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An analytical review of volatility metrics for bubbles and crashes

Journal paper - academic journal
Harold L. Vogel, Richard A. Werner
International Review of Financial Analysis, Volume 38, March 2015, Pages 15–28
Publication year: 2015

Highlights

  • Surveys previous significant studies on bubbles, crashes, and volatility
  • Why do prices become secondary to quantity via the short-side rationed principle
  • Adds new perspectives on defining and measuring bubbles, crashes, and volatility
  • Introduces an extreme events line (EEL) and a crash intensity indicator

Abstract

Bubbles and crashes have long been an important area of research that has not yet led to a comprehensive theoretical or empirical understanding of how to define, measure, and compare such extreme market events. Highlights of the vast literature on bubbles, crashes, and volatility are surveyed and a promising direction for future research, based on a theory of short-side rationing, is described. The theory suggests that, especially in extreme market conditions, marginal quantities held or not held become transactionally more important than the prices paid or received. Our approach is empirically implemented by fitting monthly elasticity of return variances to an exponential expression. From this follows a comparison of changes in implied versus realized volatility, generation of an extreme events line (EEL), and a crash intensity comparison metric. These methods open a new perspective from which it is possible to analyze bubble and crash events as applied to different time scales and asset classes that include bonds, real estate, foreign exchange, and commodities.

Keywords

Bubbles; Crashes; Elasticity of variance; Extreme events line; Herding; Tranquility zone; Volatility

A lost century in economics: Three theories of banking and the conclusive evidence

Journal paper - academic journal
Richard A. Werner
International Review of Financial Analysis, Volume 46, July 2016, Pages 361–379
Publication year: 2015

Highlights

  • The three theories of how banks function and whether they create money are reviewed
  • A new empirical test of the three theories is presented
  • The test allows to control for all transactions, delivering clear-cut results.
  • The fractional reserve and financial intermediation theories of banking are rejected
  • Capital adequacy based bank regulation is ineffective, credit guidance preferable
  • This is shown with the case study of Barclays Bank creating its own capital
  • Questions are raised concerning the lack of progress in economics in the past century
  • Policy implications: borrowing from abroad is unnecessary for growth

Abstract

How do banks operate and where does the money supply come from? The financial crisis has heightened awareness that these questions have been unduly neglected by many researchers. During the past century, three different theories of banking were dominant at different times: (1) The currently prevalent financial intermediation theory of banking says that banks collect deposits and then lend these out, just like other non-bank financial intermediaries. (2) The older fractional reserve theory of banking says that each individual bank is a financial intermediary without the power to create money, but the banking system collectively is able to create money through the process of ‘multiple deposit expansion’ (the ‘money multiplier’). (3) The credit creation theory of banking, predominant a century ago, does not consider banks as financial intermediaries that gather deposits to lend out, but instead argues that each individual bank creates credit and money newly when granting a bank loan. The theories differ in their accounting treatment of bank lending as well as in their policy implications. Since according to the dominant financial intermediation theory banks are virtually identical with other non-bank financial intermediaries, they are not usually included in the economic models used in economics or by central bankers. Moreover, the theory of banks as intermediaries provides the rationale for capital adequacy-based bank regulation. Should this theory not be correct, currently prevailing economics modelling and policy-making would be without empirical foundation. Despite the importance of this question, so far only one empirical test of the three theories has been reported in learned journals. This paper presents a second empirical test, using an alternative methodology, which allows control for all other factors. The financial intermediation and the fractional reserve theories of banking are rejected by the evidence. This finding throws doubt on the rationale for regulating bank capital adequacy to avoid banking crises, as the case study of Credit Suisse during the crisis illustrates. The finding indicates that advice to encourage developing countries to borrow from abroad is misguided. The question is considered why the economics profession has failed over most of the past century to make any progress concerning knowledge of the monetary system, and why it instead moved ever further away from the truth as already recognised by the credit creation theory well over a century ago. The role of conflicts of interest and interested parties in shaping the current bank-free academic consensus is discussed. A number of avenues for needed further research are indicated.

Keywords

Bank accounting; Bank credit; Credit creation; Economics; Financial intermediation; Foreign borrowing; Fractional reserve banking; Money creation

A half-century diversion of monetary policy? An empirical horse-race to identify the UK variable most likely to deliver the desired nominal GDP growth rate

Journal paper - academic journal
Josh Ryan-Collins, Richard A. Werner, Jennifer Castle
Journal of International Financial Markets, Institutions and Money, Volume 43, July 2016, Pages 158–176
Publication year: 2015

Highlights

  • Post-crisis monetary policy has struggled to stimulate nominal demand.
  • We model UK nominal GDP growth over 50 years with past monetary policy targets.
  • The ‘general-to-specific’ methodology is used to find the best explanatory variables.
  • Bank credit for GDP-transactions explains nominal GDP best.
  • Interest rates and money aggregates do not influence nominal GDP significantly.

Abstract

The financial crisis of 2007–2008 triggered monetary policy designed to boost nominal demand, including ‘Quantitative Easing’, ‘Credit Easing’, ‘Forward Guidance’ and ‘Funding for Lending’. A key aim of these policies was to boost the quantity of bank credit to the non-financial corporate and household sectors. In the previous decades, however, policy-makers had not focused on bank credit. Indeed, over the past half century, different variables were raised to prominence in the quest to achieve desired nominal GDP outcomes. This paper conducts a long-overdue horse race between the various contenders in terms of their ability to account for observed nominal GDP growth, using a half-century of UK data since 1963. Employing the ‘General-to-Specific’ methodology, an equilibrium-correction model is estimated suggesting a long-run cointegrating relationship between disaggregated real economy credit and nominal GDP. Short-term and long-term interest rates and broad money do not appear to influence nominal GDP significantly. Vector autoregression and vector error correction modelling shows the real economy credit growth variable to be strongly exogenous to nominal GDP growth. Policy-makers are hence right to finally emphasise the role of bank credit, although they need to disaggregate it and specifically target bank credit for GDP-transactions.

Keywords

Bank credit; Credit channel; General-to-specific method; Growth; Monetary policy transmission; Quantitative Easing; Quantity Theory of Credit

 

Princes of the Yen: The Documentary

Video
Publication year: 2014

Set in 20th Century Japan the documentary explores the role and power of Central Banks and how they can be used to change a country’s economic political and social structures A documentary adaption off the book by Professor Richard Werner.

IMDB Rating: 8.1/10 (18 December 2016)
IMDBWatch on Youtube

How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking

Journal paper - academic journal
Richard A. Werner
International Review of Financial Analysis, Volume 36, December 2014, Pages 71–77
Publication year: 2014

Abstract

Thanks to the recent banking crises interest has grown in banks and how they operate. In the past, the empirical and institutional market micro-structure of the operation of banks had not been a primary focus for investigations by researchers, which is why they are not well covered in the literature. One neglected detail is the banks’ function as the creators and allocators of about 97% of the money supply (Werner, 1997 and Werner, 2005), which has recently attracted attention (Bank of England, 2014a, Bank of England, 2014b, Werner, 2014b and Werner, 2014c). It is the purpose of this paper to investigate precisely how banks create money, and why or whether companies cannot do the same. Since the implementation of banking operations takes place within a corporate accounting framework, this paper is based upon a comparative accounting analysis perspective. By breaking the accounting treatment of lending into two steps, the difference in the accounting operation by bank and non-bank corporations can be isolated. As a result, it can be established precisely why banks are different and what it is that makes them different: They are exempted from the Client Money Rules and thus, unlike other firms, do not have to segregate client money. This enables banks to classify their accounts payable liabilities arising from bank loan contracts as a different type of liability called ‘customer deposits’. The finding is important for many reasons, including for modelling the banking sector accurately in economic models, bank regulation and also for monetary reform proposals that aim at taking away the privilege of money creation from banks. The paper thus adds to the growing literature on the institutional details and market micro-structure of our financial and monetary system, and in particular offers a new contribution to the literature on ‘what makes banks different’, from an accounting and regulatory perspective, solving the puzzle of why banks combine lending and deposit-taking operations under one roof.

Keywords

Bank accounting; Bank lending; Client money rules; Credit creation; Loans; Monetary reform

Enhanced Debt Management: Solving the eurozone crisis by linking debt management with fiscal and monetary policy

Journal paper - academic journal
Richard A. Werner
Journal of International Money and Finance, Volume 49, Part B, December 2014, Pages 443–469
Publication year: 2014

Abstract

Unconventional approaches to suit unusual circumstances have become acceptable in monetary policy, a formerly highly conservative discipline. In this paper it is argued that unconventional approaches should also be considered in sovereign debt management, in order to contribute to resolving the eurozone sovereign debt crisis. First, the Troika crisis lending to indebted sovereign borrowers in the eurozone is reviewed and compared with standard IMF post-crisis lending. The main difference and shortcoming is the unsustainable character of the eurozone approach, due to the omission of demand stimulation components. To address this and other shortcomings, the features of an ideal alternative funding tool are identified. It would solve the funding problems of affected sovereigns, help stabilise the banking system, but most of all stimulate domestic demand and hence end the vicious downward spiral. It is found that this funding method can be implemented as part of enhanced public debt management by each nation’s debt management office.

Keywords

Bank credit; Credit creation; Enhanced Debt Management; Public debt management; Quantitative Easing; Quantity Theory of Credit

Can banks individually create money out of nothing? — The theories and the empirical evidence

Journal paper - academic journal
Richard A. Werner
International Review of Financial Analysis, Volume 36, December 2014, Pages 1–19
Publication year: 2014

Abstract

This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, “out of thin air”.

Keywords

Bank credit; Credit creation; Financial intermediation; Fractional reserve banking; Money creation

Towards a More Stable and Sustainable Financial Architecture – A Discussion and Application of the Quantity Theory of Credit

Journal paper - academic journal
Richard A. Werner
Credit and Capital Markets – Kredit und Kapital, Volume 46, Issue 3, Pages 357–387
Publication year: 2013

Abstract

Thanks to the banking crisis, there has been a greater awareness that leading economic theories and models, as well as influential advanced textbooks in macroeconomics and monetary economics may have been amiss when they neglected to include banks in their analyses. Economists are now labouring to include banking in their models. However already sixteen years ago a paper was published in this journal which presented probably the simplest possible framework that incorporates the economic consequences of banking into a macroeconomic framework: The ‘Quantity Theory of Credit’ (QTC, Werner (1997)). It resolves a number of perceived ‘anomalies’ in macroeconomics and finance, can be used to explain and predict banking crises, and carries a number of policy implications about how to enhance financial stability and deliver sustainable growth. Unlike many better known and far more complex models and theories, it has fared well during the turbulent period since it was proposed. In this paper QTC is revisited and a number of questions that have been raised in the profession concerning it are discussed. It is then applied to the following questions: how to detect and avoid banking crises; how to deliver sustainable and stable economic growth; how to end post-crisis recessions quickly – such as those in many European economies – while minimising costs to the tax payer; and finally, what a financial architecture would look like that has a higher chance of delivering the latter goals on a regular basis.

 

Quantitative Easing and the Quantity Theory of Credit

Other
Richard A. Werner
Royal Economic Society Newsletter, July 2013, Pages 20–22
Publication year: 2013
‘Quantitative easing’ (QE), has received much publicity in the past five years. However, its effectiveness remains disputed. Moreover, there are different views about what constitutes QE. It is the purpose of this contribution to review the origins and varying applications of QE, using and thereby explaining the macroeconomic model that gave rise to the concept. Called the ‘Quantity Theory of Credit’, this is arguably the simplest empirically-grounded model that incorporates the key macroeconomic role of the banking sector — a task belatedly recognised as crucial by researchers in the aftermath of the 2008 crisis.

Crises, the spatial distribution of economic activity, and the geography of banking - a commentary

Journal contribution
Richard A. Werner
Environment and Planning A, Volume 45, Issue 12, 2013, Pages 2789–2796
Publication year: 2013

The geography of the financial crisis has become a growing area of research (Aalbers, 2009; Cameron, 2008; Sidaway, 2008). Wainwright and Rodgers (2013) argue that the financial crisis “could be better viewed as a series of uneven and interrelated crises” (page 1008), including the sovereign debt crisis, on which they elaborate by focusing on the need to examine tax systems and their implications across a variety of economic spaces. Theirs is a timely call that should be supported by all social scientists in a collaborative and interdisciplinary effort.

Towards a new research programme on ‘banking and the economy’ — Implications of the Quantity Theory of Credit for the prevention and resolution of banking and debt crises

Journal paper - academic journal
Richard A. Werner
International Review of Financial Analysis, Volume 25, December 2012, Pages 1–17
Publication year: 2012

Abstract

The financial crisis has triggered a new consensus among economists that it is necessary to include a banking sector in macroeconomic models. It is also necessary for the finance and banking literature to consider how best to incorporate systemic, macroeconomic feedbacks into its modelling of financial intermediation. Thus a new research programme on the link between banking and the economy is needed. This special issue is devoted to this theme. In this paper an overview of the issues and problems in the economics and finance literature is presented, and a concrete, simple approach is identified of how to incorporate banks into a macroeconomic model that solves many of these issues. The model distinguishes between the type of credit that boosts GDP and credit that is associated with asset prices and banking crises. The model is consistent with the empirical record. Some applications are discussed, namely the prediction and prevention of banking crises, implications for fiscal policy, and a solution to the European sovereign debt crisis that stimulates growth while avoiding the corner solutions of euro exit or fiscal union.

Keywords

Bank credit; Banking and the economy; Credit creation; Disaggregation of credit; Methodology; Quantity equation; Macroeconomics; Quantity Theory of Credit

Lessons from the Bank of England on ‘quantitative easing’ and other ‘unconventional’ monetary policies

Journal paper - academic journal
Victor Lyonnet, Richard Werner
International Review of Financial Analysis, Volume 25, December 2012, Pages 94–105
Publication year: 2012

Abstract

This paper investigates the effectiveness of the ‘quantitative easing’ policy, as officially implemented by the Bank of England since March 2009. A policy of the same name had previously been implemented in Japan, which serves as a reference. While the majority of the previous literature has measured the effectiveness of QE by its impact on interest rates, in this paper the effectiveness of all Bank of England policies, including QE, is measured by their impact on the declared goal of the QE policy, namely nominal GDP growth. Further, unlike other works on policy evaluation, in this paper we use the general-to-specific econometric modelling methodology (a.k.a. the ‘Hendry’ or ‘LSE’ methodology) in order to determine the relative importance of Bank of England policies, including QE. The empirical analysis indicates that QE as defined and announced in March 2009 had no apparent effect on the UK economy. Meanwhile, it is found that a policy of ‘quantitative easing’ as defined in the original sense of the term (Werner, 1995c) is supported by empirical evidence: a stable relationship between a lending aggregate (disaggregated M4 lending, singling out bank credit for GDP transactions) and nominal GDP is found. The findings imply that the central bank should more directly target the growth of bank credit for GDP-transactions, which was still contracting in late 2011. A number of measures exist to boost it, but they have hitherto not been taken.

Keywords

Central banking; Credit creation; General-to-specific methodology; Intermediate targets; Monetary policy; Operating tools; Qualitative easing; Quantitative easing; QE; Zero bound

Where does money come from? A guide to the UK monetary and banking system

Book - authored
Josh Ryan-Collins, Tony Greenham, Richard Werner, Andrew Jackson
London: New Economics Foundation
Publication year: 2011

More than a century after Hartley Withers’s “The Meaning of Money” and 80 years after Keynes’s “Treatise on Money”, the fundamentals of how banks create money still needs explaining and this book meets that need with clear exposition and expert marshalling of the relevant facts. According to The Bank of England “By far the largest role in creating broad money is played by the banking sector…when banks make loans they create additional deposits for those that have borrowed”, yet this little known fact remains contrary to public perception. Based on detailed research and consultation with experts, including the Bank of England, this book reviews theoretical and historical debates on the nature of money and banking and explains the role of the central bank, the Government and the European Union. Following a sell out first edition and reprint, this second edition includes new sections on Libor and quantitative easing in the UK and the sovereign debt crisis in Europe. Used as a core text by a growing number of economics departments, this book has been widely praised by students and comes highly recommended by directors of undergraduate studies at leading universities, including Dr Andy Denis at City University “Not only does it present a clear alternative to the standard textbook view of money, but argues it clearly and simply with detailed attention to the actual behaviour and functioning of the banking system” and Emeritus Professor of Economics at University College London, Victoria Chick “Warmly recommended to the simply curious, the socially concerned, students and those who believe themselves experts, alike. Everyone can learn from it” and Professor Emeritus of Banking and Finance, London School of Economics, Charles A E Goodhart “As Richard Werner and his co-authors Josh Ryan Collins, Tony Greenham and Andrew Jackson document…a clear path through the complex thickets of misunderstandings of this important issue. In addition the authors provide many further insights into currently practices of money and banking”. This book is intended for a wide range of audiences, including not only those new to the field but also to policy makers and academics working on the challenges of financial reform and regulation.

Neue Wirtschaftspolitik: Was Europa aus Japans Fehlern lernen kann

Book - authored
Richard A. Werner
Munich: Vahlen
Publication year: 2007

Im Jahr 1990 erlebte Japan eine nie gekannte Wirtschaftskrise. Binnen Jahresfrist verlor der Nikkei-Index über 40 Prozent. Die fallenden Börsen schlugen bis auf den Immobilienmarkt durch. Banken sperrten Kredite, Firmen mussten Insolvenz anmelden, Grundstückspreise fielen, bis sie 1996 in den Städten 50 Prozent unter den Höchstwerten vor 1990 lagen. Noch heute spürt Japan die Folgen dieser Krise. Richard A. Werner war über ein Jahrzehnt in Japan und erlebte hautnah das Entstehen dieser Krise und die Versuche, die Rezession zu bekämpfen, mit. In seinem Werk zieht er die Parallelen zwischen der damaligen Situation in Asien und unserer heutigen in Europa. Er zeigt, mit welchen politischen und wirtschaftlichen Strategien, Japan der damaligen Situation Herr zu werden versuchte, welche Fehler gemacht wurden und was erfolgreich war.

New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance

Book - authored
R. Werner
Basingstoke: Palgrave Macmillan
Publication year: 2005

Modern mainstream economics is attracting an increasing number of critics of its high degree of abstraction and lack of relevance to economic reality. Economists are calling for a better reflection of the reality of imperfect information, the role of banks and credit markets, the mechanisms of economic growth, the role of institutions and the possibility that markets may not clear. While it is one thing to find flaws in current mainstream economics, it is another to offer an alternative paradigm which, can explain as much as the old, but can also account for the many ‘anomalies’. That is what this book attempts. Since one of the biggest empirical challenges to the ‘old’ paradigm has been raised by the second largest economy in the world – Japan – this book puts the proposed ‘new paradigm’ to the severe test of the Japanese macroeconomic reality.

The enigma of the great recession

Book - authored
Richard Werner
Tokyo: PHP Institute Press
Publication year: 2003

Princes of the Yen: Japan's Central Bankers and the Transformation of the Economy

Book - authored
Richard A. Werner
Armonk, New York: M.E. Sharpe
Publication year: 2003

This eye-opening book offers a disturbing new look at Japan’s post-war economy and the key factors that shaped it. It gives special emphasis to the 1980s and 1990s when Japan’s economy experienced vast swings in activity.
According to the author, the most recent upheaval in the Japanese economy is the result of the policies of a central bank less concerned with stimulating the economy than with its own turf battles and its ideological agenda to change Japan’s economic structure. The book combines new historical research with an in-depth behind-the-scenes account of the bureaucratic competition between Japan’s most important institutions: the Ministry of Finance and the Bank of Japan. Drawing on new economic data and first-hand eyewitness accounts, it reveals little known monetary policy tools at the core of Japan’s business cycle, identifies the key figures behind Japan’s economy, and discusses their agenda. The book also highlights the implications for the rest of the world, and raises important questions about the concentration of power within central banks.

Dismantaling the Japanese Model

Book - authored
Kikkaawa, M., Werner, R.A.
Tokyo: Kodansha
Publication year: 2003

Central banking and structural changes in Japan and Europe

Book - authored
Richard A. Werner
Tokyo: Soshisha
Publication year: 2003