Suchergebnisse

The Securities Settlement Systems (SSS) in the People's Republic of China (PRC) are organized around three different types of markets, which are the bond market, the corporate securities market, and the futures market. The China Government Depositary and Clearing Corporation Limited (CCDC) is the SSS as well as the central securities depository (CSD) for bonds. The China Securities Depository and Clearing Corporation Limited (SD and C) is the central counterparty (CCP), SSS, as well as the CSD for all instruments traded on the Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE). The four futures exchanges have their own clearing and settlement departments, which offer the function of a CCP. The CCDC, SD and C, and Shanghai Futures Exchange (SHFE), Dalian Commodities Exchange (DCE), and Zhengzhou Commodities Exchange (ZCE) operate important securities and derivatives settlement systems both, due to the large volume and value of transactions and the fact that they support key financial sector markets (interbank bond market, stock exchanges and futures). The assessment of the bonds market-CCDC system against the Recommendations for Securities Settlement Systems (RSSS) concludes that the system observes (observed or broadly observed) thirteen of the 19 recommendations, being one not applicable. The assessment of the stock exchanges-SD and C system against the RSSS concludes that the system observes (observed or broadly observed) seventeen of the 19 recommendations. The assessment of the commodities futures markets-SHFE system against the Recommendations for Central Counterparties (RCCP) concludes that the system observes (observed or broadly observed) eleven of the 15 recommendations, being one not applicable. The present document is the assessment of securities and derivatives settlement systems in the PRC based on the recommendations of the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) for RSSS and the recommendations of CPSS-IOSCO for Central Counterparties (RCCP). The paper is divided into following five parts: the first part gives general information; the second gives information and methodology used for assessment; the third part is securities and derivatives settlement systems infrastructure overview; the fourth part is main findings from the assessment with international standards; and the fifth part gives authorities' response.

A worldwide financial crisis of enormous magnitude continues to unfold rapidly. Unlike other crises in recent decades, the current episode is rooted in industrial countries' financial systems and is affecting low-income and middle-income countries (MICs) alike. Defaults on securitized sub-prime mortgages as a real estate market bubble burst led to failures or near-failures of several large financial institutions and a collapse of inter-bank and commercial paper markets. A tightening of credit, combined with declining consumer confidence, has brought on worldwide recession with growing unemployment, and many fear that the downturn will be severe and protracted. At the same time, the rapidly multiplying signs of contraction are prompting strong responses, including fiscal stimulus packages and reductions in benchmark lending rates, on the part of several of the affected developed countries. The Bank Group is well placed to help mitigate the impact of the current crisis with financing and advisory services, and its clients are already requesting increased support. A rapid, high-quality response that combines financial and advisory support can do much to ease the inevitable ramifications of the crisis. Lessons from evaluations of previous Bank Group responses to past crises can help inform the response to the current crisis in order to increase its effectiveness.

The economy continues to recover with most sectors rebounding strongly from the sharp drop in output late 2008 and early 2009. Preliminary estimates suggest that real Gross Domestic Product (GDP) grew by 6.1 percent year-on-year in 2010, following an outturn of minus 1.3 percent in 2009. However, winter arrived in Mongolia with the agriculture sector still feeling the impact from last year's dzud. The sector has now experienced double-digit contractions for the third quarter in a row. The exchange rate against the US dollar has been slowly appreciating back to the pre-crisis level. In December 2010, the average monthly exchange rate against the US$ appreciated by 3.0 percent, compared to the previous month, or 15 percent compared to December 2009. The latest survey conducted in informal labor markets in December 2010 revealed a reduction in number of casual workers by about 40 percent compared to September due to the seasonal closure of construction labor markets, and reduced outdoor sales activities due to cold weather. Mongolia has made significant progress in improving budget transparency, but there is still considerable room for improvement. Finally, although Mongolia's laws are easily accessible online and court processes are generally impartial and transparent, the predictability of court decisions is limited and the courts, enforcement and registration agencies are often perceived as corrupt by the public.

This article reviews the main issues of regulating and supervising banks in emerging markets with a view toward evaluating the long-run options. Particular attention is paid to Latin America and East Asia. These economies face a severe policy commitment problem that leads to excessive bailouts and potential devaluation of claims of foreign investors. This exacerbates moral hazard and makes a case for importing external discipline (for example, acquiring foreign short-term debt). However, external discipline may come at the cost of excessive liquidation of entrepreneurial projects. The article reviews the tradeoffs imposed by external discipline and examines various arrangements, such as narrow banking, foreign banks and foreign regulation, and the potential role for an international agency or international lender of last resort.

The improvement in public finances since last year, coupled with buoyant revenue due to the commodity price recovery, has led to growing pressures for increased government spending. Recently approved budget amendments envisage a 4.5 percent of gross domestic product (GDP) increase in spending on the originally approved 2010 budget, while the Mid-Term Budget Framework (MTBF) for 2011-2013 projects another 12.1 percent of GDP increase in spending in 2011. The main driver for the increases is the execution of promises made by both coalition parties to distribute monthly percentage rate, or MNT 1.5million (around US$1000) to each citizen in the form of cash and non-cash handouts and large public sector wage increases planned for October of this year. If these public spending plans materialize, they will set the stage for a renewed bout of high inflation and a possible return to the macroeconomic vulnerability characteristic of the boom-and-bust cycle of the recent past. In the real sector, the impact of increasing inflation is evidenced through a decline in real wages. The latest informal wage survey indicates that on average, workers' nominal wages have increased by about 10 percent from January 2010 to June 2010; this is because of an increase in job opportunities in the construction sector. Real wages, however, have declined on average due to the significant increase in the consumer price index.

Arguing that a relatively high cost of deposit insurance indicates that a bank takes excessive risks, this article estimates the cost of deposit insurance for a large sample of banks in 14 economies to assess the relationship between the risk-taking behavior of banks and their corporate governance structure. The results suggest that banks with concentrated ownership tend to take the greatest risks, and those with dispersed ownership engage in a relatively low level of risk taking. Moreover, as a proxy for bank risk, the cost of deposit insurance has some power in predicting bank distress

With President Milei's election in Argentina, dollarization is suddenly on the table. I'm for it. Here's why. Why not? A standard of valueStart with "why not?'' Dollarization, not a national currency, is actually a sensible default. The dollar is the US standard of value. We measure length in feet, weight in pounds, and the value of goods in dollars. Why should different countries use different measures of value? Wouldn't it make sense to use a common standard of value? Once upon a time every country, and often every city, had its own weights and measures. That made trade difficult, so we eventually converged on international weights and measures. (Feet and pounds are actually a US anachronism since everyone else uses meters and kilograms.  Clearly if we had to start over we'd use SI units, as science and engineering already do.) Moreover, nobody thinks it's a good idea to periodically shorten the meter in order to stimulate the economy, say by making the sale of cloth more profitable. As soon as people figure out they need to buy more cloth to make the same jeans, the profit goes away. PrecommitmentPrecommitment is, I think,  the most powerful argument for dollarization (as for euorization of, say, Greece): A country that dollarizes cannot print money to spend more than it receives in taxes. A country that dollarizes must also borrow entirely in dollars, and must endure costly default rather than relatively less costly inflation if it doesn't want to repay debts. Ex post inflation and devaluation is always tempting, to pay deficits, to avoid paying debt, to transfer money from savers to borrowers, to advantage exporters, or to goose the economy ahead of elections. If a government can precommit itself to eschew inflation and devaluation, then it can borrow a lot more money on better terms, and its economy will be far better off in the long run. An independent central bank is often advocated for precommitment value. Well, locating the central bank 5,000 miles away in a country that doesn't care about your economy is as independent as you can get!The Siren Vase. Greek 480-470 BC. Source: The Culture CriticPrecommitment is an old idea. See picture. It's hard. A country must set things up so that it cannot give in to temptation ex post, and it will regret and try to wriggle out of that commitment when the time comes. A lot of the structure of our laws and government amount to a set of precommitments. An independent central bank with a price-level mandate is a precommitment not to inflate. A constitution and property rights are precommitments not to expropriate electoral minorities. Especially in Argentina's case, precommitment is why full dollarization is better than an exchange rate peg or a currency board. A true exchange rate peg -- one dollar for one peso, as much as you like -- would seem to solve the temptation-to-inflate problem. But the country can always abrogate the peg, reinstitute currency controls, and inflate. An exchange rate peg is ultimately a fiscal promise; the country will raise enough taxes so that it can get the dollars necessary to back its currency. When that seems too hard, countries devalue the peg or abandon it altogether. A currency board is tougher. Under a currency board,  every peso issued by the government is backed by a dollar. That seems to ensure adequate reserves to handle any conceivable run. But a strapped government eyes the great Uncle-Scrooge swimming pool full of dollars at the currency board, and is tempted to abrogate the board, grab the assets and spend them. That's exactly how Argentina's currency board ended. Dollarization is a burn the ships strategy. There is no return. Reserves are neither necessary nor sufficient for an exchange rate peg. The peg is a fiscal promise and stands and falls with fiscal policy. A currency board, to the governmentFull dollarization -- the country uses actual dollars, and abandons its currency -- cannot be so swiftly undone. The country would have to pass laws to reinstitute the peso, declare all dollar contracts to be Peso contracts, ban the use of dollars and try to confiscate them. Dollars pervading the country would make that hard. People who understand their wealth is being confiscated and replaced by monopoly money would make it harder -- harder than some technical change in the amount of backing at the central bank for the same peso notes and bank accounts underlying a devalued peg or even an abrogated currency board. The design of dollarization should make it harder to undo. The point is precommitment, to make it as costly as possible for a following government to de-dollarize, after all. It's hard to confiscate physical cash, but if domestic Argentine banks have dollar accounts and dollar assets, it is relatively easy to pronounce the accounts in pesos and grab the assets. It would be better if dollarization were accompanied by full financial, capital, and trade liberalization, including allowing foreign banks to operate freely and Argentinian banks to become subsidiaries of foreign banks. Absence of a central bank and domestic deposit insurance will make that even more desirable. Then Argentinian bank "accounts" could be claims to dollar assets held offshore, that remain intact no matter what a future Peronist government does. Governments in fiscal stress that print up money, like Argentina, also impose an array of economy-killing policies to try to prop up the value of their currency, so the money printing generates more revenue. They restrict imports with tariffs, quotas, and red tape; they can restrict exports to try to steer supply to home markets at lower prices; they restrict currency conversion and do so at manipulated rates; they restrict capital markets, stopping people from investing abroad or borrowing abroad; they force people to hold money in oligopolized bank accounts at artificially low interest rates. Dollarization is also a precommitment to avoid or at least reduce all these harmful policies, as generating a demand for a country's currency doesn't do any good to the government budget when there isn't a currency. Zimbabwe dollarized in 2009, giving up on its currency after the greatest hyperinflation ever seen. The argument for Argentina is similar. Ecuador dollarized successfully in much less trying circumstances. It's not a new idea, and unilateral dollarization is possible. In both cases there was a period in which both currencies circulated. (Sadly, Zimbabwe ended dollarization in 2019, with a re-introduction of the domestic currency and redenomination of dollar deposits at a very unfavorable exchange rate. It is possible to undo, and the security of dollar bank accounts in face of such appropriation is an important part of the dollarization precommitment.) The limits of precommitmentDollarization is no panacea. It will work if it is accompanied by fiscal and microeconomic reform. It will be of limited value otherwise. I'll declare a motto: All successful inflation stabilizations have come from a combination of fiscal, monetary and microeconomic reform. Dollarization does not magically solve intractable budget deficits. Under dollarization, if the government cannot repay debt or borrow, it must default.  And Argentina has plenty of experience with sovereign default. Argentina already borrows abroad in dollars, because nobody abroad wants peso debt, and has repeatedly defaulted on dollar debt.  The idea of dollar debt is that explicit default is more costly than inflation, so the country will work harder to repay debt. Bond purchasers, aware of the temptation to default, will put clauses in debt contracts that make default more costly still. For you to borrow, you have to give the bank the title to the house. Sovereign debt issued under foreign law, with rights to grab assets abroad works similarly. But sovereign default is not infinitely costly and countries like Argentina sometimes choose default anyway. Where inflation may represent simply hugging the mast and promising not to let go, default is a set of loose handcuffs that you can wriggle out of painfully. Countries are like corporations. Debt denominated in the country's own currency is like corporate equity (stock): If the government can't or won't pay it back the price can fall, via inflation and currency devaluation. Debt denominated in foreign currency is like debt: If the government can't or won't pay it back, it must default. (Most often, default is partial. You get back some of what is promised, or you are forced to convert maturing debt into new debt at a lower interest rate.) The standard ideas of corporate finance tell us who issues debt and who issues equity.  Small businesses, new businesses, businesses that don't have easily valuable assets,  businesses where it is too easy for the managers to hide cash, are forced to borrow, to issue debt. You have to borrow to start a restaurant. Businesses issue equity when they have good corporate governance, good accounting, and stockholders can be sure they're getting their share. These ideas apply to countries, and the choice between borrowing in their own currency and borrowing in foreign currency. Countries with poor governance, poor accounting, out of control fiscal policies, poor institutions for repayment, have to borrow in foreign currency if they are going to borrow at all, with intrusive conditions making default even more expensive. Issuing and borrowing in your own currency, with the option to inflate, is the privilege of countries with good institutions, and democracies where voters get really mad about inflation in particular. Of course, when things get really bad, the country can't borrow in either domestic or foreign currency. Then it prints money, forcing its citizens to take it. That's where Argentina is. In personal finance, you start with no credit at all; then you can borrow; finally you can issue equity. On the scale of healthier economies, dollarizing is the next step up for Argentina. Dollarization and foreign currency debt have another advantage. If a country inflates its way out of a fiscal mess, that benefits the government but also benefits all private borrowers at the expense of private savers. Private borrowing inherits the inflation premium of government borrowing, as the effective government default induces a widespread private default. Dollarization and sovereign default can allow the sovereign to default without messing up private contracts, and all prices and wages in the economy. It is possible for sovereigns to pay higher interest rates than good companies, and the sovereign to be more likely to default than those companies. It doesn't always happen, because sovereigns about to default usually grab all the wealth they can find on the way down, but the separation of sovereign default from inflationary chaos is also an advantage. Greece is a good example, and a bit Italy as well, both in the advantages and the cautionary tale about the limitations of dollarization. Greece and Italy used to have their own currencies. They also had borders, trade controls, and capital controls. They had regular inflation and devaluation. Every day seemed to be another "crisis" demanding another "just this once" splurge. As a result, they paid quite high interest rates to borrow, since savvy bondholders wanted insurance against another "just this once."They joined the EU and the eurozone. This step precommitted them to free trade, relatively free capital markets, and no national currency.  Sovereign default was possible, but regarded as very costly. Having banks stuffed with sovereign debt made it more costly.  Leaving the euro was possible, but even more costly. Deliberately having no plan to do so made it more costly still. The ropes tying hands to the mast were pretty strong. The result: borrowing costs plummeted. Governments, people and businesses were able to borrow at unheard of low rates. And they did so, with aplomb. The borrowing could have financed public and private investment to take advantage of the new business opportunities the EU allowed. Sadly it did not. Greece soon experienced the higher ex-post costs of default that the precommitment imposed. Dollarizaton -- euroization -- is a precommitment, not a panacea. Recommitments impose costs on yourself ex post. Those costs are real.  A successful dollarization for Argentina has to be part of a joint monetary, fiscal, and microeconomic reform. (Did I say that already? :) ) If public finances aren't sorted out, a default will come eventually. And public finances don't need a sharp bout of "austerity" to please the IMF. They need decades of small primary surpluses, tax revenues slightly higher than spending, to credibly pay down any debt. To get decades of revenue, the best answer is growth. Tax revenue equals tax rate times income. More income is a lot easier than higher tax rate, which at least partially lowers income. Greece and Italy did not accomplish the microeconomic reform part. Fortunately, for Argentina, microeconomic reform is low-hanging fruit, especially for a Libertarian president. TransitionWell, so much for the Promised Land, they may have asked of Moses, how do we get there? And let's not spend 40 years wandering the Sinai on the way. Transition isn't necessarily hard. On 1 January 1999, Italy switched from Lira to Euro. Every price changed overnight, every bank account redenominated, every contract reinterpreted, all instantly and seamlessly. People turned in Lira banknotes for Euro banknotes. The biggest complaint is that stores might have rounded up converted prices. If only Argentina could have such problems. Why is Argentina not the same? Well, for a lot of reasons. Before getting to the euro, Italy had adopted the EU open market. Exchange rates had been successfully pegged at the conversion rate, and no funny business about multiple rates. The ECB (really the Italian central bank) could simply print up euros to hand out in exchange for lira. The assets of the Italian central bank and other national central banks were also redenominated in euro, so printing up euros to soak up national currencies was not inflationary -- assets still equal liabilities. Banks with lira deposits that convert to Euro also have lira assets that convert to euro. And there was no sovereign debt crisis, bank crisis,  or big inflation going on. Italian government debt was trading freely on an open market. Italy would spend and receive taxes in euros, so if the debt was worth its current price in lira as the present value of surpluses,  it was worth exactly the same price, at the conversion rate, in euro. None of this is true in Argentina. The central problem, of course, is that the government is broke. The government does not have dollars to exchange for Pesos. Normally, this would not be a problem. Reserves don't matter, the fiscal capacity to get reserves matters. The government could simply borrow dollars internationally, give the dollars out in exchange for pesos, and slowly pay off the resulting debt. If Argentina redenominated interest-bearing peso debt to dollars at a market exchange rate, that would have no effect on the value of the debt. Obviously, borrowing additional dollars would likely be difficult for Argentina right now. To the extent that its remaining debt is a claim to future inflationary seigniorage revenues, its debt is also worth less once converted to dollars, even at a free market rate, because without seigniorage or fiscal reforms, budget deficits will increase. And that leads to the primary argument against dollarization I hear these days. Yes it might be the promised land, but it's too hard to get there. I don't hear loudly enough, though, what is the alternative? One more muddle of currency boards, central bank rules, promises to the IMF and so forth? How do you suddenly create the kind of stable institutions that Argentina has lacked for a century to justify a respectable currency? One might say this is a problem of price, not of quantity. Pick the right exchange rate, and conversion is possible. But that is not even clearly true. If the state is truly broke, if pesos are only worth anything because of the legal restrictions forcing people to hold them, then pesos and peso debt are genuinely worthless. The only route to dollarization would be essentially a complete collapse of the currency and debt. They are worth nothing. We start over. You can use dollars, but you'll have to export something to the US -- either goods or capital, i.e. stock and bonds in private companies -- to get them. (Well, to get any more of them. Lots of dollars line Argentine mattresses already.) That is enough economic chaos to really put people off. In reality, I think the fear is not a completely worthless currency, but that a move to quick dollarization would make peso and peso claims worth very little, and people would rebel against seeing their money holdings and bank accounts even more suddenly worthless than they are now. Maybe, maybe not. Just who is left in Argentina counting on a robust value of pesos? But the state is not worth nothing. It may be worth little in mark to market, or current dollar borrowing capacity. But a reformed, growing Argentina, with tax, spending, and microeconomic reform, could be a great place for investment, and for tax revenue above costs. Once international lenders are convinced those reform efforts are locked in, and Argentina will grow to anything like its amazing potential, they'll be stumbling over themselves to lend. So a better dollarization plan redeems pesos at the new greater value of the post-reform Argentine state. The question is a bit of chicken and egg: Dollarization has to be part of the reform, but only reform allows  dollarization with a decent value of peso exchange.  So there is a genuine question of sequencing of reforms. This question reminds me of the totally fruitless discussion when the Soviet Union broke up. American economists amused themselves with clever optimal sequencing of liberalization schemes. But if competent benevolent dictators (sorry, "policy-makers") were running the show, the Soviet Union wouldn't have failed in the first place. The end of hyperinflation in Germany. Price level 1919-1924. Note left-axis scale. Source: Sargent (1982) "The ends of four big inflations." A better historical analogy is, I think, the ends of hyperinflation after WWI, so beautifully described by Tom Sargent in 1982. The inflations were stopped by a sudden, simultaneous, fiscal, monetary, and (to some extent) microeconomic reform. The fiscal problem was solved by renegotiating reparations under the Versailles treaty, along with  severe cuts in domestic spending, for example firing a lot of government and (nationalized) railroad workers. There were monetary reforms, including an independent central bank forbidden to buy government debt. There were some microeconomic reforms as well. Stopping inflation took no monetary stringency or high interest rates: Interest rates fell, and the governments printed more money, as real money demand increased. There was no Phillips curve of high unemployment. Employment and the economies boomed. So I'm for almost-simultaneous and fast reforms. 1) Allow the use of dollars everywhere. Dollars and pesos can coexist. Yes, this will put downward pressure on the value of the peso, but that might be crucial to maintain interest in the other reforms, which will raise the value of the peso. 2) Instant unilateral free trade and capital opening. Argentina will have to export goods and capital to get dollars. Get out of the way. Freeing imports will lower their prices and make the economy more efficient. Capital will only come in, which it should do quickly, if it knows it can get out again. Float the peso. 3) Long list of growth - oriented microeconomic reforms. That's why you elected a Libertarian president.  4) Slash spending. Reform taxes. Low marginal rates, broad base. Subsidies in particular distort prices to transfer income. Eliminate. 5)  Once reforms are in place, and Argentina has some borrowing capacity, redenominate debt to dollars, and borrow additional dollars to exchange pesos for dollars. All existing peso contracts including bank accounts change on the date. Basically, you want people to hold peso bills and peso debt in the interim as claims on the post-reform government. Peso holders have an incentive to push for reforms that will raise the eventual exchange value of the peso.   6) Find an interim lender. The central problem is who will lend to Argentina in mid stream in order to retire pesos. This is like debtor in possession financing but for a bankrupt country. This could be a job for the IMF. The IMF could lend Argentina dollars for the purpose of retiring pesos. One couldn't ask for much better "conditionality" than a robust Libertarian pro-growth program. Having the IMF along for the ride might also help to commit Argentina to the program. (The IMF can force conditionality better than private lenders.) When things have settled down, Argentina should be able to borrow dollars privately to pay back the IMF. The IMF might charge a decent interest rate to encourage that. How much borrowing is needed? Less than you think. Interest-paying debt can simply be redenominated in dollars once you pick a rate. That might be hard to pay off, but that's a problem for later. So Argentina really only needs to borrow enough dollars to retire cash pesos. I can't find numbers, but hyper inflationary countries typically don't have much real value of cash outstanding. The US has 8% of GDP in currency outstanding. If Argentina has half that, then it needs to borrow only 4% of GDP in dollars to buy back all its currency. That's not a lot. If the peso really collapses, borrowing a little bit more (against great future growth of the reform program) to give everyone $100, the sort of fresh start that Germany did after WWII and after unification, is worth considering. Most of the worry about Argentina's borrowing ability envisions continued primary deficits with slow fiscal adjustment. Make the fiscal adjustment tomorrow."You never want a serious crisis to go to waste," said Rahm Emanuel wisely. "Sequencing" reforms means that everything promised tomorrow is up for constant renegotiation. Especially when parts of the reform depend on other parts, I'm for doing it all as fast as possible, and then adding refinements later if need be. Roosevelt had his famous 100 days, not a 8 year sequenced program. The Argentine reform program is going to hurt a lot of people, or at least recognize losses that had long been papered over in the hope they would go away. Politically, one wants  to make the case "We're all in this, we're all hurting. You give up your special deal, preferential exchange rate, special subsidy or whatever, but so will everyone else. Hang with me to make sure they don't get theirs, and in a year we'll all be better off." If reforms are in a long sequence, which means long renegotiation, it's much harder to get buy in from people who are hurt earlier on that the ones who come later will also do their part.  The standard answersOne standard critique of dollarization is  monetary policy and "optimal currency areas." By having a national currency, the country's wise central bankers can artfully inflate and devalue the currency on occasion to adapt to negative shocks, without the inconvenience and potential dislocation of everyone in the country lowering prices and wages. Suppose, say, the country produces beef, and exports it in order to import cars. If world demand for beef declines, the dollar price of beef declines. The country is going to have to import fewer cars. In a dollarized country, or with a pegged exchange rate,  the internal price of beef and wages go down. With its own country and a floating rate, the value of the currency could go down, leaving beef and wages the same inside the country, but the price of imported cars goes up.  If lowering prices and wages causes more recession and dislocation than raising import prices, then the artful devaluation is the better idea.  (To think about this question more carefully you need traded and non-traded goods; beef, cars, and haircuts. The relative price of beef, cars, and haircuts along with demand for haircuts is also different under the two regimes). Similarly, suppose there is a "lack of demand'' recession and deflation. (90 years later, economists are still struggling to say exactly where that comes from.) With its own central bank and currency, the country can artfully inflate just enough to offset the recession. A country that dollarizes also has to import not-always-optimal US inflation. Switzerland did a lot better than the US and EU once again in the covid era. This line of thinking answers the question, "OK, if Argentina ($847 bn GDP, beef exports) should have its own currency in order to artfully offset shocks, why shouldn't Colorado ($484 bn GDP, beef exports)?''  Colorado is  more dependent on trade with the rest of the US than is Argentina. But, the story goes, people can more easily move across states. A common federal government shoves "fiscal stimulus" to states in trouble. Most of all, "lack of demand" recessions seem to be national, in part because of the high integration of states, so recessions are fought by national policy and don't need state-specific monetary stimulus. This is the standard "optimal currency area" line of thinking, which recommends a common currency in an integrated free trade zone such as US, small Latin American countries that trade a lot with the US, and Europe. Standard thinking especially likes a common currency in a fiscal union.  Some commenters felt Greece should keep or revert to the Drachma because the EU didn't have enough common countercyclical fiscal policy. It likes independent currencies elsewhere.I hope you're laughing out loud by now. A wise central bank, coupled with a thrifty national government, that artfully inflates and devalues just enough to technocratically exploit price stickiness and financial frictions, offsetting national "shocks" with minimum disruption, is a laughable description of Argentina's fiscal and monetary policies. Periodic inflation, hyperinflation and default, together with a wildly overregulated economy with far too much capital and trade controls is more like it. The lure of technocratic stabilization policy in the face of Argentina's fiscal and monetary chaos is like fantasizing whether you want the tan or black leather on your new Porsche while you're on the bus to Carmax to see if you can afford a 10-year old Toyota. Another reason people argue that even small countries should have their own currencies is to keep the seigniorage. Actual cash pays no interest. Thus, a government that issues cash earns the interest spread between government bonds and interest. Equivalently, if demand for cash is proportional to GDP, then as GDP grows, say 2% per year, then the government can let cash grow 2% per year as well, i.e. it can print up that much cash and spend it. But this sort of seigniorage is small for modern economies that don't have inflation. Without inflation, a well run economy might pay 2% for its debt, so save 2% by issuing currency. 2% interest times cash which is 10% of GDP is 0.2% of GDP. On the scale of Argentinian (or US) debt and deficits, that's couch change.  When inflation is higher, interest rates are higher, and seigniorage or the "inflation tax" is higher. Argentina is living off that now. But the point is not to inflate forever and to forswear bigger inflation taxes. Keeping this small seigniorage is one reason for countries to keep their currency and peg to the dollar or run a currency board. The currency board holds interest-bearing dollar assets, and the government gets the interest. Nice. But as I judge above, the extra precommitment value of total dollarization is worth the small lost seigniorage.  Facing Argentina's crisis, plus its catastrophic century of lost growth, lost seigniorage is a cost that I judge far below the benefit. Other countries dollarize, but agree with the US Fed to rebate them some money for the seigniorage. Indeed, if Argentina dollarizes and holds 10% of its GDP in non-interest-bearing US dollars, that's a nice little present to the US. A dollarization agreement with Argentina to give them back the seignorage would be the least we can do. But I don't think Argentina should hold off waiting for Jay Powell to answer the phone. The Fed has other fires to put out. If Argentina unilaterally dollarizes, they can work this sort of thing out later. Dollarization would obviously be a lot easier if it is worked out together with the US government and US banks. Getting cash sent to Argentina, getting banks to have easy payment systems in dollars and links to US banks would make it all easier. If Argentina gets rid of its central bank it still needs a payment system to settle claims in dollars. Accounts at, say, Chase could function as a central bank. But it would all be easier if the US cooperates. Updates:Some commenters point out that Argentina may be importing US monetary policy just as the US imports Argentine fiscal policy. That would lead to importing a big inflation. They suggest a Latin American Monetary Union, like the euro, or using a third country's currency. The Swiss franc is pretty good. Maybe the Swiss can set the world standard of value. Both are good theoretical ideas but a lot harder to achieve in the short run. Dollarization will be hard enough. Argentines have a lot of dollars already, most trade is invoiced in dollars so getting dollars via trade is relatively easy, the Swiss have not built out a banking infrastructure capable of being a global currency. The EMU lives on top of the EU, and has its own fiscal/monetary problems. Building a new currency before solving Argentina's problems sounds like a long road. The question asked was dollarization, so I stuck to that for now. I imagined here unilateral dollarization. But I didn't emphasize enough: The US should encourage dollarization! China has figured this out and desperately wants anyone to use its currency. Why should we not want more people to use our currency? Not just for the seigniorage revenue, but for the ease of trade and international linkages it promotes. The Treasury and Fed should have a "how to dollarize your economy" package ready to go for anyone who wants it. Full integration is not trivial, including access to currency, getting bank access to the Fed's clearing systems, instituting cyber and money laundering protocols, and so forth. Important update: Daniel Raisbeck and Gabriela Calderon de Burgos at CATO have a lovely essay on Argentinian dollarization, also debunking an earlier Economist article that proclaimed it impossible. They include facts and comparison with other dollarization experiences, not just theory as I did. (Thanks to the correspondent who pointed me to the essay.) Some quotes:At the end of 2022, Argentines held over $246 billion in foreign bank accounts, safe deposit boxes, and mostly undeclared cash, according to Argentina's National Institute of Statistics and Census. This amounts to over 50 percent of Argentina's GDP in current dollars for 2021 ($487 billion). Hence, the dollar scarcity pertains only to the Argentine state....The last two dollarization processes in Latin American countries prove that "purchasing" the entire monetary base with U.S. dollars from one moment to the next is not only impractical, but it is also unnecessary. In both Ecuador and El Salvador, which dollarized in 2000 and 2001 respectively, dollarization involved parallel processes. In both countries, the most straightforward process was the dollarization of all existing deposits, which can be converted into dollars at the determined exchange rate instantly.in both Ecuador and El Salvador, dollarization not only did not lead to bank runs; it led to a rapid and sharp increase in deposits, even amid economic and political turmoil in Ecuador's case....There is a general feature of ending hyperinflation: People hold more money. In this case, people hold more bank accounts once they know those accounts are safe. Short summary of the rest, all those dollar deposits (out of mattresses into the banking system) allowed the central bank to retire its local currency liabilities. Emilio Ocampo, the Argentine economist whom Milei has put in charge of plans for Argentina's dollarization should he win the presidency, summarizes Ecuador's experience thus:People exchanged their dollars through the banks and a large part of those dollars were deposited in the same banks. The central bank had virtually no need to disburse reserves. This was not by design but was a spontaneous result.In El Salvador also, Dollar deposits also increased spontaneously in El Salvador, a country that dollarized in 2001. By the end of 2022, the country's deposits amounted to 49.6 percent of GDP—in Panama, another dollarized peer, deposits stood at 117 percent of GDP.El Salvador's banking system was dollarized immediately, but the conversion of the circulating currency was voluntary, with citizens allowed to decide if and when to exchange their colones for dollars. Ocampo notes that, in both Ecuador and El Salvador, only 30 percent of the circulating currency had been exchanged for dollars four months after dollarization was announced so that both currencies circulated simultaneously. In the latter country, it took over two years for 90 percent of the monetary base to be dollar‐​based.Cachanosky explains that, in an El Salvador‐​type, voluntary dollarization scenario, the circulating national currency can be dollarized as it is deposited or used to pay taxes, in which case the sums are converted to dollars once they enter a state‐​owned bank account. Hence, "there is no need for the central bank to buy the circulating currency" at a moment's notice.Dollarization starts with both currencies and a peg. As long as people trust that dollarization will happen at the peg, the conversion can take a while. You do not need dollars to soak up every peso on day 1. Dollarization is, above, a commitment that the peg will last for years, not a necessary commitment that the peg will last a day. I speculated about private borrowing at lower rates than the sovereign, once default rather than inflation is the only way out for the sovereign. This happened: ... as Manuel Hinds, a former finance minister in El Salvador, has explained, solvent Salvadorans in the private sector can borrow at rates of around 7 percent on their mortgages while international sovereign bond markets will only lend to the Salvadoran government at far higher rates. As Hinds writes, under dollarization, "the government cannot transfer its financial costs to the private sector by printing domestic money and devaluing it."A nice bottom line: Ask people in Ecuador, El Salvador, and Panama what they think:This is yet another lesson of dollarization's actual experience in Latin American countries. It is also a reason why the vast majority of the population in the dollarized nations has no desire for a return to a national currency. The monetary experiences of daily life have taught them that dollarization's palpable benefits far outweigh its theoretical drawbacks. Even more important update:From Nicolás Cachonosky How to Dollarize Argentina  The central problem is non-money liabilities of the central bank. A detailed plan. Many other blog posts at the link. See his comment below.  Tyler Cowen on dollarization in Bloomberg. Great quote: The question is not how to adopt a new currency, it is how to adopt a new currency and retain a reasonable value for the old one. Dollarization is easy. Hyperinflate the Peso to zero a la Zimbabwe.  Repeat quote. Emilio Ocampo on dollarization as a commitment device. One of the main reasons to dollarize is to eliminate high, persistent, and volatile inflation. However, to be effective, dollarization must generate sufficient credibility, which in turn depends critically on whether its expected probability of reversal is low.... The evidence suggests that, in the long-run, the strongest insurance against reversal is the support of the electorate, but in the short-run, institutional design [dollarization] can play a critical role.Fifty years ago, in testimony to U.S. Congress, Milton Friedman argued that "the whole reason why it is an advantage for a developing country to tie to a major country is that, historically speaking, the internal policies of developing countries have been very bad. U.S. policy has been bad, but their policies have been far worse. ... (1973, p.127)."In this respect, not much has changed in Argentina since. Craig Richardson explains how dollarization failed in Zimbabwe, a wonderful cautionary tale. Deficits did not stop, the government issued "bonds" and forced banks to buy them, bank accounts became de linked from currency. Gresham's law prevailed, the government "bonds" circulating at half face value drove out cash dollars. With persistent government and trade deficits there was a "dollar shortage." 

(This post continues part 1 which just looked at the data. Part 3 on theory is here) When the Fed raises interest rates, how does inflation respond? Are there "long and variable lags" to inflation and output?  There is a standard story: The Fed raises interest rates; inflation is sticky so real interest rates (interest rate - inflation) rise; higher real interest rates lower output and employment; the softer economy pushes inflation down. Each of these is a lagged effect. But despite 40 years of effort, theory struggles to substantiate that story (next post), it's had to see in the data (last post), and the empirical work is ephemeral -- this post.  The vector autoregression and related local projection are today the standard empirical tools to address how monetary policy affects the economy, and have been since Chris Sims' great work in the 1970s. (See Larry Christiano's review.) I am losing faith in the method and results. We need to find new ways to learn about the effects of monetary policy. This post expands on some thoughts on this topic in "Expectations and the Neutrality of Interest Rates," several of my papers from the 1990s* and excellent recent reviews from Valerie Ramey and  Emi Nakamura and Jón Steinsson, who  eloquently summarize the hard identification and computation troubles of contemporary empirical work.Maybe popular wisdom is right, and economics just has to catch up. Perhaps we will. But a popular belief that does not have solid scientific theory and empirical backing, despite a 40 year effort for models and data that will provide the desired answer, must be a bit less trustworthy than one that does have such foundations. Practical people should consider that the Fed may be less powerful than traditionally thought, and that its interest rate policy has different effects than commonly thought. Whether and under what conditions high interest rates lower inflation, whether they do so with long and variable but nonetheless predictable and exploitable lags, is much less certain than you think. Here is a replication of one of the most famous monetary VARs, Christiano Eichenbaum and Evans 1999, from Valerie Ramey's 2016 review: Fig. 1 Christiano et al. (1999) identification. 1965m1–1995m6 full specification: solid black lines; 1983m1–2007m12 full specification: short dashed blue (dark gray in the print version) lines; 1983m1–2007m12, omits money and reserves: long-dashed red (gray in the print version) lines. Light gray bands are 90% confidence bands. Source: Ramey 2016.  Months on x axis. The black lines plot the original specification. The top left panel plots the path of the Federal Funds rate after the Fed unexpectedly raises the interest rate. The funds rate goes up, but only for 6 months or so. Industrial production goes down and unemployment goes up, peaking at month 20. The figure plots the level of the CPI, so inflation is the slope of the lower right hand panel. You see inflation goes the "wrong" way, up, for about 6 months, and then gently declines. Interest rates indeed seem to affect the economy with long lags. This was the broad outline of consensus empirical estimates for many years. It is common to many other studies, and it is consistent with the beliefs of policy makers and analysts. It's pretty much what Friedman (1968) told us to expect. Getting contemporary models to produce something like this is much harder, but that's the next blog post. What's a VAR?I try to keep this blog accessible to nonspecialists, so I'll step back momentarily to explain how we produce graphs like these. Economists who know what a VAR is should skip to the next section heading. How do we measure the effect of monetary policy on other variables? Milton Friedman and Anna Schwartz kicked it off in the Monetary History by pointing to the historical correlation of money growth with inflation and output. They knew as we do that correlation is not causation, so they pointed to the fact that money growth preceeded inflation and output growth.  But as James Tobin pointed out, the cock's crow comes before, but does not cause, the sun to rise. So too people may go get out some money ahead of time when they see more future business activity on the horizon.  Even correlation with a lead is not causation. What to do? Clive Granger's causality and Chris Sims' VAR, especially "Macroeconomics and Reality" gave today's answer. (And there is a reason that everybody mentioned so far has a Nobel prize.) First, we find a monetary policy "shock," a movement in the interest rate (these days; money, then) that is plausibly not a response to economic events and especially to expected future economic events. We think of the Fed setting interest rates by a response to economic data plus deviations from that response, such as interest rate = (#) output + (#) inflation + (#) other variables + disturbance. We want to isolate the "disturbance," movements in the interest rate not taken in response to economic events. (I use "shock" to mean an unpredictable variable, and "disturbance" to mean deviation from an equation like the above, but one that can persist for a while. A monetary policy "shock" is an unexpected movement in the disturbance.)  The "rule" part here can be but need not be the Taylor rule, and can include other variables than output and inflation. It is what the Fed usually does given other variables, and therefore (hopefully) controls for reverse causality from expected future economic events to interest rates. Now, in any individual episode, output and inflation and inflation following a shock will be influenced by subsequent shocks to the economy, monetary and other. But those average out. So, the average value of inflation, output, employment, etc. following a monetary policy shock is a measure of how the shock affects the economy all on its own. That is what has been plotted above. VARs were one of the first big advances in the modern empirical quest to find "exogenous" variation and (somewhat) credibly find causal relationships. Mostly the huge literature varies on how one finds the "shocks." Traditional VARs use regressions of the above equations and the residual is the shock, with a big question just how many and which contemporaneous variables one adds in the regression. Romer and Romer pioneered the "narrative approach," reading the Fed minutes to isolate shocks.  Some technical details at the bottom and much more discussion below. The key is finding shocks. One can just regress output and inflation on the shocks to produce the response function, which is a "local projection" not a "VAR," but I'll use "VAR" for both techniques for lack of a better encompassing word. Losing faithShocks, what shocks?What's a "shock" anyway? The concept is that the Fed considers its forecast of inflation, output and other variables it is trying to control, gauges the usual and appropriate response, and then adds 25 or 50 basis points, at random, just for the heck of it. The question VARS try to answer is the same: What happens to the economy if the Fed raises interest rates unexpectedly, for no particular reason at all? But the Fed never does this. Ask them. Read the minutes. The Fed does not roll dice. They always raise or lower interest rates for a reason, that reason is always a response to something going on in the economy, and most of the time how it affects forecasts of inflation and employment. There are no shocks as defined.I speculated here that we might get around this problem: If we knew the Fed was responding to something that had no correlation with future output, then even though that is an endogenous response, then it is a valid movement for estimating the effect of interest rates on output. My example was, what if the Fed "responds" to the weather. Well, though endogenous, it's still valid for estimating the effect on output. The Fed does respond to lots of things, including foreign exchange, financial stability issues, equity, terrorist attacks, and so forth. But I can't think of any of these in which the Fed is not thinking of these events for their effect on output and inflation, which is why I never took the idea far. Maybe you can. Shock isolation also depends on complete controls for the Fed's information. If the Fed uses any information about future output and inflation that is not captured in our regression, then information about future output and inflation remains in the "shock" series. The famous "price puzzle" is a good example. For the first few decades of VARs, interest rate shocks seemed to lead to higher inflation. It took a long specification search to get rid of this undesired result. The story was, that the Fed saw inflation coming in ways not completely controlled for by the regression. The Fed raised interest rates to try to forestall the inflation, but was a bit hesitant about it so did not cure the inflation that was coming. We see higher interest rates followed by higher inflation, though the true causal effect of interest rates goes the other way. This problem was "cured" by adding commodity prices to the interest rate rule, on the idea that fast-moving commodity prices would capture the information the Fed was using to forecast inflation. (Interestingly these days we seem to see core inflation as the best forecaster, and throw out commodity prices!) With those and some careful orthogonalization choices, the "price puzzle" was tamped down to the one year or so delay you see above. (Neo-Fisherians might object that maybe the price puzzle was trying to tell us something all these years!) Nakamura and Steinsson write of this problem: "What is being assumed is that controlling for a few lags of a few variables captures all endogenous variation in policy... This seems highly unlikely to be true in practice. The Fed bases its policy decisions on a huge amount of data. Different considerations (in some cases highly idiosyncratic) affect policy at different times. These include stress in the banking system, sharp changes in commodity prices, a recent stock market crash, a financial crisis in emerging markets, terrorist attacks, temporary investment tax credits, and the Y2K computer glitch. The list goes on and on. Each of these considerations may only affect policy in a meaningful way on a small number of dates, and the number of such influences is so large that it is not feasible to include them all in a regression. But leaving any one of them out will result in a monetary policy "shock" that the researcher views as exogenous but is in fact endogenous." Nakamura and Steinsson offer 9/11 as another example summarizing my "high frequency identification" paper with Monika Piazzesi: The Fed lowered interest rates after the terrorist attack, likely reacting to its consequences for output and inflation. But VARs register the event as an exogenous shock.Romer and Romer suggested that we use Fed Greenbook forecasts of inflation and output as controls, as those should represent the Fed's complete information set. They provide narrative evidence that Fed members trust Greenback forecasts more than you might suspect. This issue is a general Achilles heel of empirical macro and finance: Does your procedure assume agents see no more information than you have included in the model or estimate? If yes, you have a problem. Similarly, "Granger causality" answers the cock's crow-sunrise problem by saying that if unexpected x leads unexpected y then x causes y. But it's only real causality if the "expected" includes all information, as the price puzzle counterexample shows. Just what properties do we need of a shock in order to measure the response to the question, "what if the Fed raised rates for no reason?" This strikes me as a bit of an unsolved question -- or rather, one that everyone thinks is so obvious that we don't really look at it. My suggestion that the shock only need be orthogonal to the variable whose response we're estimating is informal, and I don't know of formal literature that's picked it up. Must "shocks" be unexpected, i.e. not forecastable from anything in the previous time information set? Must they surprise people? I don't think so -- it is neither necessary nor sufficient for  shock to be unforecastable for it to identify the inflation and output responses. Not responding to expected values of the variable whose response you want to measure should be enough.  If bond markets found out about a random funds rate rise one day ahead, it would then be an "expected" shock, but clearly just as good for macro. Romer and Romer have been criticized that their shocks are predictable, but this may not matter. The above Nakamura and Steinsson quote says leaving out any information leads to a shock that is not strictly exogenous. But strictly exogenous may not be necessary for estimating, say, the effect of interest rates on inflation. It is enough to rule out reverse causality and third effects. Either I'm missing a well known econometric literature, as is everyone else writing the VARs I've read who don't cite it, or there is a good theory paper to be written.Romer and Romer, thinking deeply about how to read "shocks" from the Fed minutes, define shocks thus to circumvent the "there are no shocks" problem:we look for times when monetary policymakers felt the economy was roughly at potential (or normal) output, but decided that the prevailing rate of inflation was too high. Policymakers then chose to cut money growth and raise interest rates, realizing that there would be (or at least could be) substantial negative consequences for aggregate output and unemployment. These criteria are designed to pick out times when policymakers essentially changed their tastes about the acceptable level of inflation. They weren't just responding to anticipated movements in the real economy and inflation. [My emphasis.]  You can see the issue. This is not an "exogenous" movement in the funds rate. It is a response to inflation, and to expected inflation, with a clear eye on expected output as well. It really is a nonlinear rule, ignore inflation for a while until it gets really bad then finally get serious about it. Or, as they say, it is a change in rule, an increase in the sensitivity of the short run interest rate response to inflation, taken in response to inflation seeming to get out of control in a longer run sense. Does this identify the response to an "exogenous" interest rate increase? Not really.  But maybe it doesn't matter. Are we even asking an interesting question? The whole question, what would happen if the Fed raised interest rates for no reason, is arguably besides the point. At a minimum, we should be clearer about what question we are asking, and whether the policies we analyze are implementations of that question. The question presumes a stable "rule," (e.g. \(i_t = \rho i_{t-1} + \phi_\pi \pi_t + \phi_x x_t + u_t\)) and asks what happens in response to a deviation \( +u_t \) from the rule. Is that an interesting question? The standard story for 1980-1982 is exactly not such an event. Inflation was not conquered by a big "shock," a big deviation from 1970s practice, while keeping that practice intact. Inflation was conquered (so the story goes) by a change in the rule, by a big increase in $\phi_\pi$. That change raised interest rates,  but arguably without any deviation from the new rule \(u_t\) at all. Thinking in terms of the Phillips curve \( \pi_t = E_t \pi_{t+1} + \kappa x_t\), it was not a big negative \(x_t\) that brought down inflation, but the credibility of the new rule that brought down \(E_t \pi_{t+1}\). If the art of reducing inflation is to convince people that a new regime has arrived, then the response to any monetary policy "shock" orthogonal to a stable "rule" completely misses that policy. Romer and Romer are almost talking about a rule-change event. For 2022, they might be looking at the Fed's abandonment of flexible average inflation targeting and its return to a Taylor rule. However, they don't recognize the importance of the distinction, treating changes in rule as equivalent to a residual. Changing the rule changes expectations in quite different ways from a residual of a stable rule. Changes with a bigger commitment should have bigger effects, and one should standardize somehow by the size and permanence of the rule change, not necessarily the size of the interest rate rise. And, having asked "what if the Fed changes rule to be more serious about inflation," we really cannot use the analysis to estimate what happens if the Fed shocks interest rates and does not change the rule. It takes some mighty invariance result from an economic theory that a change in rule has the same effect as a shock to a given rule. There is no right and wrong, really. We just need to be more careful about what question the empirical procedure asks, if we want to ask that question, and if our policy analysis actually asks the same question. Estimating rules, Clarida Galí and Gertler. Clarida, Galí, and Gertler (2000) is a justly famous paper, and in this context for doing something totally different to evaluate monetary policy. They estimate rules, fancy versions of \(i_t = \rho i_{t-1} +\phi_\pi \pi_t + \phi_x x_t + u_t\), and they estimate how the \(\phi\) parameters change over time. They attribute the end of 1970s inflation to a change in the rule, a rise in \(\phi_\pi\) from the 1970s to the 1980s. In their model, a higher \( \phi_\pi\) results in less volatile inflation. They do not estimate any response functions. The rest of us were watching the wrong thing all along. Responses to shocks weren't the interesting quantity. Changes in the rule were the interesting quantity. Yes, I criticized the paper, but for issues that are irrelevant here. (In the new Keynesian model, the parameter that reduces inflation isn't the one they estimate.) The important point here is that they are doing something completely different, and offer us a roadmap for how else we might evaluate monetary policy if not by impulse-response functions to monetary policy shocks. Fiscal theoryThe interesting question for fiscal theory is, "What is the effect of an interest rate rise not accompanied by a change in fiscal policy?" What can the Fed do by itself? By contrast, standard models (both new and old Keynesian) include concurrent fiscal policy changes when interest rates rise. Governments tighten in present value terms, at least to pay higher interest costs on the debt and the windfall to bondholders that flows from unexpected disinflation. Experience and estimates surely include fiscal changes along with monetary tightening. Both fiscal and monetary authorities react to inflation with policy actions and reforms. Growth-oriented microeconomic reforms with fiscal consequences often follow as well -- rampant inflation may have had something to do with Carter era trucking, airline, and telecommunications reform. Yet no current estimate tries to look for a monetary shock orthogonal to fiscal policy change. The estimates we have are at best the effects of monetary policy together with whatever induced or coincident fiscal and microeconomic policy tends to happen at the same time as central banks get serious about fighting inflation. Identifying the component of a monetary policy shock orthogonal to fiscal policy, and measuring its effects is  a first order question for fiscal theory of monetary policy. That's why I wrote this blog post. I set out to do it, and then started to confront how VARs are already falling apart in our hands. Just what "no change in fiscal policy" means is an important question that varies by application. (Lots more in "fiscal roots" here, fiscal theory of monetary policy here and in FTPL.) For simple calculations, I just ask what happens if interest rates change with no change in primary surplus. One might also define "no change" as no change in tax rates, automatic stabilizers, or even habitual discretionary stimulus and bailout, no disturbance \(u_t\) in a fiscal rule \(s_t = a + \theta_\pi \pi_t + \theta_x x_t + ... + u_t\). There is no right and wrong here either, there is just making sure you ask an interesting question. Long and variable lags, and persistent interest rate movementsThe first plot shows a mighty long lag between the monitor policy shock and its effect on inflation and output. That does not mean that the economy has long and variable lags. This plot is actually not representative, because in the black lines the interest rate itself quickly reverts to zero. It is common to find a more protracted interest rate response to the shock, as shown in the red and blue lines. That mirrors common sense: When the Fed starts tightening, it sets off a year or so of stair-step further increases, and then a plateau, before similar stair-step reversion. That raises the question, does the long-delayed response of output and inflation represent a delayed response to the initial monetary policy shock, or does it represent a nearly instantaneous response to the higher subsequent interest rates that the shock sets off? Another way of putting the question, is the response of inflation and output invariant to changes in the response of the funds rate itself? Do persistent and transitory funds rate changes have the same responses? If you think of the inflation and output responses as economic responses to the initial shock only, then it does not matter if interest rates revert immediately to zero, or go on a 10 year binge following the initial shock. That seems like a pretty strong assumption. If you think that a more persistent interest rate response would lead to a larger or more persistent output and inflation response, then you think some of what we see in the VARs is a quick structural response to the later higher interest rates, when they come. Back in 1988, I posed this question in "what do the VARs mean?" and showed you can read it either way. The persistent output and inflation response can represent either long economic lags to the initial shock, or much less laggy responses to interest rates when they come. I showed how to deconvolute the response function to the structural effect of interest rates on inflation and output and how persistently interest rates rise.  The inflation and output responses might be the same with shorter funds rate responses, or they might be much different. Obviously (though often forgotten), whether the inflation and output responses are invariant to changes in the funds rate response needs a model. If in the economic model only unexpected interest rate movements affect output and inflation, though with lags, then the responses are as conventionally read structural responses and invariant to the interest rate path. There is no such economic model. Lucas (1972) says only unexpected money affects output, but with no lags, and expected money affects inflation. New Keynesian models have very different responses to permanent vs. transitory interest rate shocks. Interestingly, Romer and Romer do not see it this way, and regard their responses as structural long and variable lags, invariant to the interest rate response. They opine that given their reading of a positive shock in 2022, a long and variable lag to inflation reduction is baked in, no matter what the Fed does next. They argue that the Fed should stop raising interest rates. (In fairness, it doesn't look like they thought about the issue much, so this is an implicit rather than explicit assumption.) The alternative view is that effects of a shock on inflation are really effects of the subsequent rate rises on inflation, that the impulse response function to inflation is not invariant to the funds rate response, so stopping the standard tightening cycle would undo the inflation response. Argue either way, but at least recognize the important assumption behind the conclusions. Was the success of inflation reduction in the early 1980s just a long delayed response to the first few shocks? Or was the early 1980s the result of persistent large real interest rates following the initial shock? (Or, something else entirely, a coordinated fiscal-monetary reform... But I'm staying away from that and just discussing conventional narratives, not necessarily the right answer.) If the latter, which is the conventional narrative, then you think it does matter if the funds rate shock is followed by more funds rate rises (or positive deviations from a rule), that the output and inflation response functions do not directly measure long lags from the initial shock. De-convoluting the structural funds rate to inflation response and the persistent funds rate response, you would estimate much shorter structural lags. Nakamura and Steinsson are of this view: While the Volcker episode is consistent with a large amount of monetary nonneutrality, it seems less consistent with the commonly held view that monetary policy affects output with "long and variable lags." To the contrary, what makes the Volcker episode potentially compelling is that output fell and rose largely in sync with the actions [interest rates, not shocks] of the Fed. And that's a good thing too. We've done a lot of dynamic economics since Friedman's 1968 address. There is really nothing in dynamic economic theory that produces a structural long-delayed response to shocks, without the continued pressure of high interest rates. (A correspondent objects to "largely in sync" pointing out several clear months long lags between policy actions and results in 1980. It's here for the methodological point, not the historical one.) However, if the output and inflation responses are not invariant to the interest rate response, then the VAR directly measures an incredibly narrow experiment: What happens in response to a surprise interest rate rise, followed by the plotted path of interest rates? And that plotted path is usually pretty temporary, as in the above graph. What would happen if the Fed raised rates and kept them up, a la 1980? The VAR is silent on that question. You need to calibrate some model to the responses we have to infer that answer. VARs and shock responses are often misread as generic theory-free estimates of "the effects of monetary policy." They are not. At best, they tell you the effect of one specific experiment: A random increase in funds rate, on top of a stable rule, followed by the usual following path of funds rate. Any other implication requires a model, explicit or implicit. More specifically, without that clearly false invariance assumption, VARs cannot directly answer a host of important questions. Two on my mind: 1) What happens if the Fed raises interest rates permanently? Does inflation eventually rise? Does it rise in the short run? This is the "Fisherian" and "neo-Fisherian" questions, and the answer "yes" pops unexpectedly out of the standard new-Keynesian model. 2) Is the short-run negative response of inflation to interest rates stronger for more persistent rate rises? The long-term debt fiscal theory mechanism for a short-term inflation decline is tied to the persistence of the shock and the maturity structure of the debt. The responses to short-lived interest rate movements (top left panel) are silent on these questions. Directly is an important qualifier. It is not impossible to answer these questions, but you have to work harder to identify persistent interest rate shocks. For example, Martín Uribe identifies permanent vs. transitory interest rate shocks, and finds a positive response of inflation to permanent interest rate rises. How? You can't just pick out the interest rate rises that turned out to be permanent. You have to find shocks or components of the shock that are ex-ante predictably going to be permanent, based on other forecasting variables and the correlation of the shock with other shocks. For example, a short-term rate shock that also moves long-term rates might be more permanent than one which does not do so. (That requires the expectations hypothesis, which doesn't work, and long term interest rates move too much anyway in response to transitory funds rate shocks. So, this is not directly a suggestion, just an example of the kind of thing one must do. Uribe's model is more complex than I can summarize in a blog.)  Given how small and ephemeral the shocks are already, subdividing them into those that are expected to have permanent vs. transitory effects on the federal funds rate is obviously a challenge. But it's not impossible. Monetary policy shocks account for small fractions of inflation, output and funds rate variation. Friedman thought that most recessions and inflations were due to monetary mistakes. The VARs pretty uniformly deny that result. The effects of monetary policy shocks on output and inflation add up to less than 10 percent of the variation of output and inflation. In part the shocks are small, and in part the responses to the shocks are small. Most recessions come from other shocks, not monetary mistakes.  Worse, both in data and in models, most inflation variation comes from inflation shocks, most output variation comes from output shocks, etc. The cross-effects of one variable on another are small. And "inflation shock" (or "marginal cost shock"),  "output shock" and so forth are just labels for our ignorance -- error terms in regressions, unforecasted movements -- not independently measured quantities. (This and old point, for example in my 1994 paper with the great title "Shocks." Technically, the variance of output is the sum of the squares of the impulse-response functions -- the plots -- times the variance of the shocks. Thus small shocks and small responses mean not much variance explained.)This is a deep point. The exquisite attention put to the effects of monetary policy in new-Keynesian models, while interesting to the Fed, are then largely beside the point if your question is what causes recessions. Comprehensive models work hard to match all of the responses, not just to monetary policy shocks. But it's not clear that the nominal rigidities that are important for the effects of monetary policy are deeply important to other (supply) shocks, and vice versa. This is not a criticism. Economics always works better if we can use small models that focus on one thing -- growth, recessions, distorting effect of taxes, effect of monetary policy -- without having to have a model of everything in which all effects interact. But, be clear we no longer have a model of everything.  "Explaining recessions" and "understanding the effects of monetary policy" are somewhat separate questions. Monetary policy shocks also account for small fractions of the movement in the federal funds rate itself. Most of the funds rate movement is in the rule, the reaction to the economy term. Like much empirical economics, the quest for causal identification leads us to look at a tiny causes with tiny effects, that do little to explain much variation in the variable of interest (inflation). Well, cause is cause, and the needle is the sharpest item in the haystack. But one worries about the robustness of such tiny effects, and to what extent they summarize historical experience.  To be concrete, here is a typical shock regression, 1960:1-2023:6 monthly data, standard errors in parentheses: ff(t) = a + b ff(t-1) + c[ff(t-1)-ff(t-2)] + d CPI(t) + e unemployment(t) + monetary policy shock, Where "CPI" is the percent change in the CPI (CPIAUCSL) from a year earlier. ff(t-1)ff(t-1)-ff(t-2)CPIUnempR20.970.390.032-0.0170.985(0.009)(0.07)(0.013)(0.009)The funds rate is persistent -- the lag term (0.97) is large. Recent changes matter too: Once the Fed starts a tightening cycle, it's likely to keep raising rates. And the Fed responds to CPI and unemployment. The plot shows the actual federal funds rate (blue), the model or predicted federal funds rate (red), the shock which is the difference between the two (orange) and the Romer and Romer dates (vertical lines). You can't see the difference between actual and predicted funds rate, which is the point. They are very similar and the shocks are small. They are closer horizontally than vertically, so the vertical difference plotted as shock is still visible. The shocks are much smaller than the funds rate, and smaller than the rise and fall in the funds rate in a typical tightening or loosening cycle. The shocks are bunched, with by far the biggest ones in the early 1980s. The shocks have been tiny since the 1980s. (Romer and Romer don't find any shocks!) Now, our estimates of the effect of monetary policy look at the average values of inflation, output, and employment in the 4-5 years after a shock. Really, you say, looking at the graph? That's going to be dominated by the experience of the early 1980s. And with so many positive and negative shocks close together, the average value 4 years later is going to be driven by subtle timing of when the positive or negative shocks line up with later events. Put another way, here is a plot of inflation 30 months after a shock regressed on the shock. Shock on the x axis, subsequent inflation on the y axis. The slope of the line  is our estimate of the effect of the shock on inflation 30 months out (source, with details). Hmm. One more graph (I'm having fun here):This is a plot of inflation for the 4 years after each shock, times that shock. The right hand side is the same graph with an expanded y scale. The average of these histories is our impulse response function.  (The big lines are the episodes which multiply the big shocks of the early 1980s. They mostly converge because, either multiplied by positive or negative shocks, inflation wend down in the 1980s.) Impulse response functions are just quantitative summaries of the lessons of history. You may be  underwhelmed that history is sending a clear story.  Again, welcome to causal economics -- tiny average responses to tiny but identified movements is what we estimate, not broad lessons of history. We do not estimate "what is the effect of the sustained high real interest rates of the early 1980s," for example, or "what accounts for the sharp decline of inflation in the early 1980s?" Perhaps we should, though confronting endogeneity of the interest rate responses some other way. That's my main point today. Estimates disappear after 1982Ramey's first variation in the first plot is to use data from 1983 to 2007. Her second variation is to also omit the monetary variables. Christiano Eichenbaum and Evans were still thinking in terms of money supply control, but our Fed does not control money supply. The evidence that higher interest rates lower inflation disappears after 1983, with or without money. This too is a common finding. It might be because there simply aren't any monetary policy shocks. Still, we're driving a car with a yellowed AAA road map dated 1982 on it.  Monetary policy shocks still seem to affect output and employment, just not inflation. That poses a deeper problem. If there just aren't any monetary policy shocks, we would just get big standard errors on everything. That only inflation disappears points to the vanishing Phillips curve, which will be the weak point in the theory to come. It is the Phillips curve by which lower output and employment push down inflation. But without the Phillips curve, the whole standard story for interest rates to affect inflation goes away. Computing long-run responsesThe long lags of the above plot are already pretty long horizons, with interesting economics still going on at 48 months. As we get interested in long run neutrality, identification via long run sign restrictions (monetary policy should not permanently affect output), and the effect of persistent interest rate shocks, we are interested in even longer run responses. The "long run risks" literature in asset pricing is similarly crucially interested in long run properties. Intuitively, we should know this will be troublesome. There aren't all that many nonoverlapping 4 year periods after interest rate shocks to measure effects, let alone 10 year periods.VARs estimate long run responses with a parametric structure. Organize the data (output, inflation, interest rate, etc) into a vector \(x_t = [y_t \; \pi_t \; i_t \; ...]'\), then the VAR can be written \(x_{t+1} = Ax_t + u_t\). We start from zero, move \(x_1 = u_1\) in an interesting way, and then the response function just simulates forward, with \(x_j = A^j x_1\).  But here an oft-forgotten lesson of 1980s econometrics pops up: It is dangerous to estimate long-run dynamics by fitting a short run model and then finding its long-run implications. Raising matrices to the 48th power \(A^{48}\) can do weird things, the 120th power (10 years) weirder things. OLS and maximum likelihood prize one step ahead \(R^2\), and will happily accept small one step ahead mis specifications that add up to big misspecification 10 years out. (I learned this lesson in the "Random walk in GNP.") Long run implications are driven by the maximum eigenvalue of the \(A\) transition matrix, and its associated eigenvector. \(A^j = Q \Lambda^j Q^{-1}\).  This is a benefit and a danger. Specify and estimate the dynamics of the combination of variables with the largest eigenvector  right, and lots of details can be wrong. But standard estimates aren't trying hard to get these right. The "local projection" alternative directly estimates long run responses: Run regressions of inflation in 10 years on the shock today. You can see the tradeoff: there aren't many non-overlapping 10 year intervals, so this will be imprecisely estimated. The VAR makes a strong parametric assumption about long-run dynamics. When it's right, you get better estimates. When it's wrong, you get misspecification. My experience running lots of VARs is that monthly VARs raised to large powers often give unreliable responses. Run at least a one-year VAR before you start looking at long run responses. Cointegrating vectors are the most reliable variables to include. They are typically the state variable that most reliably carries long - run responses. But pay attention to getting them right. Imposing integrating and cointegrating structure by just looking at units is a good idea. The regression of long-run returns on dividend yields is a good example. The dividend yield is a cointegrating vector, and is the slow-moving state variable. A one period VAR \[\left[ \begin{array}{c} r_{t+1} \\ dp_{t+1} \end{array} \right] = \left[ \begin{array}{cc} 0 & b_r  \\ 0 & \rho \end{array}\right]    \left[ \begin{array}{c} r_{t} \\ dp_{t} \end{array}\right]+ \varepsilon_{t+1}\] implies a long horizon regression \(r_{t+j} = b_r \rho^j dp_{t} +\) error. Direct regressions ("local projections") \(r_{t+j} = b_{r,j} dp_t + \) error give about the same answers, though the downward bias in \(\rho\) estimates is a bit of an issue, but with much larger standard errors. The constraint \(b_{r,j} = b_r \rho^j\) isn't bad. But it can easily go wrong. If you don't impose that dividends and price are cointegrated, or with vector other than 1 -1, if you  allow a small sample to estimate \(\rho>1\), if you don't put in dividend yields at all and just a lot of short-run forecasters, it can all go badly. Forecasting bond returns was for me a good counterexample. A VAR forecasting one-year bond returns  from today's yields gives very different results from taking a monthly VAR, even with several lags, and using \(A^{12}\) to infer the one-year return forecast. Small pricing errors or microstructure dominate the monthly data, which produces junk when raised to the twelfth power. (Climate regressions are having fun with the same issue. Small estimated effects of temperature on growth, raised to the 100th power, can produce nicely calamitous results. But use basic theory to think about units.)  Nakamura and Steinsson (appendix) show how sensitive some standard estimates of impulse response functions are to these questions. Weak evidenceFor the current policy question, I hope you get a sense of how weak the evidence is for the "standard view" that higher interest rates reliably lower inflation, though with a long and variable lag, and the Fed has a good deal of control over inflation. Yes, many estimates look the same, but there is a pretty strong prior going in to that. Most people don't publish papers that don't conform to something like the standard view. Look how long it took from Sims (1980) to Christiano Eichenbaum and Evans (1999) to produce a response function that does conform to the standard view, what Friedman told us to expect in (1968). That took a lot of playing with different orthogonalization, variable inclusion, and other specification assumptions. This is not criticism: when you have a strong prior, it makes sense to see if the data can be squeezed in to the prior. Once authors like Ramey and Nakamura and Steinsson started to look with a critical eye, it became clearer just how weak the evidence is. Standard errors are also wide, but the variability in results due to changes in sample and specification are much larger than formal standard errors. That's why I don't stress that statistical aspect. You play with 100 models, try one variable after another to tamp down the price puzzle, and then compute standard errors as if the 100th model were written in stone. This post is already too long, but showing how results change with different specifications would have been a good addition. For example, here are a few more Ramey plots of inflation responses, replicating various previous estimatesTake your pick. What should we do instead? Well, how else should we measure the effects of monetary policy? One natural approach turns to the analysis of historical episodes and changes in regime, with specific models in mind. Romer and Romer pass on thoughts on this approach: ...some macroeconomic behavior may be fundamentally episodic in nature. Financial crises, recessions, disinflations, are all events that seem to play out in an identifiable pattern. There may be long periods where things are basically fine, that are then interrupted by short periods when they are not. If this is true, the best way to understand them may be to focus on episodes—not a cross-section proxy or a tiny sub-period. In addition, it is valuable to know when the episodes were and what happened during them. And, the identification and understanding of episodes may require using sources other than conventional data.A lot of my and others'  fiscal theory writing has taken a similar view. The long quiet zero bound is a test of theories: old-Keynesian models predict a delation spiral, new-Keynesian models predicts sunspot volatility, fiscal theory is consistent with stable quiet inflation.  The emergence of inflation in 2021 and its easing despite interest rates below inflation likewise validates fiscal vs. standard theories.  The fiscal implications of abandoning the gold standard in 1933 plus Roosevelt's "emergency" budget make sense of that episode. The new-Keynesian reaction parameter \(\phi_\pi\) in \(i_t - \phi_\pi \pi_t\), which leads to unstable dynamics for ](\phi_\pi>1\) is not identified by time series data. So use "other sources," like plain statements on the Fed website about how they react to inflation. I already cited Clarida Galí and Gertler, for measuring the rule not the response to the shock, and explaining the implications of that rule for their model. Nakamura and Steinsson likewise summarize Mussa's (1986) classic study of what happens when countries switch from fixed to floating exchange rates: "The switch from a fixed to a flexible exchange rate is a purely monetary action. In a world where monetary policy has no real effects, such a policy change would not affect real variables like the real exchange rate. Figure 3 demonstrates dramatically that the world we live in is not such a world."Also, analysis of particular historical episodes is enlightening. But each episode has other things going on and so invites alternative explanations. 90 years later, we're still fighting about what caused the Great Depression. 1980 is the poster child for monetary disinflation, yet as Nakamura and Steinsson write, Many economists find the narrative account above and the accompanying evidence about output to be compelling evidence of large monetary nonneutrality. However, there are other possible explanations for these movements in output. There were oil shocks both in September 1979 and in February 1981.... Credit controls were instituted between March and July of 1980. Anticipation effects associated with the phased-in tax cuts of the Reagan administration may also have played a role in the 1981–1982 recession ....Studying changes in regime, such as fixed to floating or the zero bound era, help somewhat relative to studying a particular episode, in that they have some of the averaging of other shocks. But the attraction of VARs will remain. None of these produces what VARs seemed to produce, a theory-free qualitative estimate of the effects of monetary policy. Many tell you that prices are sticky, but not how prices are sticky. Are they old-Keynesian backward looking sticky or new-Keynesian rational expectations sticky? What is the dynamic response of relative inflation to a change in a pegged exchange rate? What is the dynamic response of real relative prices to productivity shocks? Observations such as Mussa's graph can help to calibrate models, but does not answer those questions directly.  My observations about the zero bound or the recent inflation similarly seem (to me) decisive about one class of model vs. another, at least subject to Occam's razor about epicycles, but likewise do not provide a theory-free  impulse response function.  Nakamura and Steinsson write at length about other approaches; model-based moment matching and use of micro data in particular. This post is going on too long; read their paper. Of course, as we have seen, VARs only seem to offer a model-free quantitative measurement of "the effects of monetary policy," but it's hard to give up on the appearance of such an answer. VARs and impulse responses also  remain very useful ways of summarizing the correlations and cross correlations of data, even without cause and effect interpretation. In the end, many ideas are successful in economics when they tell researchers what to do, when they offer a relatively clear recipe for writing papers. "Look at episodes and think hard is not such  recipe." "Run a VAR is." So, as you think about how we can evaluate monetary policy, think about a better recipe as well as a good answer.  (Stay tuned. This post is likely to be updated a few times!) VAR technical appendixTechnically, running VARs is very easy, at least until you start trying to smooth out responses with Bayesian  and other techniques. Line up the data in a vector, i.e. \(x_t = [i_t \; \pi_t\; y_t]'\). Then run a regression of each variable on lags of the others, \[x_t = Ax_{t-1} + u_t.\] If you want more than one lag of the right hand variables, just make a bigger \(x\) vector,  \(x_t = [i_t\; \pi_t \; y_t \; i_{t-1}\; \pi_{t-1} \;y_{t-1}]'.\) The residuals of such regressions \(u_t\) will be correlated, so you have to decide whether, say, the correlation between interest rate and inflation shocks means the Fed responds in the period to inflation, or inflation responds within the period to interest rates, or some combination of the two. That's the  "identification" assumption issue. You can write it as a matrix \(C\) so that \(u_t = C \varepsilon_t\) and cov\((\varepsilon_t \varepsilon_t')=I\) or you can include some contemporaneous values into the right hand sides. Now, with \(x_t = Ax_{t-1} + C\varepsilon_t\), you start with \(x_0=0\), choose one series to shock, e.g. \(\varepsilon_{i,1}=1\) leaving the others alone, and just simulate forward. The resulting path of the other variables is the above plot, the "impulse response function." Alternatively you can run a regression \(x_t = \sum_{j=0}^\infty \theta_j \varepsilon_{t-j}\) and the \(\theta_j\) are (different, in sample) estimates of the same thing. That's "local projection". Since the right hand variables are all orthogonal, you can run single or multiple regressions. (See here for equations.) Either way, you have found the moving average representation, \(x_t = \theta(L)\varepsilon_t\), in the first case with \(\theta(L)=(I-AL)^{-1}C\) in the second case directly. Since the right hand variables are all orthogonal, the variance of the series is the sum of its loading on all of the shocks, \(cov(x_t) = \sum_{j=0}^\infty \theta_j \theta_j'\). This "forecast error variance decomposition" is behind my statement that small amounts of inflation variance are due to monetary policy shocks rather than shocks to other variables, and mostly inflation shocks.   Update:Luis Garicano has a great tweet thread explaining the ideas with a medical analogy. Kamil Kovar has a nice follow up blog post, with emphasis on Europe. He makes a good point that I should have thought of: A monetary policy "shock" is a deviation from a "rule." So, the Fed's and ECB's failure to respond to inflation as they "usually" do in 2021-2022 counts exactly the same as a 3-5% deliberate lowering of the interest rate. Lowering interest rates for no reason, and leaving interest rates alone when the regression rule says raise rates are the same in this methodology.  That "loosening" of policy was quickly followed by inflation easing, so an updated VAR should exhibit a strong "price puzzle" -- a negative shock is followed by less, not more inflation. Of course historians and practical people might object that failure to act as usual has exactly the same effects as acting. * Some Papers: Comment on Romer and Romer What ends recessions? Some "what's a shock?"Comment on Romer and Romer A new measure of monetary policy. The greenbook forecasts, and beginning thoughts that strict exogeneity is not necessary. Shocks monetary shocks explain small fractions of output variance.Comments on Hamilton, more thoughts on what a shock is.What do the VARs mean? cited above, is the response to the shock or to persistent interest rates?The Fed and Interest Rates, with Monika Piazzesi. Daily data and interest rates to identify shocks. Decomposing the yield curve with Monika Piazzesi. Starts with a  great example of how small changes in specification lead to big differences in long run forecasts. Time seriesA critique of the application of unit root tests pretesting for unit roots and cointegration is a bad ideaHow big is the random walk in GNP? lessons in not using short run dynamics to infer long run properties. Permanent and transitory components of GNP and stock prices a favorite of cointegration really helps on long run propertiesTime series for macroeconomics and finance notes that never quite became a book. Explains VARs and responses.