What Is Money?

This blog has been dealing with some weighty issues for the past few weeks, and that's understandable given events. But I was thinking it was time we reverted to some fundamentals and something on the lighter side. And I found it in today's edition of The Wall Street Journal. The front page story deals with Mackerel Economics. It's not about the world-wide mackerel market (although I did find out there is a shortage). Nor is it about the peculiarities of the mackerel industry. It's about mackerel being the currency of choice in the Federal Prison System in the U.S.

Now many of us probably thought "cigarettes" were the medium of exchange, but that was phased out some time ago because of health concerns. Consequently, rather than convert to strict barter, the economic system of the prison needed a substitute currency.

Mackerel actually seems to serve well, given the institutional (pardon the pun) restrictions. It fulfills the three functions of money - medium of exchange, measure of value and store of value fairly well. How it serves as medium of exchange is evident in the article. But, you may ask second and third functions. The measure of value is achieved because the cost is fairly uniform ($1 a package). The third function is met because the fish comes in sealed, foil pouches and few people actually eat the product. Many commodity based money systems have problems on this count because the underlying asset has more than one use. It even holds for gold.

If you want to approach the topic of money using the basic characteristics of money, mackerel seem to have some of the characteristics: durability, uniformity, acceptability. Others such as portability, divisibility, storability, are more limiting: prison authorities can impose limits on "substitute currencies" because of barter restrictions; and the foil pouches are not divisible. Also, since mackerel have more limited use "outside." Prisoners due for release often end up giving it away (bequest?) or “spending" it all before leaving.

Regardless, this is an interesting way to introduce the idea of money to your students and to help them understand that money is defined by function. (Now, I wonder if they have a monetary authority. Maybe the Flounder Reserve?)

I look forward to your comments.

Resources for "Current Events"

Here are a few more resources that I think you may find useful when discussing how we got to the current events. Some of them are more than you want for student use, but all of them provide some sense of background and/or perspective on current issues.

The first has actually been available since May of this year. Those of you familiar with the National Public Radio (NPR) program, This American Life, may have already heard this episode on "The Giant Pool of Money". You can listen to the episode or go for the free transcript (as I did). There's not a lot of data there, but the anecdotes are valuable - similar to what you would find in a book reviewed on this blog earlier, this summer, Confessions of a Subprime Lender. But the final point is important. There's lots of blame to go around.

The second resource popped up last week. Harvard University held a Financial Markets Roundtable on the situation last Thursday and included several prominent faculty members in the discussion. The program is long - over 90 minutes - but very informative. I did wish for fewer normative and more positive statements. But in asking for observations on policy, the door of politics gets opened. You can find a link to the realplayer video at the Econlog blog. Just click on "Harvard."

Finally, for those of you who wonder if there's any value-added from computer/video games in our world of economics. Someone took a chart of U.S. Home Prices from 1890 - 2007, adjusted for inflation, and applied it the computer game Roller Coaster Tycoon. Here's the result. (HT to Mark Perry at his Carpe Diem blog).

I look forward to your comments.

Video Resource on the Current Situation

Here's a very clear illustration of how defaults on mortgages have morphed into something much larger. It's worth a look.

(HT to fellow blogger Mike Fladlien at Mikeroeconomics.)

Interdependence, Externalities and the “Credit Crunch.”

There is a silver lining around the dark cloud hanging over the U.S. economy recently. It should increase interest in your course. I don't know about where you work, but students and staff members around here are talking to me more frequently; even if it's in a light-hearted way.

But as I read and listen to news, commentary and conversations, I'm struck by one fact. There's an overarching view of "us" and "them"; and the "us" gets reparsed and redefined as often as the "them." But it is always in a way that the speaker is among the "us" and, more importantly feels put upon by the "thems", however defined. What seems to be missing is a sense or understanding of the concept of interdependence – we’re all "them" AND "us." Allow me to illustrate.

This article from The Washington Post is not atypical of a lot of recent coverage and commentary. There is a perception of outrage about the rescue plan being floated in Washington. I'll focus on the plan shortly, but I want to start by examining the perception. I am intrigued by some of the statements in the article. One person "lived within his means in an era of easy credit." Presumably, that is easier than living within one's means in an era of tight credit. Later the same person states he didn't buy an overly large house, and isn't behind on his payments. That's good. But to what extent is his success due to general growth in the economy? Did he benefit from the activity and decisions of others?

Another person in the article suggests this may take generations to unwind. That may or may not be true. I suspect it will affect how this and possibly the next generation make certain decisions - significant economic and financial events do that. But so do the rules and regulations that get put in place - that's why we have them. Still another person recalls a neighbor saying he didn't know how he afforded the house he bought, he "just signed." Evidently, those were the rules and incentives in place. The point is that none of the people interviewed seem to connect the situation we're in to the decisions and choices made by "us". Rather, there’s a tendency to recast the situation as created by "them." Some of us may have been concerned about housing and mortgages earlier in this decade, or even during the last. But we all benefitted because lower prices and financing for homes meant people could by more other stuff. "Us" was part of the "them."

Now, there is evidence that leads us to believe that the crisis may be restricted to a small (but very significant) segment of the financial industry. One of the terms bandied about recently is "credit crunch." But is there a credit crunch affecting Main Street? To me, that would imply a difficulty in finding credit. Yet, if we look at some data from the Federal Reserve Bank of St. Louis cited in the Marginal Revolution blog, credit continues to be available for consumer loans, commercial loans, and mortgages. So where's the problem? Blogger Alex Tabarok suggests it is in the area of short-term asset-backed securities. This would make sense as some of those investments were linked to mortgage loans of dubious origination. And if people doubt the value of the homes and the ability of borrowers to repay, everything resting on that foundation becomes shaky.

However, let's get back to the Post story. The subjects of the story are asking valid questions about their "role" in the bailout. This brings me to another concept. In economics, we often talk about externalities - benefits or costs that accrue to parties outside of a transaction. In the case of the proposed rescue, one could make a case that this is a case of huge negative externalities. Taxpayers are being asked to provide the funds to aid parties to transactions that did not directly involve them. Many of them did not purchase homes under questionable terms; and many did not purchase the derivative contracts that grew out of the housing boom. Consequently, the fall of housing prices and the ensuing collapse of the derivatives based on mortgages for those homes, sent ripples through the economy - negative externalities - costs that must be paid. But is the taxpayer the one who should pay for the externality? The question now becomes, was the taxpayer a beneficiary? One can argue that the average economic citizen benefited from a growing economy, stable financial environment and access to credit. To the extent that proposed plan maintains that condition, taxpayer involvement is appropriate. To the extent that taxpayers benefitted from “cheap and easy credit”, etc., it is also appropriate. Look at the past benefits, look at the present benefits, and consider the future costs.

This leads to a discussion about "them", or at least to one of the conveniently defined "thems". The rescue package is still being debated, so it is pointless address details. Nevertheless, one of the things the package will hopefully do (indeed I would submit it should be a major objective) is properly allocate costs, or as one of my econ teachers used to say "internalize the externalities." By that, he meant take the externalities and properly integrate them into the cost structure – who benefits and who pays?

To that end, a number of lessons are available to apply. As we see in this New York Times piece, (HT to blogger William Polley)Sweden underwent a mortgage-induced crisis in the early 1990s. The Swedish government intervened with a rescue package. But the Swedish government implemented some very strict conditions for intervention, among them: banks had to write down the losses before rescue. This means the losses had to be recognized on the books so that shareholder value was impacted first. Thus part of the externality was accounted for by the shareholders. Only then would the government intervene, taking stock warrants as collateral. This meant that if assets were later sold off above the price on the books, part of the profit went to repay the government. This is, if I understand correctly, part of what was done for AIG.

Now some are asking that banks be asked to do the same as AIG. But there is a subtle difference between what was done for AIG (and Freddie and Fannie) and what needs to be done for banks. This is because banks are...well, banks. The Federal Reserve System is already set up to deal with banks, providing liquidity through various channels, even taking debt as collateral. This is important. Generally when liquidating a firm, debt (liability) has a superior claim to assets over capital (owners), meaning the debt holders get paid first. While AIG was not a bank and therefore not in the normal procedures, banks can use existing channels to get money from the Fed. If the U.S. government or the Federal Reserve takes stock as collateral before a bank's losses are figured in; there is a risk of being last in line in case of liquidation. By taking debt, that should be less of a problem.

But there may be other ways of "internalizing the externalities". On the PBS program NewsHour on Tuesday, September 23, (HT to Greg Mankiw there was interview with a panel of economists about the proposed plan. All more or less agreed something needed to be done, but the consensus was that the plan needed modification. Of particular note were comments by Alan Meltzer of Carnegie-Mellon University. He suggested that the aid should be in the form of loans to be paid back with interest. (Indeed, if we look at some of the recent plans, loans not only are being made, but some of them have fairly steep interest rates – reflecting greater risk.) And that until the loans were paid back, dividends to stockholders would be suspended and bonuses to executives would also not be paid. (My initial reaction was "and don't let the executives jump ship until the loan is repaid." But I'm not sure having the same people steering the ship when it hit the iceberg is a good thing. Maybe you let them go without departure bonuses. To extend the analogy, this would be akin to setting them adrift in a lifeboat without the full complement of provisions.) Meltzer’s suggestion provides a certain incentive for the firms to mark down the losses, and then work quickly to restore profitability in order to pay off the loans. But that’s about "them", isn’t it?

We're still examining the "us" behind the rescue package. Even if the costs are properly shifted, there's still going to be some overhang. Who should pick that up? In the long-run, one could probably wait for a market solution, letting the losses hit various parties involved, whether culpable or not. That may not sit well with our sense of justice in some cases, and it may sit well in others. It depends on who is taking the specific hit. But one needs to look at the big picture. Fed Chairman Ben Bernanke, in his economic outlook delivered before Congress yesterday, pointed out that some things are being implemented that would reduce the potential loss to the taxpayer. The general situation is also causing reactions one would expect. "Nonconforming jumbo mortgages cannot be securitized and thus carry much higher interest rates" - so much for financing a big house on the cheap with little or no documentation. And he pointed out that the cases of Fannie and Freddie, while large and unusual, were largely the result of those organizations being government-sponsored, an issue that was addressed back in July.

Where does that leave us in the classroom? We've got lots of examples to use as explanations and illustrations when discussing externalities, incentives, the role of banks and credit, exotic financial instruments, and the role of the Fed (see last week's post). I also submit that, depending on the details of the rescue package, there is something to use when discussing institutions (the rules of the game) in the financial markets. Hopefully, the final package will not set up institutions that promote situations like this.

Overall, I am reminded of an anecdote an economist once shared with me after the savings & loan crisis of the late 1970s and early 80s. He was a guest on a radio call-in program and one irate caller said that “government got us into this; government should have to pay for it.” The economist then reminded everyone that we are the government. The "them" is "us". The same goes for the economy. The economy is merely the sum of all of our personal decisions. Our decisions are shaped, in part, by the rules we put in place (or allow to be put in place), and in part by our desire to improve our lot, our attempts to "get the most for the least." Whether we know that our actions are "right", whether rules are "correct", or whether the consumer/taxpayer ultimately gets the check, the economy is still of our making. We’re all on the same boat. That’s interdependence.

In the end, as the discussion on the bailout continues, and various constituencies jockey for their place at the payout window, I am reminded of something said by the French economist, Frederick Bastiat. To the best of my memory it was "we all look to live at the government’s expense, but we forget that the government lives at our expense." I look forward to your comments.

Opportunities for Teachers

The Powell Center for Economic Literacy is offering a number of programs that may be of interest to select groups of teachers.

First, for high school teachers, particularly those who teach A.P. Economics, the Powell Center and the Federal Reserve Bank of Richmond are sponsoring the biennial A.P. Economics Conference, November 2 - 4, 2008. The program offers sessions of particular interest to teachers of A.P. Economics, but may also be of interest to those of you teaching IB or other economics courses. This year's conference features speakers Tim Harford, author of The Logic of Life and The Undercover Economist; Russell Roberts, author of The Price of Everything and host of the EconTalk podcast site; and Federal Reserve Board Governor Kevin Warsh. For information on the program and registration, go to this page of the Powell Center site, and click on the links near the bottom of the page.

For middle school teachers in the Baltimore, MD area, Powell, in cooperation with the Baltimore Branch of the Federal Reserve Bank of Richmond and the Maryland Council on Economic Education is offering Mid-Size Economics, a program on economics for middle school social studies teachers in Maryland on Thursday, November 13, 2008. Teachers can examine the program and register at the Powell Center site.

The same groups will also be hosting a program on Kid-Size Economics for elementary school teachers, at the Baltimore Branch of the Federal Reserve Bank on Friday, November 14, 2008. Interested teachers can see the program and register here.

Please feel free to leave questions on this blog.

The Functions of the Federal Reserve

During the past couple of weeks, the financial turmoil has forced many people to focus on the Federal Reserve. While there are a number of good resources for teachers about the Fed, virtually all of them consolidated here, I thought it might be helpful to review some information about the Fed in a way that could help put its recent activity into context.

We are frequently reminded that the Federal Reserve is the "nation's central bank." And we will spend some time on that nearer the end of this post. But there are other functions of the Fed that are frequently overlooked, yet provide a background for what has happened as events have unfolded.

First, the Federal Reserve is a bank - or more precisely, a number of banks - and one of its functions is to act as such. But the Fed has an unusual clientele. Perhaps its most important customer is the U.S. government. The Fed is the government's bank. That means that all moneys sent to the U.S. government in the form of taxes, etc. end up deposited at the Fed. Likewise, Federal payments are drawn on the government's account at the Fed. The reason for this is that prior to the creation of the Federal Reserve, U.S. funds were deposited in private banks. This had the potential for favoritism and political patronage. As a consequence, placing federal monies in the Federal Reserve Banks eliminated that source of conflict.

The Fed also is a bank for banks. This also goes back to the formation of the Federal Reserve. One of the Fed's primary jobs in early years was to help limit bank runs. This was accomplished by charging the Fed with being the "lender of last resort." Essentially, banks could go to the Fed for money (cash specifically) if yhey did not have enough on hand to meet demand. The money would be borrowed against collateral (loans and government securities) and interest charged for the loan - the rate was called the discount rate. (Discount because the interest was paid off the front end of the loan - the loan was discounted by the amount of the interest.) It is this "lender of last resort" function that has played in some of the Fed's actions of the past couple of weeks. But you should be asking "how?" Many of the institutions involved weren't banks - therefore they weren't Fed customers. This brings us to the second function.

Another charge of the Federal Reserve is to maintain an efficient payment system. Usually this is done by providing currency and coin to financial institutions as needed; facilitating the clearing of checks drawn by one bank on another bank; and providing electronic payments and transfers between institutions. But in unusual circumstances, the Fed can provide funds in an effort to prevent the payments system from freezing up. Generally, banks can and do borrow funds from each to facilitate payment. But in times of stress, they may stop lending to one another - and they may stop lending to non-bank financial institutions (brokerages, investment firms, insurance firms). In situations like this, the Fed can step in - lending to banks to enable them to lend to other firms - to prevent the payment mechanism from coming
to a stop. And as we've seen, the Fed and Treasury have moved together to provide funds directly to non-bank financial firms to prevent the same thing. But like the "lender of last resort" idea, the Fed is taking securities as collateral - in some cases stock or stock warrants, in other cases loans.

The final role of the Federal Reserve is to act as the nation's central bank. This means it is responsible for making sure the nation's money supply grows at a rate that is conducive to price stability and maximum sustainable growth. Again, in times of crisis, the Fed may have to choose which of the dual mandates set forth by Congress take precedence. When the financial system is threatening to come to a halt - growth takes the front seat. Consequently, making more funds available (increasing the money supply) may generate concerns about inflation and the value of the dollar, but once the market stabilizes the funds can be drawn out of the system again. This is what happened during the stock market "crash" of 1987.

I've just provided a very general outline here. I would encourage you to check out the site mentioned earlier in this blog. (Here's the link, again.) And you may want to check the web site of your local Federal Reserve Bank to see if they provide additional information or resources.

I look forward to comments.

AIG and CDS

For those of you trying to sort out what's behind the AIG implosion, the answer is a derivative contract called a collateralized Debt Swap (CDS). These contracts are used to transfer the risk of default on debt (bonds and other debt-based securities) to other parties. There's a good graphic explaining how they work here, courtesy of The New York Times.

The problem for AIG is their exposure to these instruments. As an insurer, they were involved in a lot of these contracts to help other firms hedge against loss. But the value of the underlying contracts (mortgages in many cases) was uncertain. This is leaving AIG exposed to a lot of claims as contracts go into default. When that happens, AIG makes a payment. Consequently, with the number of default payments they've had to make, AIG is short capital.

There's more to come on this, but in the interim, I will point you to two other resources that may help you as the smoke clears. The first is a YouTube video that features an interview with Princeton economics professor and former Federal Reserve vice-chairman, Alan Blinder. (HT to Greg Mankiw.)

The other is the blog by Professor William Polley at Western Illinois University. I met Dr. Polley when I was in Chicago and he writes one of the best Fed watching blogs for educators. I always appreciate his insights.

I look forward to your insights, as well.