"Welfare for Wall Street"

Thomas Palley says the recent emergency rate cut is "welfare, Federal Reserve-style":

Welfare for Wall Street, by Thomas I. Palley: The Federal Reserve’s recent surprise decision to lower its short-term interest rate target by three-quarters of a point has received much attention. Most commentary has focused on the idea that the Fed is trying to stimulate spending in the hope of preventing a recession. Over-looked, and equally important, is the fact that lower interest rates raise asset prices, which is something Wall Street desperately needs to prevent a systemic meltdown.

The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. But let’s not fool ourselves about Wall Street and free markets. The Fed is using its government granted power of fixing interest rates to bailout Wall Street. That is welfare, Federal Reserve-style.

Normally, economists focus on the effect of interest rates on business investment and consumer spending. The thinking is that lower rates cause increased spending, albeit with long and variable lags and the net impact is also highly uncertain and contingent on the state of confidence.

However, another feature of lower interest rates is that they increase the price of fixed income assets. Thus, when interest rates go down, bond prices go up, and that is critical for understanding recent Federal Reserve policy moves.

The U.S. financial system is currently deeply stressed. Growing perceptions of heightened default risk on mortgages and consumer debts have caused large price declines for securities backed by these assets. That in turn has caused massive losses at banks and insurance companies, eroding their capital. This erosion has placed many firms in danger of regulatory insolvency, unable to meet capital requirements. Some are in deeper danger of bankruptcy with the value of liabilities exceeding assets.

The problem is acutely visible among bond insurers, where rising default rates have reduced asset values while simultaneously increasing potential payouts on insured securities. If the bond insurers are downgraded, this could trigger a cascade of losses that could fracture the system. This is because insured bonds would fall in value, thereby wiping out further capital.

This possibility means maintaining asset prices, and preventing further mark-to-market losses is critical. The Fed’s problem is that as quickly as it has been lowering the federal funds rate, default rates on mortgage and consumer debts have been rising. Consequently, rising credit risk has offset the effect of a lower federal funds rate, so that asset prices have remained weak.

Moreover, there are pitfalls in the low interest rate policy. On one hand lower rates increase bond prices and also reduce defaults on adjustable rate mortgages. On the other hand, lower interest rates could trigger a wave of mortgage re-financing by those good risks still capable of re-financing. That would cause pre-payment losses to holders of existing mortgage backed securities, while also concentrating the proportion of remaining bad risks. The net effect is prices of mortgage-backed securities could fall further.

The fact that Wall Street needs this helping hand has important public policy implications. The existing system of regulation by capital requirements helps discipline risk-taking, but it has proven inadequate. The problem is individual firms do not take account of the impact of their risk-taking on others, so that the system takes on too much risk. This problem can only be solved by a system-wide regulator who monitors and limits total risk-taking. Yet, that is exactly what the Federal Reserve has rejected during the last twenty-five years of de-regulation.

Remedying this failing calls for deep regulatory reform that is nothing less than paradigm change. This is something the Fed will resist and Congress will have to push. But until deep regulatory reform is enacted, the “welfare for Wall Street” problem will persist.

Comments

[spencer]

But that is what the Fed was created to do.

That is its' job.

[paine]

not a bad piece

spot lights the fomc fraud
but admits sanity for us non samsons
requires aquiesence

"The Federal Reserve is right to play the interest rate card aggressively since the economy-wide costs of a financial meltdown are so large. "

and a scream of never again ..
"deep regulatory reform ."

though i'd also call for ten thousand
life term indictments
for looting too

[dirtyal]

Well said. I think it succinctly summarizes what a lot of people are thinking.

I was all up in arms about it and the inflationary aspects of what it might or might not do, until Payne helped set me back on an even keel.

I guess that just because Wall Street benefits from the interest rate cut(s), it still might not be a bad think if it keeps the economy from tanking for long enough to apply some decent first-aid measures.

I still think that, ultimately, we are headed for a time when we will all be sorry about inflation. But, again as Payne says, we can make provisions for "expected inflation" and if the rate cuts keep the market more orderly, I guess we should be willing to live with the by-product of a free pass for Wall Street types.

[F. Frederson]

But until deep regulatory reform is enacted, the “welfare for Wall Street” problem will persist.

I could get behind Bernanke's cuts (and Greenspan's way back when) if they were accompanied by increased oversight. In fact, Bernanke should explicitly offer that deal BEFORE the next cut. Else, no cut. Let the Wall Street and the IBs burn if they won't play.

[johnchx]

Will somebody please explain to Thomas Palley about the difference between long-term and short-term interest rates?

You see, the assets whose values Palley seems to think the Fed wants to prop up turn out to be completely unaffected by the sort of thing the Fed has been doing. For example, on January 18th, the 10-year Treasury yield was 3.66%. On January 22nd, the day of the Fed's surprise 75 bp reduction, the 10-year rate fell by only 14 bps, and it has regained all but 5 basis points as of today. The 20-year rate has been affected even less: 4.30% on January 18th, 4.30% today. And yes, these are "riskless" Treasury security rates; there's no offsetting rise in the risk premium.

Is the Fed "supporting Wall Street" by trying to avert a recession? Yes, that's its job. Is the Fed trying to prop up the prices of stocks and long-term bonds directly by lowering the overnight inter-bank lending rate? Probably not: they'd be stupid to try, and if they are, they're completely failing. So: there is no illicit "bail out" of Wall Street by this channel.

Can we please stop saying such silly things?

[James Killus]

johnchx,

You're right. It's the stimulus package that's a direct attempt to prop up Wall Street.

[esb]

The history of this week contains a signature defining event.

Benjamin Zimbabwe Benranke (as he is now being unaffectionately named in Davos by the "money-runner" community) succumbed to his long-harbored fears of a sudden end of civilization as we know it and decided to prevent the collapse through the use of his favored tool, inflation.

And to what was BZB reacting? Well, to the actions of various futures on 21Jan2007 and 22Jan2007.

And how did the ECB react to same? Well, by saying, in effect, lets wait a day or two and see just WTF is going on here.

And what WAS going on there? Well, as every money runner and investment banker now knows, what was going on there was the unwinding of the fraud of a single SoGen con man on a very light trading day.

The ECB was spot on, and BZB has shown himself to be a horses ass with a PhD.

A horses ass with our futures in his incompetent hands.

The wrong man in the wrong job at the wrong time

Bush, Cheney, Rumsfeld, Powell, Rice, Gonzales and Bernanke ... the seven stooges

[billy]

http://www.slate.com/id/2182709/

Crashing the Subprime PartyHow the feds stopped the states from averting the lending mess.
By Nicholas Bagley
Posted Thursday, Jan. 24, 2008, at 11:19 PM ET

....That's when the feds came in. Some of the biggest players in the secondary mortgage market are national banks, and the states' efforts to curb predatory lending clashed with the banks' fervent desire to keep the market in subprime loans rolling. And so the national banks turned to the Treasury Department's Office of the Comptroller of the Currency. The OCC is a somewhat conflicted agency: While its primary regulatory responsibility is ensuring the safety and soundness of the national bank system, almost its entire budget comes from fees it imposes on the banks—meaning that its funding depends on keeping them happy. It was unsurprising, then, that the OCC leapt to attention when the national banks asked it to pre-empt the Georgia-like subprime laws on the grounds that they conflicted with federal banking law.

While the banks' legal arguments were thin, the OCC issued regulations in early 2004 nullifying the state laws as they applied to national banks. In part, the OCC reasoned that the states just got it wrong: As the then-comptroller explained in a speech to the Federalist Society, "We know that it's possible to deal effectively with predatory lending without putting impediments in the way of those who provide access to legitimate subprime credit." With the state laws nullified, national banks were free to engage in the sharp practices the states were hoping to stamp out. (Indeed, Georgia scuttled its law because it didn't want to give national banks a competitive advantage over its state institutions.) Facing intense pressure from subprime lenders and Wall Street, and left without a real chance of holding investors responsible for purchasing ill-advised loans, state legislatures gave up.

[ken melvin]

I'm reminded of Einstein's definition of insanity. Isn't this how we got into this mess? SF Chron's gleeing about a raise in mortgage cap that allows for the financing of two bedroom bungalows for up to $730K. Took care of that.

[paine]

johnchx
i think you have a point
palley here is too anxious
to show the fed as a bankers flunkey

and at that
he uses too graphic a basis

more vivid then the truth indeed

and
needless to say you are right
short policy rate changes
have little if any direct immediate effect
on long market rates
bond or mortgage
we saw that when greenscum raised rates
back in the middle of the house lot boom
and mortgage rates gyrated
and then went mostly sideways

but then what do the short policy rates
causally effect ???

are they a mere signal of intent ??

in this case
the credit creation spigot
will now on till further notice
flow with a forgiving grace

for that matter
how do short rate drops
enhance effective demand ??

you imply they do
so how ??

surely even if bank margins
are fattened by lowered cost of funds
that hardly spells recover
in the product markets

i agree
half at least of the following p line is
off base
"... economists focus on the effect of interest rates
on business investment and consumer spending"
since 'business investment'
hardly turns on policy rate moves
except by voooodooo

okay the in flow of receivables
from over inventory cash strapped outfits
might improve outlooks
for smaller bank loan dependent
firms but final household demand
must lift first before better cash positions
translate into bigger production orders

its easier to see the bail out
if its through freddie and fannie
buying up uncovered jumbo mortgages

but the bucket of p's piece
still holds its water

the fiasco could have been avoided
and can be in the future
with proper regs in place and enforced

but i ramble ....

[dd]

"This problem can only be solved by a system-wide regulator who monitors and limits total risk-taking. Yet, that is exactly what the Federal Reserve has rejected during the last twenty-five years of de-regulation."

Actually under GLBA the Fed is effectively the system-wide regulator with responsibility to insure the safety and soundness of the system. No expert but an initial reading indicates the FRB has sufficient power to limit risk taking as appropriate under Section 114 (12 USC 1828a (Prudential Safeguards.
Then too one is reminded that the Fed had sufficient authority to halt the subprime lending debacle under HOEPA and declined to do so.

[paine]

this is for certain a correct and even necessary reform

" a system-wide regulator
who monitors and limits total risk-taking."

by constant bank portfolio reviews and adjusted
balance sheet loss reserves
but bond insures loss reserves
and bond rating agency standards
needed too be constantly monitored too
and surely much much else

jobs for a couple divisions
of green eye shade guys

i suggest we give the hi fi reg outfits
a budget the same size as
the silly war on drugs crew gets

[paine]

dd missed your commment while typing mine
very true i'm sure

its about enforcement not empowerment

[dd]

So the dilemma of this uber-regulator is who might protect the public interest if not the FRB? When even the SEC rejoices at shareholders losses unrecoverable against IBs it regulates the game is pretty much over.
http://online.wsj.com/article/SB120122165664315337.html?mod=googlenews_wsj

[paine]

"Can we please stop saying such silly things?"

no because with a very liberal poetic license
the fed is bailing out wall street
with an expedition and completeness
no steel towns citizens
get when the local plant closes

[dd]

paine, there are laws and laws and more heaped upon them all in an effort to confound rather than regulate. It's an old trial lawyer's game: give them all the paper in heaps and stacks and bury the most important deep within.

[paine]

esb

"decided to prevent the collapse through the use of his favored tool, inflation"

don't you mean potential injection of monetary base
ie
two or three steps from asset inflation and even further from the commodity inflation
you hard dollar ducks oughta quack about

its really crying wolf here
when the dragon is headed our way from the opposite direction
when massive asset deflation
is the order of the day
a little monetary base injection is sanity

what makes you hard dollar nuts so glib
you're one trick firey hoop jump
gets more ill advised with the end of each trading day

[Fred]

johnchx: Read a little truth. Most people are not and should not be expected to be financial wizards capable of hedging themselves against Fed policy. This includes most business owners and managers, especially in smaller businesses. That means the only people who can fully hedge against and/or take advantage of monetary policy are the financial specialists on Wall Street. The average person makes their economic decisions based on the assumption of current interest rates remaining stable, whereas Wall Street looks ahead and anticipates not only what the Fed might do but also what the average person might do in response to the Fed and also what the other Wall Street players might do. If current interest rates are stable, then all this anticipation does no good and Wall Street profits dry up. But if interest rates are constantly being manipulated, then Wall Street is in a position to outsmart the average person and consequently a disproprionate amount of our national income goes towards idle Wall Street speculation. This is where we are now. Add to that moral hazards, both for the financial world as a whole (due to FDIC bailouts to speak nothing of the coming agency bailouts) as well as for individual players in the finance industry (due to foolish compensation schemes, which themselves are due to shareholder passivity, which in turn is due to the proliferation of small investors, encouraged by government policy such as IRAs and 401Ks), and we have the recipe for a massive transfer of wealth from the average person to Wall Street. And voila, that is exactly what has been happening for the past 20 years.

The underlying problem is overemphasis on monetary policy. The solution is to replace monetary policy for the most part with a much more flexible fiscal policy. For example, allow the Fed to move the payroll tax threshold up and down each 6 weeks, as needed to add or subtract aggregate demand from the system.

[paine]

"all in an effort to confound rather than regulate."

lovely line

[paine]

"For example, allow the Fed to move the payroll tax threshold up and down each 6 weeks, as needed to add or subtract aggregate demand from the system"

james meade
the brit wizard had that idea in 40 or 41
we could have no end of transparent
flow rate algorithmns based on automatic info streams
with of course manual over rides to add
the spice of human error now and again

[paine]

"The underlying problem is overemphasis on monetary policy"

and the why of that
is a tale for a thousand and one nights

[dd]

"The existing system of regulation by capital requirements helps discipline risk-taking, but it has proven inadequate."
Is this true? It is the current system that encourages risk taking as even illiquid assets can be exponentially leveraged. In the great olden days assets without a healthy public market were valued at zero on the theory that when liquidity collapses so do illiquid assets.

[paine]

the real stick is the standards for reserves against loses
which wacks the bottom line pronto
in the early 90's
many times as i went about looking for a line of credit
for my outfit
i was told by bankers
a loan to my outfit under present reg conditions
would create an immediate paper loss to the bank
because it would be reserved against enough to more then wipe out any profit the bank might make on the loan
even though they figured
my outfit was maybe good for the advance
i didn't get it

this was a drama played out
in a million mid sized corporate offices
across america back then

[paine]

well maybe not a million

[James]

As I recall, banks borrow short to lend long.

Shorter term rates with a positive yield curve increase the banks operating margins (providing they are getting paid their principal).

The Fed bailed out Wall Street, in that they did the 75 bp cut to stave off a stock market selloff and give the boys on Broad and Wall a reassurance.

The problem is that lower rates and looser money are not the problem, after all. The problem is chronic malinvestment, endemic fraud, and rotten accounting contributing to insolvency.

The problem is that the bankers will sustain the system by sacrificing everything else to do it, because they are afraid to ever let anything of their own fail.

[esb]

paine ...

Your position logicallly leads to the "tentative plan" being shopped around Davos this week by one of the "campaigns," the one which will most likely place its principal in the WH next January.

Apparently, the candidate has taken the tentative decision that a floor must and will be placed under residential prices in Q2 2009.

And the intermediating methodology used to accomplish this feat is proposed to be DIRECT lending to first-time buyers for owner-occupied units (with an as-yet-undetermined dollar limit) on terms that include unamortizing principal payable only on sale or on the death of the borrower, 1% (subject to final determination following additional studies) thirty-year fixed rates and direct subsidies to partially defray property taxes and possibly insurance costs.

This is as close to a "free house on every free lot" (at least for the first-time buyer) as can be imagined in any utopian daydream.

It certainly would prevent any final market clearing, as you always espouse.

It certainly would give you the inflation you crave.

And it certainly has been the ultimate nonstarter at Davos, even among the socialists, but then again, it seems to be only the Americans who embrace inflation as a sane tool.

Tanta ... should you care to address the effects of such a plan here it might be helpful in putting a pebble in front of this "save the world through mindless government action" steamroller.

[dd]

There's business and then a gambling enterprise and the latter has crowded out the former; but it was the former that need the loosening regs. Them gamblers (aka speculators) is wily and now the system is at their mercy and heck we know the speculators will double down (a chicken in every pot bet).
I guess BB doesn't have a chance as there is no Giuliani to lead the bad boys off in cuffs (aka discipline the system). So can the breach be repaired or have the boys sunk us? GS layoffs give pause.

[donna]

Well, to be fair to BB, we're not going to have a fiscal policy or any chance of actual regulation of the markets until next year at the earliest, so he's really on his own here.

[dd]

The question is whether he's on his own or with the pack and it's impossible to tell as there is no meaningful counterpoint; but then maybe that is the answer. If there was a seriousness about "discipline" it would have already occurred. Even with the Enron meltdown there was a swift reaction (albeit against the wrong parties); but now from all corners there is nothing but defense from the Supreme Court to Congress to the WH to the SEC WSJ op-ed. Have answered my own question and will say good night.

[paine]

esb you write like eliot janeway
i love it
like a mouth full of cotton candy

[paine]

"the candidate has taken the tentative decision that a floor must and will be placed under residential prices in Q2 2009."

a floor ???
and not a ceiling

obviously its "nominal " lot value
deflation the brutes want to prevent
seems prudent to let the high plateau slowly subside at the rate of inflation

and as to uncle becoming
the single lender for home mortgages
i'm all for that
so long as eventually
uncle uses
the chosen administered rates
on mortgages as a ground rent tax

as to teaser low rates
that never stop teasing
on first home buys only
that's liable to revolve keenly
and well

in the long run
all this is metaphor

[paine]

"It certainly would prevent any final market clearing, as you always espouse.

It certainly would give you the inflation you crave"

"final market clearing" ????
that notion is for fish at the pier
maybe a few other commodity types
but
definitely NOT
your house lot
no not lot value inflation
just an end to disinflation
at a point short of the tipping point
into down right deflation

[paine]

"And it certainly has been the ultimate nonstarter at Davos,"

surprise surprise

davos is icing without a cake

"even among the socialists...inflation as a sane tool"

never knew a suit and tie socialist
who wasn't a sound finance fool

[gordon]

In the light of the whole series of scandals from Savings & Loans to the present, if a bright, energetic and ambitious young man asked me for my advice as to what career to pursue, I would have no hesitation in advocating crime. Fraud would be best, particularly financial fraud on a big scale if possible, but perhaps it might be necessary to start by peddling valueless investments or signing off on corrupt audits. With energy and determination, young fellow, you too can aspire to dip into the multi-billion dollar bonus pool, insulated from ever drying up by our marks, the taxpayers.

[esb]

Sorry paine, but the icings are the Russian "trophy nieces."

I term which I (in a moment of inebriated brilliance [or recklessness] minted and tossed out in mixed company a few hours ago at "drinks." Got lots of laughs, though one Russian "gentleman" kept looking over at his "protector." Oops on me, perhaps.

There is nothing more amusing than saying something funny in a group which does not share a common language but where translators are in use. As the translations play on the ducks quack in a row.

Returning to seriousness let me say that last year what amazed me was the absolute hatred expressed toward the USA and anything connected with it by the Russians (at least the "inside ones.")

This year the common sentiment is absolute contempt for the monetary and fiscal incompetence of the leadership of the USA.

Bernanke is a universal joke in Europe.

And much of the late night humor surrounds his patent stupidity on Monday night and Tuesday morning. While ECB members were calling around for information, Benjamin Zimbabwe Bernanke was calling around and shouting, "its the end of the world and we have to save it," something I have heard repeatedly.

Like I said, the man is a horse's ass, and that is exactly how he is viewed, widely.

Of course, what matters here is how he is viewed by HRC, when compared with Bob Rubin.

I'll leave it to you to weigh and measure the two, but if you want a bet on the outcome, I'm your man.

[Blissex]

«While its primary regulatory responsibility is ensuring the safety and soundness of the national bank system, almost its entire budget comes from fees it imposes on the banks—meaning that its funding depends on keeping them happy.»

But the conflict has been intentionally created precisely because of that consequence.

Similarly the US patent office, that was created to reject the grant of monopolies to patents that were not worth it, now depends for its entire budget on patent applicant fees, with the obvious result that it has become a strong advocate of an ever greater expansion of the patent system.

Business interests have found that having congresspeople depend on them for their campaign budgets has been a very effective and profitable situation, and have sought to extend that principle to regulators, not just the politicians above them.

[zinc]

I think we may have it wrong. The Fed is trying to bail themselves out. A potentially much more dangerous scenario.

There is no doubt that greenspan was willingly on board to instigate a bubble to prop up the "trickle down" tax cuts. Atlas shrugged is all about the super abilities of the "arian capitalist" and greeny is a randian believer.

Bernanke was the bushkateer at the CEA and no doubt, as the heir apparent, up to his eyeballs in the creation of the bubble economy. I figure greeny let him drive the last few years. Especially with the leg breaker Cheney (former electrician from Glenrock, Wyo) smirking in the background.

Like rogue traders, Bushco and the Bushkateer Fed is desperate to cover their trades. Desperation pervades all of the new reality. Can we just get them to leave early and take Bernanke with them.

[ndd]

So like a remake of "Blazing Saddles" from hell, Wall Street points a gun to its head and threatens to shoot itself. And all the chicken littles hide under their blankies, knees-a-quivering, screaming that the sky is falling, peeing in their diapers, and begging the street to take one more hit of Other People's Money to make the monster go away.

Seriously, once again the Fed has set interest rates under the inflation rate, penalizing savers. Not the slightest whiff of new regulation, or making sure financial houses cannot get "too big to fail", or reforms to make sure that existing regulations must be enforced (ever heard of "Mandamus", anyone?).

Why can we not set up new Federally chartered investment banks, say one per Fed district, and let them re-establish a sound market (exactly as Buffett is doing with Muni bond insurance), and then let the existing Big Boyz non-FDIC insured investment banks and funds go under if that's what their real worth is?

I am a fairly middle of the road investor, but the coddling of Wall Street has simply gone beyond the pale. And if that's how I feel, imagine how the bus drivers and clerks and service workers on Main Street feel. Do you not think the seeds of a whirlwind are being sown?

So, all I want to know is, How do I get my hands on the trigger? SHOOT, DAMMIT, SHOOT!

[Bob]

It would be nice if the wall streeters had the kind of "character" that poor people have and were able to survive on their own without welfare.

[Blissex]

«Seriously, once again the Fed has set interest rates under the inflation rate, penalizing savers.»

Because there are many savers left in the USA :-). How many voters are net savers? How many campaign donors are debtors and asset owners?

The party of inflation in the USA is now over 70% of voters and essentially all campaign donors. What do you think, that congresspeople would rather make the vast majority of their voters poorer and not be re-elected?

[getting older]

We have met the enemy and he is us.

You are missing the real roots of the problem. Wall Street does what it does and only a fool would expect different. But you need to ask why are they in a position to do this? So let's go back to a planet far, far away, and a long time ago. A planet where truck drivers lived in simple houses and doctors and lawyers lived in somewhat nicer, but still fairly modest houses. Everyone got a 30 year mortgage from their local banker and lived in the house until the mortgage was paid off. House prices rose in line with inflation and wages. Wall Street bankers dealt with large corporations and didn't care to waste their time with home mortgages.

Then, because of the baby boomers leaving home, household size decreasing and immigration, demand for houses, especially in "desirable areas", like San Francisco, LA, NYC goes up. Now, if demand for cars or TV sets or computers goes up, some smart businessmen build factories to make more and, voila, prices rapidly equilibrate. Even very low interest rates don't affect prices much. You know how car companies offer 0 % interest when sales are slow? yet that doesn't drive prices up? Why not? Because there are all those factories making plenty of cars.

Now let's get to the bad guys-you and me. So now there is a growing demand for housing. So now the smart businessmen come along to build affordable housing to satsfy all that demand, and everyone lives happily everafter, right? Uh-oh, sorry! Guess what? Mr and Mrs existing homeowner don't want all those new houses and all those new people (some of whom may have excess skin pigmentation) in their neighbourhood. That might keep property values from rising. And my kid might have to sit next to someone strange in school. No let's restrict development.

So, unlike every other market, where rising demand is met with rising production, in housing, rising demand is met with zoning laws. And the inevitable result is, of course, rising prices. The truck driver from our happy planet sells his modest house (perhaps with some aditions over the years) at a huge profit to a young doctor or lawyer. The doctor or lawyer sells his house at a huge profit to an investment banker. Now, all of a sudden, no one can afford those nice 30 year fixed-rate mortgages. So they have to have teaser ARMs, neg am, no doc, Alt-A time bombs just to get a foot in the door. And, since local banker are unwilling or unable to provide those time bombs, into the breach steps Wall Street.

But, ladies and gents, I submit to you that the root of it all is home prices rising well beyond inflation and wages. And the root of that is you and me.

[getting older]

We have met the enemy and he is us.

You are missing the real roots of the problem. Wall Street does what it does and only a fool would expect different. But you need to ask why are they in a position to do this? So let's go back to a planet far, far away, and a long time ago. A planet where truck drivers lived in simple houses and doctors and lawyers lived in somewhat nicer, but still fairly modest houses. Everyone got a 30 year mortgage from their local banker and lived in the house until the mortgage was paid off. House prices rose in line with inflation and wages. Wall Street bankers dealt with large corporations and didn't care to waste their time with home mortgages.

Then, because of the baby boomers leaving home, household size decreasing and immigration, demand for houses, especially in "desirable areas", like San Francisco, LA, NYC goes up. Now, if demand for cars or TV sets or computers goes up, some smart businessmen build factories to make more and, voila, prices rapidly equilibrate. Even very low interest rates don't affect prices much. You know how car companies offer 0 % interest when sales are slow? yet that doesn't drive prices up? Why not? Because there are all those factories making plenty of cars.

Now let's get to the bad guys-you and me. So now there is a growing demand for housing. So now the smart businessmen come along to build affordable housing to satsfy all that demand, and everyone lives happily everafter, right? Uh-oh, sorry! Guess what? Mr and Mrs existing homeowner don't want all those new houses and all those new people (some of whom may have excess skin pigmentation) in their neighbourhood. That might keep property values from rising. And my kid might have to sit next to someone strange in school. No let's restrict development.

So, unlike every other market, where rising demand is met with rising production, in housing, rising demand is met with zoning laws. And the inevitable result is, of course, rising prices. The truck driver from our happy planet sells his modest house (perhaps with some aditions over the years) at a huge profit to a young doctor or lawyer. The doctor or lawyer sells his house at a huge profit to an investment banker. Now, all of a sudden, no one can afford those nice 30 year fixed-rate mortgages. So they have to have teaser ARMs, neg am, no doc, Alt-A time bombs just to get a foot in the door. And, since local banker are unwilling or unable to provide those time bombs, into the breach steps Wall Street.

But, ladies and gents, I submit to you that the root of it all is home prices rising well beyond inflation and wages. And the root of that is you and me.

[ken melvin]

"Time must have a stop", Aldous said. But now, living off inflated assets could go on forever? Has no role in wealth distribution either, I suppose.

[skeptonomist]

Several commenters have pointed out that we already have a "system-wide regulator" who has power to quell excesses of financial manipulation, and it was Greenspan and is now Bernanke. The semi-autonomy of the Fed was supposed to minimize political influence, but if the Fed personnel are extremists like Greenspan there is plenty of ideological influence. The influence of the Chairman is magnified by leader-worship (formerly known as the Fuehrer-Prinzip, also as the cult of personality) in which any good thing which happens is attributed to the Hero or Maestro.

Ideally, Congress would supply a framework to keep things under control. They actually did many constructive things of this sort in the New Deal, but this has been partially eroded by deregulation. But certainly nothing will happen until there are fewer than 40 Republican Senators and the President is not Republican.

The appointment of the Fed chairman is probably more important under the present system than that of Supreme Court Justices, and it should not be rubber-stamped by Congress - screening for ideological bias is essential. Bernanke has been careful to avoid any appearance of political bias, as in R vs. D, but some of his comments have indicated that he buys into the essentially conservative idea that the Fed is capable of handling any and all economic problems.

[dirtyal]

The Fed is only "independent" when it's leaning against a Democratic president. When the Republicans are in power, they are "fellow travelers".

Bernanke had taken it to a whole new level, however.

Last week, everyone was talking about the Fed being a "one trick pony" with the one trick being to worry about inflation. It's funny what a week brings in this fast moving world we live in.

Everyone who predicts serious problems with inflation is right on! (IMHO)

[bullbust]

FANNIE MAE- from "we help FAMILIES," to "we help WALL STREET"

http://www.cnbc.com/id/22841437/site/14081545?__source=yahoo%7Cheadline%7Cquote%7Ctext%7C&par=yahoo

Take a look at Fannie Mae’s “About Fannie Mae” web page circa 2005: About Fannie Mae.
Now take a look at the same page today: About Fannie Mae.

The focus has clearly shifted from families:

In 2005: “Our public mission, and our defining goal, is to help more families achieve the American Dream of homeownership. We do that by providing financial products and services that make it possible for low-, moderate-, and middle-income families to buy homes of their own.”

to lenders:

In 2008: “We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market. Fannie Mae has a federal charter and operates in America’s secondary mortgage market to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates. Our job is to help those who house America.”

[bullbust]

Home > Economic Data - FRED® > Releases > Release: H.3 Aggregate Reserves of Depository Institutions and the Monetary Base > Series: BORROW, Total Borrowings of Depository Institutions from the Federal Reserve

Series: BORROW, Total Borrowings of Depository Institutions from the Federal Reserve

Have a stiff drink before you look at this graph.

http://research.stlouisfed.org/fred2/series/BORROW?rid=19

The Fed bailing out the bankers.

[Bernard Yomtov]

Paine,

While I am interested in your comments, I find them nearly unreadable because of the poetry-style format. Is this intentional, or just a function of my browser or yours?

If intentional, I wonder if you might use a more conventional format. It would help my understanding of your points greatly. Thanks.

[RW]

A lot of 'best guesses' as to Fed motive in this piece and subsequent comments so no harm in adding another:

Linking the Fed rate cut to the movement of equity futures is probably a post hoc error; i.e., Bernanke knows what the Fed's mandate really is, in fact he wrote the book, he is still trying to find a way out of the mess that Greenspan made which in turn was an attempt to compensate of the refusal of the ruling Republican party to do the right thing on the fiscal front.

Ah, these ripples in the water, how soon they become billows on the sea.

In the article Palley writes: "The problem is acutely visible among bond insurers, where rising default rates have reduced asset values while simultaneously increasing potential payouts on insured securities."

My 'best guess' is the stock market decline was irrelevant, a coincidence. There are several large monoline insurers, representing trillions (that is not a typo) of $USD in counterparty risk, that have probably become insolvent. If true this would seriously damage prices of high quality bonds held in the hundreds of thousands of portfolios, including those of some of the biggest money-centers on the planet, many of whom are not in a position to suffer further losses.

That wasn't too hyperbolic was it? Oh well, FWIW.

[barry payne - economist]

paine, while I'm interested in your comments, they require slow careful reading just to chew each word up enough to swallow, much less digest, even upon reading several times ...

... is this a veiled form of resistance to capitalism or are you just using shortcut internet lingo to outdo calmo?

[dd]

paine's poetic style demands more than mere thought as it plays with the mind. don't change paine.

[johnchx]

paine asks: but then what do the short policy rates causally effect ???

Good question. I think the most honest answer is, "Nobody knows with certainty and it isn't necessarily the same thing at all times." And there's a (more or less) legitimate school of thought that claims that monetary policy doesn't really do anything. I'll try to lay out how I see it, but the backdrop should be an understanding that is still a question that macroeconomists argue about amongst themselves.

My perspective is that it's probably confusing to say that monetary policy "stimulates" demand. This gives the impression that its goal is to increase it from whatever level it may have at the time. And possibly, during the sixties, say, when some economists believed that monetary policy could simply choose any arbitrary level of economic activity, this was a reasonable way to talk about what monetary policy does. But these days, almost nobody thinks that. These days, the prevailing opinion is that there's a "natural" level of economic activity, given by the "fundamentals" (tastes, technology, and the available endowments of labor and capital), but that peculiarities of the banking system can push an economy out-of-alignment with the fundamentals, leading to recessions or episodes of inflation. The goal of monetary policy is to keep the vicissitudes of the banking sector from causing either of these misfortunes.

In "recession-fighting" mode, the Fed is basically trying to prevent a collapse of demand caused by a sudden constriction of the broad money supply (M2).

What's M2 and why might it fall? Let's start with the monetary base -- all the cash plus bank reserves on deposit with the Fed. Since both of these are included in M2, M2 can never be smaller than the monetary base, and the monetary base is what's directly controlled by the Fed. As of December, the monetary base was about $836 billion (of which $793 billion was cash).

M2 in December was $7.5 trillion, or about nine times the monetary base. What's the difference? Simply put: bank accounts, primarily balances in savings and checking accounts. Where do these balances come from? Ultimately, they come from bank lending. Unlike every other form of lending and borrowing, bank loans create deposits. The more banks lend, the more money (in the M2 sense) there is. (This is a fact that drives the gold bugs absolutely insane with rage.)

So: if banks scale back their loan portfolios, there is simply less money in the world. But households and businesses, it is believed, have "targets" for their money holdings and will change their behavior to try to meet those targets. In particular, if their balances fall below a certain comfort zone, they'll cut back on spending. But, unless bank lending increases again, households and businesses cannot possibly all get their balances back to the levels they were at before -- there simply isn't enough money. And the actions they're taking -- cutting back on expenditures -- are exactly the ones that may induce banks to curtail lending further, making the problem worse, not better.

So Fed's job is to help ensure that the total volume of bank lending doesn't suddenly fall. Why might bank lending suddenly fall?

There are a few reasons that the Fed can't do anything about. First, losses on existing loans could put banks in the position of being capital-constrained, i.e. they have to curtail lending because losses have left them short of their regulatory capital requirements. Second, economic conditions (or information about economic conditions) could change in such a way that making additional loans simply isn't profitable (or, to put the same thing differently, things change such that borrowers are unwilling to pay the prevailing interest rates).

But there's a third kind of problem the Fed can address: bank's inability to lend because they are liquidity-constrained (or fear that they might become liquidity-constrained in the near future). Banks need liquidity for one thing, and one thing only: to cover net withdrawals. Now, one thing that might cause a bank to experience net withdrawals comes immediately to mind: a bank run. But the real defenses against bank runs are FDIC insurance and the availability (not necessarily the use) of the discount window as a lender-of-last-resort. Less visible, but -- I think -- of more current concern is the fact that a bank can expect to experience net withdrawals if other banks slow the pace of their lending.

To see how this might work, think about a world with just three banks, and in which customers are spread evenly among them (i.e. every bank has one-third of the customers). When bank A originates a loan (of, say $300), it expects the customer to spend the money with no regard to which bank(s) the payees happen to use. So, on average, a $300 loan will wind up as $100 in deposits in each of the three banks -- meaning a gross outflow of $200 in reserves from bank A. But if banks B and C are lending at the same pace, it can expect customers of banks B and C to make payments to its customers which will offset the $200 outflow, so total withdrawals will net to zero. But if other banks slow their lending, inflows won't fully offset the outflows, and bank A will see its reserves decline. If the trend isn't reversed somehow, bank A will eventually collapse.

So, as a precaution, if banks expect trouble ahead, even if its own loans are healthy, a bank may want to increase its reserves. To accomplish this, a bank must engineer net deposits, which means that it must slow its lending by more than its peer banks slow theirs. Obviously, all the banks can't do this at once; if they try, they'll only choke off lending activity, collapse M2, and force a deep depression.

At this point, we should be in familiar territory: the Fed can create reserves out of thin air. By doing so, it allows banks to increase their "precautionary" reserve balances to whatever level is necessary to assuage their fears, and prevent them from entering a vicious circle of competitive loan curtailment.

The bottom line is that monetary policy isn't a magic wand for doing anything anybody wants to the economy. Instead, it's a tool for managing the dangerous and intrinsic instability of the banking system. And it doesn't so much "stimulate" demand as prevent a bank-driven demand collapse.

[johnchx]

bullbust writes: Have a stiff drink before you look at this graph.

http://research.stlouisfed.org/fred2/series/BORROW?rid=19
The situation isn't quite as out-of-whack as the graph makes it look. The December figure includes the TAF (which is comparable in scale and effect to an open market operation) as if it were a whopping discount window loan.

The December figure comparable to the previous months in the series is $3.8 billion, a high number in historical perspective to be sure, but not quite the $15 billion spike that the graph shows.

The latest figure for discount window borrowing is down to about $1.4 billion.

[johnchx]

James Killus writes:You're right. It's the stimulus package that's a direct attempt to prop up Wall Street.

*chuckle!*

Actually, I think Stan Collender has the best explanation of the stimulus package:But here's the key: the bill being considered is intended to stimulate voting behavior at least as much as the economy. Political considerations rather than economic theory is the primary motivation.

[michael mccoy]

The new motto of Wall Street: Privatize profits, socialize losses.

[Tony]

Just give these execs food stamps and public housing like everybody else on welfare gets... this is unfair.