traveler off his feet and land him in servitude.   Luckily England pulled back from the edge in time, but other countries were not so fortunate.  India’s experience with central planning is presented as an object lesson to all others who might be so tempted; Germany’s miraculous postwar recovery is the counterexample on the other side. The book recounts, as its subtitle announces, The Great Policy Debates and Experiments of the Last Hundred Years.  They are listed in the first sentence of the Introduction:  “the adoption of central banking in the United States and elsewhere; command economies during the First World War; communist central planning in the Soviet Union, Eastern Europe, and China; fascism in Mussolini’s Italy; National Socialism in Hitler’s Germany; the New Deal in Roosevelt’s United States; the Bretton Woods international monetary system and the adoption of Keynesian macroeconomic policies after the Second World War; major nationalizations in postwar Great Britain; the reemergence of free-market principles in postwar Germany; Soviet-style Five-Year Plans in India; the final abandonment of gold in favor of a system of fluctuating exchange rates among unanchored government fiat monies; regulation and deregulation and reregulation around the globe; the collapse and repudiation of communism in Russia and Eastern Europe; market-led growth policies in the East Asian “tigers’ and then in China and India; “neoliberal” policies promoting the globalization of economic activities.” Whew!  Let it be stipulated that the book covers a lot of territory, and also that it is rip-roaring read.   I learned, for example, that according to biographer Harrod, Keynes’ “recipe for the young economist was to know his Marshall thoroughly and read his Times every day carefully.”  If Keynes were alive today, I’m sure he’d agree with me that is the Financial Times you want to read every day carefully. So I had fun reading the book, but let me now turn to a bit of criticism.  My main concern is with the way essentially every one of the debates and experiments is read through the very same constricting lens.   So far as I can see, all are viewed as variations on the long-ago Socialist Calculation Debate between Oscar Lange and Ludwig von Mises.   Can a centrally planned economy even work, much less outperform a free market economy?  According to White, Mises was right and Lange was wrong, but unfortunately the matter did not end there, but rather has been playing out on the world stage ever since.  You might think I would be more sympathetic to White’s way of framing the policy debates of the 20th century, since my own assessment of the Walrasian turn in economics is probably even more negative than White’s.  He singles out Lange as the origin of the tendency.   In my own research, I have put the spotlight instead on Jacob Marschak, but leave that aside.  The important point is that the Walrasian turn imagined that the economy could be envisioned as a set of simultaneous equations, and the market-clearing set of relative prices as the solution to these equations.  This vision captivated postwar economics, monetarists and Keynesians alike (Friedman and Tobin), and today new classicals and new Keynesians alike as well.  White doesn’t like it for Hayekian reasons, having to do with information and time.  As for me, I don’t like it for Frank Hahn reasons—it has no place in it for money.  But either way, the important historical fact is that this way of thinking about economics rose to become dominant, pushing White’s favored Austrian tradition into the background, and also my own favored Money View tradition. When I agreed to discuss this book, I imagined that we might have our own clash of ideas on the subject of money, where Larry is an advocate of free banking, including competitive note issue.  I imagined I would ask him whether he views the shadow banking system as an example of competitive note issue!  Unfortunately he doesn’t say very much about money in the book.  There are only two money chapters, one on Bretton Woods (Keynes) and one on postwar inflation (Milton Friedman).   Nevertheless, it is pretty clear that he views central banking through the same lens as everything else—it is just another example of government stepping in to do what free markets do better, in this case replacing the bankers’ clearinghouses that predated modern central banks.   I beg to differ.  I align myself with Bagehot, who famously stated that “Money will not manage itself, and Lombard Street has a great deal of money to manage”.  More generally, I align myself with the larger tradition of British central banking thought of which Bagehot was a part, including Ralph Hawtrey, Charles Goodhart, and I would even say John Maynard Keynes.   Like all central bankers, Keynes was trying to find ways to keep an inherently unstable system from blowing apart, not just domestically but also internationally; the international role of the pound was in decline throughout Keynes’ life, but very much present as an intellectual context for his thinking and writing.  This is a very different frame from White, but also, I hasten to add, very different from Krugman. Krugman serves White as a kind of stalking horse, probably in hope that Krugman will attack the book and so sell more copies!  But for my purposes Krugman is interesting for a different reason, as a concrete example of how different American Keynesianism was from the economics of Keynes.  The Keynesian economics that White explains in Chapter 5 is more the economics of Krugman than it is the economics of Keynes.  White traces it, correctly, back to Samuelson and even farther to Alvin Hansen, but he sees Hansen as nothing more than a popularizer of Keynes.  That’s the standard view, but as someone who has written a biography of Hansen, I have to take issue with this account.  Maybe I make things worse for Hansen by saying so, but I must insist that Hansen be understood fundamentally as an American institutionalist, very much akin to those who made Roosevelt’s New Deal.  For White that makes things worse because he sees the American institutionalists—Ely, Commons, et al—as successors to the German historical school, the Marx-influenced “socialists of the chair” who supported Hitler and fascism.  Indeed, for White as for Hayek, the important thing about Hitler’s national socialism is that it was socialism; behind Hitler (and Mussolini too) is Lenin.  So for him the American institutionalists are, like the British Fabian society, tainted by the intellectual company they keep.  I beg to differ.  The American institutionalists were just as much rejecting Marx and the classical economics tradition as they were Marshall and the neoclassical tradition.  For better or worse, they saw these theories as products of class-ridden tired old Europe, not applicable to the New World.  For them government was not the agent of the oppressive king but rather the collectivity of town fathers gathering together to solve common problems.   Europeans—including Keynes and Hayek equally—typically found it difficult to understand what these Americans were up to, and also tended to treat them as intellectual inferiors.  But the Americans were up to something, and it wasn’t fascism or socialism; it was democratic self-government. I have already indicated that I trace one side of my adoptive intellectual ancestry to the tradition of British central banking.  I trace the other side to the American institutionalists.  In both respects, I am coming from a different place than Larry, so I expect we will have a bit of “clash of ideas” in the Q&A.  But I submit to you that what separates us is more obscured than illuminated by viewing subsequent debate through the narrow lens of the socialist calculation debate, much less the emotionally charged lens of enemies versus defenders of freedom.  He and I, along with pretty much every other economist I have ever met, are all defenders of freedom, each in our own way.

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16 апреля 2012, 11:50

Mehrling on Soros

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  The text below is the comment I offered on Mr. Soros' opening speech at INET's Berlin Conference April 12, 2012.  The text of Mr. Soros' own speech is here.  Video of the entire session is below--my bit starts at 55:00.     I first encountered Mr. Soros and his theory of reflexivity back in the spring of 1987 when he visited The Brookings Institution to talk about his book The Alchemy of Finance.  I was there on a Dissertation Fellowship, working on a set of papers I called “Toward a Credit Theory of Money”.  Because of my topic, I was interested in what Mr. Soros had to say.  But I was also unprepared to take it all in since I knew very little finance, and anyway I was trying to finish the dissertation not to launch out in a new direction.   So I missed that opportunity, and consequently I am grateful for a second chance today, some 25 years later, to engage with Mr. Soros’ newest thinking. ***** Mr. Soros accuses economists of a fundamental mistake, two mistakes really, 1) a mistaken conception of the object they are studying which has led them to, 2) a mistaken method for studying it.  Let us stipulate that Mr. Soros is right about that.  The next question, to my mind, is: Why are economists so wedded to these fundamental mistakes and so resistant to correction?  I’m sure there are many reasons—the usual accompaniments of human endeavor, hubris, status, power--but the theory of Mr. Soros suggests to me one additional candidate explanation. Mr. Soros has referred to the European Union as a fantastical object. I want to propose right here at the beginning of the conference that we seriously consider the possibility that intertemporal general equilibrium functions for economists as a “fantastical object”.    Observers of economics easily miss this, focusing instead on the fights between those who think government intervention is the solution and those who think government intervention is the problem.  But typically both sides of this fight have vividly in front of them the very same fantastical object; they are fighting about how best to make that fantastical object a present reality, but they are in agreement about resisting Mr. Soros’ attempts to get them to let go of their fantastical object.   David Tuckett teaches us that fantastical objects play a key role in the way fund managers handle their jobs, which require them to make myriad consequential decisions under conditions of radical uncertainty.  But the situation of the fund manager is just a more extreme version of the situation we all face.   We all try to figure out how the world works, but inevitably we have imperfect knowledge.  And no matter how hard we try, our understanding of the world never quite catches up with where the world actually is, and sometimes our understanding can fall quite far behind.  Why is this?  Why is our knowledge inevitably imperfect?  One reason is that the world is rapidly evolving—institutional evolution and technological change routinely transform the world outside our window.  Every ten years or so, something becomes routine that only ten years before was on no one’s radar screen as even a possibility.  Another reason is that the world is complex, with many moving parts that interact in ways that it is hard for anyone, or even for any supercomputer, to predict in advance.  Mr. Soros himself emphasizes yet a third reason, that the deliberate actions we take, based on our understanding of the world, actually change the world outside our window.   I don’t suppose he is talking about people like me, a simple professor slaving away in the archives.  I suppose he is talking about people like many of you, men and women of affairs, in business or politics, whose decisions directly change the world.  This is an important distinction, I think, and perhaps a direction in which Mr. Soros might develop his theory further, because it links up with another one of his fundamental themes, the inherent instability of credit.  The point is this.  We all face the same existential situation, the necessity to act under conditions of radical uncertainty, and we all grab on to fantastical objects for succor as we do so.  But some of us, some few of us, have the opportunity to make our fantastical objects a reality, or anyway to try by our actions to do so.  Great wealth or great power provide that opportunity, but so does credit. Everyone has a vision of a possible future, but those with credit have the opportunity to build out a little piece of their imagined future in the actual present.  And in this way, they have an opportunity to actually create the future they only imagine, or anyway to try it out.  And for other people watching, this credit-financed “trying out” amounts to actual evidence, concrete present evidence, in favor of a particular vision of the future.  In this way, one man’s fantastical object becomes another man’s fantastical object, and if the second man also has credit, he too has an opportunity to build out a little piece of the now-shared vision, and--hey presto--more evidence that the fantastical object is a plausible candidate for future reality.  That’s how bubbles get started. But the more fundamental point is this.  The interlocking structure of credit is a bridge that we build from the present out into the unknown future, from the present shore out over the void toward shores only imagined.  The credit system privileges some visions of the future over others; that’s how the bridge gets started on one direction rather than another, but there is always a bridge.  And there is always a reality check—what Hyman Minsky called the “survival constraint”.  Credit is a promise made; the reality check comes when the promise comes due, when it becomes clear that reality is in important respects not aligned with the fantastical object.  The failure, or necessitous extension, of one promise calls into doubt all the others based on the same fantastical object, and the whole structure threatens to collapse. I say that it threatens to collapse, because when you are dealing with credit, you are dealing also with banks and central banks, which can themselves extend promises not kept, or even cancel them.  For a while, maybe, banks practice forbearance because they genuinely believe in the prospect that led them to make the loans in the first place.  But at a crucial point, they switch to a different fantastical object, the prospect of catastrophic cascading default, a prospect which can be avoided only by strong and forthright action in the present, not by themselves but by their own banker, the central bank.  Lender of last resort, dealer of last resort, and outright bailout becomes the order of the day.  Liquidation is delayed, and in the meanwhile maybe something turns up. But though fear of collapse may be enough to prompt action to prevent collapse, expansion cannot be reignited until a new positive fantastical object has a chance to take hold, and we start again to build our next fantastical bridge, out over the void into the future. ***** Mr. Soros is concerned about Europe, and he suggests that the road forward involves recommitment to the old fantastical object, the European Union as the embodiment of open society.  But Mr. Soros is also concerned about economics, and there he suggests that the road forward involves rejection of the old fantastical object, and commitment to an open-ended exploration of new economic thinking.   Probably most economists, present company excepted, take exactly the opposite view, preferring to give up on the dream of Europe and recommit to the dream of intertemporal equilibrium.  So that’s where we are as we come together today, exquisitely poised between the known but discredited fantastical objects of the past and unknown fantastical objects of the future.  For me, that’s what this conference is all about.  It is about considering which fantastical objects we will choose to help us on the next stage of our journey, and which we will leave behind as so much dead weight.  Multiple possible futures spread out before us, no one knows which is the one that will actually happen, but nonetheless we have to act, we have to place our bets.

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