Classical dichotomy

The classical dichotomy (Patinkin, 1965) refers to the idea that real variables, like output and employment, are independent of monetary variables. In this view, the primary function of money is to act as a lubricant for the efficient production and exchange of commodities. This conception of money rests on "real analysis", which describes an ideal-type economy as a system of barter between rational utility-maximizing individuals (Schumpeter, 1994, p. 277).

In this sense, money is "the unpremeditated resultant, of particular, individual efforts of the members of society, who have little by little worked their way to a determination of the different degrees of saleableness in commodities" (Menger, 1892, p. 242). Hence, money is considered simply as a social technology for the adjudication and determina- tion of "terms of trade", which are inherently specific to individual dyadic economic exchanges (Dodd, 1994, p. 6). It is thus a social "vehicle" that has no efficacy other than to overcome transaction costs concerning the inconveniences of barter, which result from the absence of a double coincidence of wants (Jevons, 1875, p. 3).

Clearing system

A clearing system consists of a series of norms and coordinated processes by which financial institutions systematically collect and mutually exchange data or documents on funds or securities transfers to other financial intermediaries at an agreed place called "clearing house". These procedures can also involve the determination of partici- pants' bilateral and/or multilateral net positions and aim at simplifying the discharge of respective obligations on a net or net net basis in a settlement system. Occasionally, the expression "clearing system" implies a mechanism of multilateral netting by novation and the settlement of the corresponding payments or, imprecisely, the process itself of settling transactions. Since their functioning involves "a moderate stock of solid Money [. . .] [while] a large proportion of both solid and paper Money might be spared" (Seyd, 1871, p. 5) and they naturally aim at "eliminating or reducing cash transfers" (Einzig, 1935, p. 66), clearing systems gained particular success in the nineteenth century.

Corridor and floor systems

A corridor-type (with its floor-type variant) system is an approach to the setting of inter- est rates that an increasing number of central banks have adopted since the mid 1990s. The system has now become the operational framework that most central banks utilize for implementing their strategies on interest rates.

The interest rate policy of central banks consists of a strategy and an operational framework. Strategically, central banks set their desired level for one or more interest rates, based on what they consider adequate in terms of their public policy objectives. Operationally, they use a set of instruments and procedures to effectively steer the chosen interest rates toward the target policy rate. Since the 1990s, the prevailing operational framework for monetary policy implementation is a corridor system. In the 2000s, the central banks of Japan and New Zealand, as well as a number of other central banks in the aftermath of the global financial crisis, have further modified their framework and embraced a floor system.

Credibility and reputation

The issues of credibility and reputation of monetary authorities were introduced by the "New classical economists", in order to develop additional arguments in favour of monetary policy rules and against the use of discretionary policies. Their main goal was to show that an "inflation bias" emerges in cases where monetary policy is discretionary. Monetary authorities are said to be credible if private agents believe in their commit- ment to price stability. Kydland and Prescott (1977) showed that it is in the best interests of central banks to announce a low-inflation policy and then, if private agents believe in the policy announced, to switch to a higher-inflation policy in order to temporarily reduce the rate of unemployment. As a matter of consequence, central banks will have a credibility issue, because rational agents will not believe them.

This credibility issue raised by Kydland and Prescott (1977) can only arise under very restrictive theoretical circumstances: central banks have to make their decision first before private agents can react, the game needs to be a one-shot one, and agents as well as the central bank must have full information and must not cooperate.

Credit bubble

A credit bubble is a sustained and accelerating growth of bank loans relative to the growth of Gross Domestic Product (GDP), which finances a boom in both economic activity and in asset prices. The proposition that this growth of credit adds to demand - especially for financial assets - above and beyond that generated from existing incomes contradicts the "loanable funds" vision of lending in which loans are "pure redistribu- tions" which "should have no significant macroeconomic effects" (Bernanke, 2000, p. 24), as lending simply redistributes spending power from lender to borrower without enhancing aggregate demand. However, in the endogenous-money view, lending enables demand to increase in the aggregate, thus financing a growth in economic activity and rising prices on asset markets. Prior to the global economic and financial crisis that erupted in 2008, the dominant view in economics was that the proposition that "credit bubbles" had any macroeconomic significance was a figment of the imaginations of non- economists. The Modigliani-Miller theorem (Modigliani and Miller, 1958) - the relevant subset of the efficient markets hypothesis - argued for the irrelevance of credit to both the valuation of firms (except for the effect of the tax-deductibility of interest payments) and economic performance. The proposition that there could be a "financial accelera- tor" (Bernanke et al., 1996) gave conventional theory an argument as to how credit could impact on economic activity, but this mechanism relied on agency costs owing to asym- metric information and acted through the price of credit rather than its volume.

Core inflation

There are several measures of inflation. The official measure - that is, the rate of change in the Consumer Price Index (CPI) in most countries - is also referred to as "headline inflation" owing to its ability to make news headlines. Headline inflation, however, is often subject to large and temporary fluctuations arising from supply shocks, for example production declines due to unfavourable weather conditions or external factors affecting the prices of one or more consumer goods imported into a country. Another measure of inflation aims at removing these volatile components from headline inflation. The concept of core inflation is based on the idea of identifying the underlying persistent trend of inflation.

There are multiple approaches to derive core inflation from headline inflation. Among them, the most widely used approach is excluding selected groups of items from the basket used to compute headline inflation and recalculating the weighted change of prices of the remaining items in the basket. Food and energy items and interest charges are the most popular exclusions. The exclusion method is used by central banks more frequently than other methods, as that method is computationally simple, easy to understand and derivable without any time lag.

Currency crisis

A currency crisis is a form of financial crisis marked by the abrupt devaluation of a nation's currency ending a period of fixed or pegged exchange rates. A sudden shift in international asset portfolios, with its rapid reversal of capital flows, is the proximate cause of a severe collapse in the external value of a nation's monetary unit. And most would agree that all such events are characterized by "investors fleeing a currency en masse out of fear that it might be devalued, in turn fueling the very devaluation they anticipated" (Krugman, 2007, p. 1). While investor action driven by a fear of a crisis drives the actual crisis, the dramatic change in the external value of a nation's currency defining the actual crisis implicates a nation's macroeconomic accounts, particularly its fiscal deficit, sovereign debt, and balance of payments.

Commodity money

A commodity is any good or service that is useful as an input in production or con- sumption and can be exchanged with other goods or services. The exchangeability of commodities presupposes the existence of a common element that makes them commen- surable to each other. Classical economists argued that the common element contained in commodities is that they are products of labour. Hence, the quantity of labour time spent to produce any commodity becomes the measurement stick of its worthiness. Of course, there are differences and qualifications within this broad classical approach. For example, Marx's concept of abstract socially necessary labour time - that is, the labour time without its specific characteristics - is what gives worthiness to commodities.

Historically certain commodities, owing to certain useful attributes they possessed, became money commodities; that is, the means through which the other commodities can express their worthiness and in doing so become the medium for quoting prices. If gold, for example, is the money commodity, the other commodities express their worthiness in terms of a certain quantity of gold (for example, 1 US dollar 5 1/4 ounce of gold). The value - to wit, the abstract socially necessary labour time - contained in a commodity, relative to the value of gold, gives the direct price or a first approximation of the monetary expression of value and a centre of gravity for observed (market) prices (Shaikh, 1980).

Credit guidance

Pioneered by the Reichsbank in 1912, credit guidance is a technique used at one stage by most central banks to manipulate bank credit creation in order to achieve monetary policy and sometimes industrial policy outcomes. This technique was transferred from Europe to Asia by Hisato Ichimada, who trained with Reichsbank president Hjalmar Schacht in the 1920s in Berlin, before later becoming the governor of the Bank of Japan, which used that instrument continuously from 1942 until at least 1991 (Werner, 2002, 2003a).

The common name for “credit guidance” in East Asia is “window guidance”. In this procedure, the central bank determines quarterly loan growth quotas for all banks in a top-down process starting with the desired nominal GDP growth, followed by the cor- responding growth in bank credit for GDP transactions (in accordance with the quantity theory of credit), which is then awarded pro rata to individual banks according to their assets size. Progress with the implementation of the loan quota is reported by the banks to the central bank on a monthly basis. During the monthly hearings, all information on bank balance re-allocate existing purchasing power. That, however, is a private sector activity whose regulation is difficult to justify. Not so for bank credit creation, which exploits the public privilege of issuing money for new transactions. As a result, a conflict of interest exists in the case of for-profit banks maximizing their shareholders’ value: their activities may be harmful for society or at least not “socially useful”. In this case, regulation, such as in the form of credit guidance, is justified.

Carney, Mark

Mark Carney (1965-) is a Canadian banker who in 2013 became the 120th Governor of the Bank of England. He is the first non-Briton to hold that position. Prior to this appointment, Carney served (from 2008 through 2013) as the eighth Governor of the Bank of Canada. His actions during the 2008-09 global financial crisis are widely believed to have helped Canada avoid its most severe consequences.

Carney was educated in economics at the Universities of Harvard and Oxford. He worked for 13 years for Goldman Sachs in several locations and capacities, including managing director for investment banking. In 2003, he began a career in public service in Canada. He was appointed as a Deputy Governor of the Bank of Canada in 2003, and then seconded by the Canadian Department of Finance (in 2004) to serve as Senior Associate Deputy Minister. In that position he handled several delicate files, including income trusts (flow-through investment vehicles designed to avoid corporate taxes) and the 2007 freeze in Canada's asset-backed commercial paper market. He was appointed Governor of the Bank of Canada, replacing the retiring David Dodge, beginning in February 2008.

Capital flight

The Latin American "lost decade" of the 1980s has been an important case study for researchers. During that period, Latin American governments had great difficulty in servicing their external debt. Argentinean, Brazilian, Bolivian and Peruvian economies experienced both stagnation and hyperinflation, while at the same time the private sector increased its accumulation of foreign-exchange reserves. A very similar situa- tion repeated during the Russian and Argentinean crises of 1997 and 2001. The loans granted by the International Monetary Fund to these governments followed a similar fate: local elites hoarded most of the foreign exchange outside the country. What would have been the fate of Latin America had all that money been available to service external debts? Paradoxical situations like these were the main motivation of the literature on capital flight. (On the relationship between capital flight and Latin American debt crises, see Pastor, 1989.)

The definition of capital flight is an old question that goes back at least to the inter-war period. According to Kindleberger (1937), capital flight is that part of capital outflows motivated by political and economic risk.

Collateral

The term "collateral" refers to a tangible asset or a secure financial asset, such as a gov- ernment bond, which is used to guarantee a debt issued by the owner of the asset. The existence of collateral is intended to make the debt less risky, as the creditor has a legal claim on the asset in the case of default by the debtor. As such, collateral is fundamental to the smooth functioning of financial markets.

In this sense, collateral is part of a significant number of lending and borrowing trans- actions undertaken by market participants. For instance, source collateral is provided to investment banks by hedge funds and commercial banks directly, and by other financial market participants such as pension funds and insurers via their custodians (Singh, 2012). While the existence of collateral is crucial to the individual investor, particularly the creditor, collateral also plays an important role in the financial system at the macro- economic level, notably because source collateral is frequently re-pledged, which allows for the creation of collateral chains and hence an interdependent network of lending and borrowing transactions at the aggregate level.

Capital requirements

Capital requirements, also referred to as minimum mandatory capital adequacy require- ments, constitute the cornerstone of banking regulation in advanced and emerging economies. They are designed to ensure that banks and depository institutions more generally hold an adequate amount of capital to withstand losses on their assets during periods of stress. Against this backdrop, minimum capital requirements serve as a buffer to reduce the risk of banks becoming insolvent and thus unable to carry out their activi- ties on an ongoing basis, eventually protecting depositors and taxpayers and fostering the stability of the financial system as a whole. Notice that in order to ensure their solvency and reinforce the confidence of depositors and investors, banks may voluntarily choose to maintain capital adequacy ratios above the regulatory minimum.

Credit creation

The credit creation theory of banking is one of three theories concerning the role of banks in the economy. It maintains that each individual bank is able to provide credit and to issue money out of nothing, without having to have received new reserves first (as by contrast the fractional reserve theory of banking maintains), or without having to have received new deposits first (as the financial intermediation theory of banking maintains). Credit creation is recognized by, among others, Schumpeter (1912), Austrian school authors such as von Mises (1934 [1953]), post-Keynesian authors such as Moore (1988) and Rochon and Rossi (2003), and empirical economists such as Werner (1992, 1997, 2005).

The question about which of the three theories of banking is correct has been disputed for at least 150 years, without ever having been put to a decisive empirical test. This has recently been provided by Werner (2014a; 2014b), whose tests involved borrowing from a bank that offered access to its internal processes and accounting. It was found that both the fractional reserve and the financial intermediation theories of banking are contra- dicted by the empirical facts.

Credit divisor

When the monetary base is endogenous, the direction of causality between that variable and loans or deposits is reversed. Hence, the orthodox concept of the money multiplier (see Phillips, 1920; Cannan, 1921; Crick, 1927) is replaced in most heterodox theories with the credit divisor, a concept developed by Le Bourva (1962 [1992]), a prominent French monetary theorist. As pointed out by Lavoie (1992b), who translated Le Bourva's original 1962 paper into English, the specific phrase diviseur de credit, or "credit divisor", first surfaced in a later article by Lévy-Garboua and Lévy-Garboua (1972, p. 259). Nonetheless, these authors attribute their turn of phrase to a suggestion by Le Bourva (1962 [1992], p. 259) himself.

Le Bourva wrote mostly about "overdraft economies", to wit, systems typified by companies that were always in debt to banks, and banks that were perpetually in debt to the central bank. In such economies, banks supply credit to creditworthy customers on demand at a fixed rate of interest, up to given credit limits. Lavoie (1992a, pp. 174 and 207-10), Renversez (1996) and others have further generalized the divisor concept to a more "financialized" economy.

Consumer price indices

In principle, the consumer price index measures the price of goods consumed by a typical consumer in a given period of time, and changes in it measure consumer price inflation. Such indices are required for the comparison of standards of living at different times or in different places, and hence for the measurement of real economic growth. Changes in the index have since the 1980s also increasingly been a specific target of central banks. Frequently, they are also used to index-link benefits, allowances and the like (sometimes including wages), often with the objective of "depoliticizing" decisions about them. Stapleford (2009), however, analysed a variety of ways in which this objective is incom- pletely met. One significant source of debate in this regard arises from difficulties about measuring consumer prices, with the suggestion that the index tends to overstate infla- tion, promoting the idea that index-linking should be adjusted accordingly.

Credit easing

The expression "credit easing" was first used prominently by the chairman of the Board of Governors of the US Federal Reserve System (Bernanke, 2009). In his speech at the London School of Economics, Bernanke (ibid.) subtly criticized the Japanese central bank and its attempts at monetary stimulation, arguing that the Japanese policies were not the best way to help the economy after a banking crisis, and that he had been implementing a different policy, which also aimed at expanding the quantity of money available, but was targeting credit availability more directly.

The expression "credit easing" derives indeed from the expression "quantitative easing", which itself originates in Japan. The Bank of Japan (BoJ) was the first central bank to adopt a policy by that name, describing its actions between 2001 and 2006 (label- ling these as "quantitative easing" retrospectively since about 2003; see Lyonnet and Werner, 2012).

Contagion

Contagion in a broad sense has been studied as the propagation of an initial adverse macroeconomic shock from one market or economy to another. It has been characterized by robust comovements or excess positive cross-country correlations in macro-financial indicators (for instance, interest rates and sovereign spreads), beyond what can be explained by fundamental economic variables (see Bekaert et al., 2005). Most empirical literature still rests on the notion of "shift contagion"; that is, significant variations in pre-existing cross-market linkages (for example, correlations and speculative attacks) or changes in the transmission mechanism between two markets or economies in crisis periods (see Forbes and Rigobon, 2002).

The measurement of contagion is best echoed in the international portfolio theory (IPT). According to the IPT, taking a Chinese investor as an example, international port- folio investments in advanced foreign markets (therefore dissimilar or less integrated) like the United States are highly desirable, as these drive inter-country correlations between bonds and stocks even further down, thereby optimizing risk reduction and maximizing asset returns (Solnik and McLeavey, 2004). The intuition is that most adverse macro- economic shocks are country-specific, such that financial markets in different economies display low correlations. The presence of contagion, therefore, apprehends this reason- ing. Here, it is worth noting that Chinese and euro-area portfolio flows into US markets have been deemed a factor of the global crisis that erupted in 2008 (see Bernanke's "global savings glut" hypothesis). In another sense, investors can hedge or diversify home-country risks through direct or capital investments in high-growth economies (for instance, US lending and portfolio flows to Mexico in the early 1990s that preceded the peso devaluation of 1994 and the subsequent "tequila" crisis).

Currency board

A currency board arrangement (CBA) is a domestic monetary regime governed by three strict rules:

(1) an exchange rate rigidly pegged to a foreign currency;

(2) the obligation for the currency issued to be freely and integrally convertible into this foreign "reserve currency"; and

(3) an obligation for the currency board to keep in its balance sheet a volume of foreign reserve currency equal to at least 100 per cent of the monetary base (that is, currency in circulation plus bank reserves).

The first generation of CBAs was the monetary core of the sterling system that reached its peak in the sterling area period. It was the major instrument of monetary integration of the most dependent British imperial territories to the motherland. By issuing its own currency against a full backing of sterling assets, a colony enjoyed the benefits of a sound local currency without the drawbacks and costs associated with using the actual sterling notes in distant lands: sterling note denominations were too large to be practical; costs related to shipping and risk of destruction or loss were high; and, furthermore, colonial authorities could capture "seignoriage revenues", that is, obtain resources from yields on reserve assets instead of letting them to the Bank of England.

Carry trade

Financial globalization has confronted central banks with carry-trade activities. These are cross-currency strategies that seek yield gains through leveraged borrowing at low interest rates in the funding currency to invest in high-yielding currencies (the Japanese yen–Australian dollar was a famous carry pair before the collapse of Lehman Brothers on 15 September 2008).

A carry trade is a risk-trading practice par excellence. Carry profits are wiped out if the target currency depreciates suddenly or if funding conditions change suddenly (see Brunnermeier et al., 2008). When confronted with such scenarios, carry traders exit rapidly and, in doing so, they put further depreciating pressure on the target currency.

Research identifies two carry-trade strategies. One involves exchanging the funds borrowed in the spot currency market in order to hold high-yielding assets in the target currency, in the form of bank deposits or tradeable domestic assets (Galati et al., 2007). However, investors need not get exposure to domestic assets. Through derivative instru- ments, carry traders can take positions that bet on future movements of the target cur- rency (Kaltenbrunner, 2010). There are clearly pro-cyclical effects: increasing demand for domestic assets during boom times and rapid price falls when carries unwind.