A plight to remember

Has London anything to teach Almaty?



Amid economic growth, prices have remained volatile in Central Asia since the turn of the century. A measure of dispersion, the standard deviation, was twice as volatile for prices in the region as for those in the United States from 2000 through 2009. Even Kazakhstan, which has the strongest economy in Central Asia, has suffered more inflation over the period than has the U.S., according to World Bank data.

Fluctuating rates of inflation induce buyers and sellers to err, because they cannot be sure whether the price changes they observe for some product are due to changes in its supply and demand or to inflation that has yet to affect other products. Such errors retard economic growth. Since long-run inflation usually occurs because of excess money in the economy, is it time for the National Bank of Kazakhstan to stabilize money supply rather than the exchange rate?

A similar debate in England almost two centuries ago may shed light on the National Bank’s predicament. In the early 1800s, the price of a typical bundle of goods in England -- the “price level” -- fell about as sharply as it rose, resembling a roller-coaster. The most influential critics of the Bank of England, called the “Currency School”, demanded that the central bank stabilize the money supply, which at that time comprised gold and silver as well as paper money. Led by Lord Overstone, the critics argued that the Bank’s fine-tuning of money had undermined its credibility. In a recession, speculators could anticipate that the bank would issue more paper money, effectively to try to stimulate spending. But because the new money was not backed by a commensurate increase in gold, a pound sterling would lose value. Speculators knew this, so they would try to profit in advance by selling pounds to banks in exchange for gold. The loss of gold reserves left the banks vulnerable to panicked withdrawals of yet more gold. Sooner or later, the banks would collapse. Rather than risk this scenario, the Bank of England should commit to a given level of money supply -- no matter what the commercial banks demanded -- in order to preserve confidence in banking. A few commercial banks would fail, because the Bank would not lend to them in emergencies; but this was better than losing the system of banks.

The friends of the Bank, called the "Banking School", thought the Currency medicine too harsh to swallow. The Bank should simply lend to anyone who was creditworthy, they argued. Because such people borrowed money only to increase output, the resulting economic growth would justify expansion of the money supply. (To buy more goods, we need more money.) The best way to stabilize the economy was to ensure that people could always get gold from banks in exchange for paper money (or near-money, like bills of exchange). Secure in that knowledge, they would not run on banks.


Taking chances


In 1844, Parliament bought the Currency argument. It compelled the Bank to back its paper money 100% with reserves of precious metals. To issue additional notes, the Bank would need additional gold. The Bank also had to separate its two main functions – managing the money supply and supporting commercial banks.

In a few years, the Bank was back in a jam. When English harvests failed, grain imports and prices rose. So did the demands for liquidity from commercial banks.  Before 1844, banks might have been able to make good on the withdrawals by drawing upon the reserves that they kept at the Bank of England. But the Bank’s Issue and Banking departments had been separated; the Issue department had plenty of gold in reserve, but the Banking department didn’t. So it balked at issuing notes.  In the liquidity crisis that followed, the government suspended the 1844 law and authorized the Bank to lend freely at an unusually high rate of interest (8%), noted an economic historian, John Wood.


Unfortunately, such largesse may bring on the crises that it was meant to prevent. Suppose that speculators anticipate that a crop failure will lead the Bank eventually to lend notes freely. They realize that this increase in money supply may lower the value of a note (in terms of the products that it can purchase). So, as soon as the crops fail, they will exchange their notes for gold while these are still worth something. Gold reserves at the banks will fall, stirring doubts about the value of the notes and paving the way to a panic.

The National Bank of Kazakhstan faces a similar conundrum today. Countries today are no longer on a gold standard, but the U.S. dollar plays a similar role, since it exchanges easily for most currencies. Should the National Bank maintain large reserves of dollars, in order to avoid lapses of public confidence in Kazakhstan’s currency? Or should it use the dollars to bail out troubled banks? Should it announce that it will permit the money supply to increase at only the rate of economic growth, no matter what the immediate demands for money may happen to be? Suddenly, London is no longer so distant from Almaty. – Leon Taylor, tayloralmaty@gmail.com


Good reading

Walter Bagehot. Lombard Street. Various publishers. 1873. A classic tract of monetary economics by the editor of The Economist.

Anna J. Schwartz. Banking School, Currency School, Free Banking School. In John Eatwell, Murray Milgate and Peter Newman, editors, New Palgrave Dictionary of Economics: Money. Norton. 1987.

John H. Wood. A history of central banking in Great Britain and the United States. Cambridge University Press. 2005. Lively and informative.


References

World Bank.  World Development Indicators.  http://www.worldbank.org/

A grain of truth

Are grain farmers in Kazakhstan acting on bad information?


The grain market in Kazakhstan may be headed for the economic version of a train wreck. According to the business weekly Kursiv’, experts expect an increase in Chinese demand for Kazakhstani grain this year, accompanied by a shortage of grain carriers and granaries in the country as well as by a reduction in the harvest since last year’s record yield.

All of these factors presage an increase in grain prices here. But what is most striking about the market is its volatility. The grain yield in 2011 was more than twice that of 2010, which in turn was 40% below the yield in 2009, according to Kursiv’.

Cobweb, anyone?

The term refers to a market in which output and prices fluctuate because producers act upon mistaken expectations. Suppose that wheat prices are unusually low in Year 1. Farmers planning for next season’s market may assume that prices will remain anemic; and so they will sow little. As a result, the harvest will be small. This scarcity of wheat will send its prices soaring in Year 2. Now farmers, anticipating a bonanza, will sow a bumper crop…which will pull prices back down in Year 3. Economists call this predicament a “cobweb” because of the ever-growing oscillations of price and quantity when plotted on a market graph. Its vital feature is that the farmer always presumes that this year’s price will also be next year’s.

The grain market in Kazakhstan may be particularly vulnerable to cobwebs because nearly 90% of the country’s yield goes into the domestic market -- partly because of the lack of export facilities, although the country is a leading exporter of wheat and flour. In the domestic market, sharp changes in output may lead to sharp changes in prices.  On the other hand, wheat farmers in northern Kazakhstan may sow regardless of the expected price because they have few other uses for the land, suggest researchers at the United States Department of Agriculture


Cobwebs in the brain


A cobweb market has two causes. First, producers assume that current conditions will hold in the coming season. The government can address this misunderstanding by publicizing more sophisticated forecasts – or by developing the futures market, which rewards accurate forecasting.

Second, the farmer when planning his sowing assumes that his harvest will be too small to affect the national output and price. That’s rational, but if every farmer makes that assumption as well as the one of cobweb prices, then the national market may indeed gyrate.

One solution to this problem – organizing the farmers into a cartel that will make sowing decisions for all – is the sort of cure that kills the patient. Unfortunately, with its penchant for industrial planning, the government may choose essentially this treatment. A less intrusive policy would have the government – perhaps via KazAgro -- buy surplus grain in bumper years and release it in years when the harvest comes a cropper.

The cobweb model fails to explain why farmers repeat their errors when there is money on the table. Perhaps the market oscillations arise from rational expectations – which use all available information, not just past prices -- about shocks to the system. For example, a cattleman must decide whether to slaughter and sell his animal now or to breed it. A rise in beef demand that seems temporary may lead to more slaughters for a while. This affects the age distribution of the cattle, the birth and death rates, and ultimately the size of the stock. The cattle cycles generated may resemble cobwebs, but they stem from well-informed decisions.

At the University of Chicago, economists Sherwin Rosen, Kevin Murphy and José Scheinkman found that a rational-expectations model snugly fit the cattle cycles observed over 115 years when adjusted for trends in beef demand. They write: “Shocks to demand and supply have persistent long-term effects on future shocks by changing farmers’ incentives to carry breeding stock and altering the age composition and reproductive capacity of herds.”

Some studies have tried to observe cobweb expectations directly, by running a laboratory experiment. Participants in a simulated market are asked to predict the price in the next period. At the University of Arizona, Charissa Wellford found “little or no indication that cobweb or rational expectations are employed by the sellers.” (A pox on both houses.) Adaptive expectations, in which one forecasts the price partly by extrapolating past prices, “perform somewhat better.” This is not the first time that a cherished notion from economics has failed to find support in the lab. -- Leon Taylor tayloralmaty@gmail.com





Good reading

Mordecai Ezekiel. The cobweb theorem. Quarterly Journal of Economics 52: 255-80. February 1938.

United States Department of Agriculture, Production Estimates and Crop Assessment Division, Foreign Agricultural Service.  Kazakhstan Wheat Production: An Overview.  Online.


References

Sherwin Rosen, Kevin M. Murphy, and José A. Scheinkman. Cattle cycles. Journal of Political Economy 102: 468-92. June 1994.

Bakitzhan Toksharayev. Nazlo recordam. Kursiv’. March 20, 2012.  Page 1.

Charissa P. Wellford. A laboratory analysis of price dynamics and expectations in the cobweb model. University of Arizona Discussion Paper 89-15. 1989. Online.