Delong: From Central Bank to Central Planning?

Brad Delong argues that "we still have not had enough central planning in finance." More particularly, he argues that the "Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price":

From central bank to central planning?, J. Bradford DeLong, Project Syndicate: For more than 170 years, it has been accepted doctrine that markets are not to be trusted when there is a liquidity squeeze. When the prices of even safe assets fall and interest rates climb to sky-high levels because traders and financiers collectively want more liquid assets than currently exist, it is simply not safe to let the market sort things out.

At such a time, central banks must step in and set the price of liquidity at a reasonable level – make it a centrally-planned and administered price – rather than let it swing free in response to private-sector supply and demand. This is the doctrine of "lender-of-last-resort."

For more than half that time – say, 85 years – it has been accepted doctrine that markets are also not to be trusted even in normal times, lest doing so lead to a liquidity squeeze or to an inflationary bubble. So, central banks must set the price of liquidity in the market day in and day out. ...

[A]s social democracy, government guideposts, and centralized planning waxed and waned elsewhere in the economy, social democracy in short-term finance went from strength to strength. First, central banks suspended the rules of the free market in liquidity squeezes. Then they set the price of liquidity as an administered price in normal times. Then they freed themselves of all but the lightest contact with their political masters: they became independent technocrats, a monetary priesthood that spoke in Delphic terms obscure to mere mortals.

The justification for this system was that it seemed to work well – or at least less badly than central banking that blindly adhered to the gold standard or no central banking at all. ...

But now it appears that, despite all this, we still have not had enough central planning in finance. For, even as the central banking authority administered the price of liquidity, the price of risk was left to the tender mercies of the market. And it is the price of risk that is the source of our current distress. ...

[T]he risk premia on non-Treasury assets have soared... And it is this rise in risk premia that threatens to send the global economy into a deep recession, and turn the financial markets from a spectacle of schadenfreude into a malign source of unemployment and idle factories worldwide. ...

The Treasury has asked for authority to purchase $700 billion of mortgages to get them off of the private sector’s books. Expanding the demand and reducing the supply of these risky assets is a way of manipulating their price. The Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price.

This was how central banking got started in the first place: letting the market and the market alone determine the price of liquidity was judged too costly for the businessmen who voted and the workers who could overthrow governments. Now it looks as though letting the market alone determine the price of risk is similarly being judged too costly for today’s voters and campaign contributors to bear.

Comments

[Ranjit Mathoda]

Warren Buffett has an interesting take on the risk of buying mortgage securities at fire sale prices, and giving the Treasury Secretary the resources and flexibility to do so: http://mathoda.com/archives/433

[hari]

BDL is right we're realigning how risk is defined in the market. But the q' is whether markets by themselves can self regulate, as Greenspan argued, better than Gov.

Now we're coming full circle, ain't it?

IMHO this is not a theoretical problem but one of deligent regulatory control/audit of the (global) banking sector, in particular. As long as there are, out there, people who think, yes (!) there is something called *free lunch* out there, you'll have constraints of controlling greed and fraud in an open market system.

So, first, make sure there is stringent management of statutory regime of regulatory mechanism by professionals (not prty hacks).

The global banking sector must be put under the microscope, especially in emerging Asian financial hubs, to ensure a even playing field.

IMF has not been forthcoming principally because it's controlled/led by US Treasury historically. US Gov wants least intervention in the free market system. Now, perhaps not only an era of free market comes to an end, but will be urgently readdressed with appropriate global policy framework to avoid unforeseen bums in international finance.

That's a big hope...but I suspect bankers will be first in the cue to reorder their internal risk control management.

Brad is wrong to call it central planning or socialism. It's an imperative policy demand in a globalized world in which credit markets have left the shores of Atlantic alliance. And cultures and habits are different and value of money is defined (also) in various ways.

[Ben Ross]

I'll take the thought a little farther. The New Deal, with banking regulation and Glass-Steagall, fenced off the low-risk end of the market for risk and made the price of risk there an administered price. The fence has to go back up, otherwise resources used to save/repair the low-risk capital market will leak into the high-risk end of the market - and eventually finance another bubble of some kind.

[Mark]

I wonder whether the current situation in finance offers broader lessons about regulation and risk management more generally--particularly the wisdom of decisionmaking based on complex economic optimization models in the absence of verifiable inputs (e.g., value of things not traded in markets) or observable outcomes (e.g., future damages avoided). Perhaps the conventional wisdom about the virtues of "performance" or "risk-based" regulation vs. simple "command and control" decision rules (e.g., minimum capital reserves/maximum leverage ratios, rigid barriers a la Glass-Steagall) deserves a fresh look.

[Cent21]

But with Pearl Harbor, it was an attack by on soviergn on another.

Here, the chance of manipulation by private interests that took risks on the scale of hundreds of $billions by just a few people is huge, and opaque.

I just can't believe that progressives are fiddling at the edges of the proposal to bail out the owners of the large-scale tainted assets, but leaving the problem of millions of individuals who on a small scale invested in the American dream in foreclosure because they took the advice of our central bank to go with adjustable rate mortgages and believed in our private institution's ability to assess risk.

Look at the Glenn Hubbard op-ed in WSJ today: http://online.wsj.com/article/SB122291076983796813.html . The thing that has to stabilize before the leveraged obligations stop blowing past equity is for the housing market to stabilize.

Any bailout really ought to focus on two things - individual homeowners who occupied the dwellings and face foreclosure, and preferred equity in institutions that need to recapitalize.

I don't think the govt can accurately price risk. As well, the idea that we can get accurate private sector pricing by having 1/10th of the assets priced on the private market with 9 to 1 leverage from the public, there's another chance for massive manipulation. Govt should restrict stupid overleveraged gambling, a priori. Not bail it out ex post facto.

I vacillate on whether the sinking bomb negotiated in Washington ought to be enacted - think it is probably necessary if only to maintain the US's position as leader of the free world and cut off a chance for a 1930's style global malaise with the USA clearly identified as the bad guys to the rest of the world. But I'd hope the govt doesn't get into the position of backstopping gambling, rather than simply limiting gambling and assuring that those that do gamble can't inflict collateral damage.

[Random Musings]

Subsidizing interest rates at levels below where the market would establish equilibrium is popular with borrowers, but it comes at a great cost to non borrowers. Systemic risk increases as rates are set lower partly in response to popular pressure. If you centrally plan rates, central planning must also take countervailing action to keep systemic risk from getting out of control. Coupling subsidized low rates with high leverage can destroy an economy.

Of course, central planning of rates is not always a good idea, and not always better than even a gold standard. It depends upon the ability of the planning committee to act wisely, and not in response to pressure from borrowers for ever lower rates. Excessively low rates unbalances domestic supply/demand for credit.

[paine]

more from the delongeurs straight talk express:

"social democracy in short-term finance went from strength to strength "

the term is social market
the fed like the vatican
is profoundly not
a democratic institution
at least if we mean by democratic institution
not some gassy notion of ultimately accountable to
the people as sovereign

but a directly accountable institution
to a people's majority preference

fine minds like our host mark's and the present pope's
are glad their beloved institution
answers instead to a higher power
the holy spirit on the one hand and perhaps ...bagehot on the other

now brad is not always
a bull horning big thnk cut to the chase
fatuity

i like this quite a bit

"the price of risk ... is the source of our current distress. ..."

and his implied prescription

to me it oghta be uncle dollar mine
as single ultimo re-insure-er

uncle regulation of front line risk taking
follows accordingly

brad has his own way .....sometimes
of tunneling
thru to rich seams

buthe'll then talk it only

walk the walk ????

no mandarin dares openly
to defy their emperor
in a land of plurality rule
of course u need to find each mandarin's
emperor de jour

brad's pro temp
well sherman.... barrack's socialism ???

[Patrick]

It's always risky to crticize ones betters, nevertheless ...

Dysfunctional pricing of risk is a symptom, not the disease, and the existing machinery could have prevented the current mess.

It could have been avoided completely had the Bush administration/Republican Congress implemented economic policy that actually made sense - like using fiscal policy to soften the landing after the dot com bust rather than brain dead monetary policy.

Even barring that, had the SEC done it's job and put the brakes on financial engineering until it was better understood, we'd still have a problem but the system wouldn't be in danger of imploding completely.

[hari]

Do we know and/or understand how BofC sets its policy priorities with mountains of dollar cash to dispose?

It's high time BDL and MT start learning the decision-making system based on Poltiburo doctrine of social democracy and income equality....

[Hal]

If the housing bubble had been pricked in good time we would not be in the mess we are in today. The problem was Greenspan who thought asset bubbles should be allowed to bubble. The dotcom bubble and biotech bubble (both came together) were bad but not catastrophic since they didn't involve virtually the whole population. The housing bubble did and hence the mess. There is nothing wrong with "wise men" (as long as they are in fact wise and Greenspan was not) deflating a bubble when they see one, especially one as fundamental as a housing bubble.

[Bruce Wilder]

Other commenters are correct, of course, to highlight what Brad DeLong misses, when he says "social democracy in short-term finance went from strength to strength", which is the erosive and entropic pressures.

The Left can adopt a simple-minded determination to lower interest rates at all times, in their corrosive determination to maximize employment and their greed for higher wages. (Oh, the horror! Don't they know capitalism thrives on lower wages and lower taxes, free to despoil nature without limit? Drill now, drill everywhere! Slap those bankers with a capital gains tax holiday! That's the ticket.)

The Right will pursue its fetish for free markets, right into re-building consumer finance as a Casino, where private wealth capitalizes the House, and the odds are . . . well, favorable to the House.

Any emergent administrative system must not only be able to earn its keep by doing its job well enough to net gain against its own costs, but it must, in subsequent stages of its evolution, develop the ability to overcome its own entropic decay with renewal, and to fight off the parasites and predators, which emerge in the new ecology it creates.

The animal body has its immune system, and aging and the flu, and reproduction with variation. Windows OS has its virii and spyware, and antivirus software, and evolves through new releases.

Greenspan, the Great Moderation and deregulation (aka dismantling the New Deal reforms combined with the incentives from the Hollywoodization of executive compensation) created a warm, moist environment favorable to the runaway growth of the parasitical fungi, we know as the Shadow Banking System.

Through the whole post-war period, central banking doctrine has studiously ignored the central importance of the yield curve, and resisted the idea that the central bank manages, not short-term interest rates per se, but the slope of the yield curve. The yield curve has been reduced, at times to a curiousity, a "leading indicator" instead of a mechanism, which, a couple years ago, many seem to think, would not be nearly as predictive this time, as in the past, because of "financial innovation".

The U.S. has run a dangerous experiment twice, first with the S&Ls and now with the banks. It would be so lovely if we learned something other than how to do the same thing a third time, . . . only bigger.

[R]

Real Economy Needed:

Bring it back. Bring back U.S. Manufacturing. The subject tossed around the other day was that we need not make T-shirts, but should take advantage of the so-called savings glut, so that we can offer financial 'innovations' and intermediated 'risk' to the rest of the world.

The lowly T-shirt. What if we made a T-shirt? We need a farmer to grow the cotton. He needs a tractor (preferably a John Deere) and fertilizer to grow the crop. The fertilizer will have to be delivered by truck and the same trucking industry will have to pick up the crop. Someone has to make that fertilizer and produce those vehicles and the tractor. The cotton will have to go to a mill to be processed. Somebody has to work there. The clothing manufacturer will buy the finished cotton material and have workers sew the t-shirts. Another truck will have to deliver the product to a wholesaler and finally a retailer.

Look up the statistics on how big of a textile industry we used to have.

I researched a paper back in 2005. Here are some facts from the U.S. Dept of Commerce, International Trade Commission, Office of Textiles and Apparel. Titled "U.S. Imports, Production, Markets, Import Production Ratios and Domestic Market Shares for Textile and Apparl Product Categories".

Let's look at some boring figures, but think about this, they are not boring, when you consider the jobs that were behind all thes numbers.

All these figures are in 1000 Dozens. By 1994, it was starting be bleak already.

Category 341/641 Cotton and MMF W&G Shirts and Blouses, not knit)

1994 U.S. Production 19,423 1000 dozen or 233 million shirts and blouses

1994 Import 25,232 1000 dozen or 303 million shirts and blouses.

Ten Years Later....

2004 U.S. Production 7,284 1000 dozen or 87.4 million shirts and blouses

2004 Import 37,236 1000 dozen or 446.8 million shirts and blouses.

You can see the huge increase in demand, but also note that U.S. Production decreased 62%, while Imports jumped 47%.

That was a whole lot of American Workers shuffled off of manufacturing jobs to the new 'Service Economy'.

[macburger]

Look at the Glenn Hubbard op-ed in WSJ today: http://online.wsj.com/article/SB122291076983796813.html . The thing that has to stabilize before the leveraged obligations stop blowing past equity is for the housing market to stabilize.

Holy cow. Are you citing that piece of crap?

Here is what Calculated Risk (who I'll take over the WSJ oped page anyday, no questions asked)

http://calculatedrisk.blogspot.com/2008/10/housing-bad-policy-proposal.html

But this piece in the WSJ by R. Glenn Hubbard and Chris Mayer demands attention: First, Let's Stabilize Home Prices .

Chris Mayer recently published a study showing that -- assuming normally functioning mortgage markets -- the cost of buying a house is now 10% to 15% below the cost of renting across most of the country.

Well, it is true that Dr. Mayer recently published a study, but I believe the conclusions were incorrect. Please note that Dr. Mayer in 2005 (with Charles Himmelberg and Todd Sinai) used a similar approach and concluded there was "little evidence of housing bubbles in almost any of the markets we have studied". I disagreed with Dr. Mayer in 2005 (many people sent me his paper), and I felt that there was no question there was a bubble. I disagree with Dr. Mayer today....

First, house prices are falling because prices are too high when compared with fundamentals like incomes and rents.

Second - and this is important to understand - the value of the securities is based on projections of future house prices, not on current house prices. If we knew the trajectory of future house prices (and the relationship to defaults), we could accurately price the various mortgage backed securties (MBS).

They were hacks in 2005, pushing the no-bubble kool-aid.

They are hacks now, pushing the housing-is-undervalued kool-aid.

[Anonymous]

I think people like DeLong and Krugman are romanticizing the problem when they talk about risk premia and confidence. The problem is much more mechanical than that. Having allowed money market funds and the commercial paper market to grow, we have been operating with a poorly designed money market infrastructure that a ten year old could have figured out would crash, if you'd just let him think about the possibility of the commercial paper market becoming illiquid.

It is blatently obvious that you can't have the banks acting as commercial paper backstops when the commercial paper market is illiquid, because there is no mechanism to direct the funds to the banks that are asked to play this role. I think this should be viewed and addressed as mechanical infrastructure problem, not as a crisis of confidence.

[Doug]

R - manufacturing is not a necessary big sector of an "information age" economy. Services and IT!

[Murph]

Mark -

Would government-administered ratings agencies (rather than the semi-government-approved -but- customer-sponsored as we have now, with S&P, Moody's, Fitch) be an effective risk-pricing solution ?

A public ratings-agency's budget could be funded by some sort of stamp tax on any public debt or equity issuance.

It seems that the weak link in the chain which allowed poor lending and irresponsible borrowing to turn into a global catastrophe was the Seal-of-Approval given by the Ratings Agencies to the packaged bundles (and packaged bundles of packaged bundles!) of these loans.

Since the Government is always going to be re-insurer of last resort for all risk, it would seem to make sense for the Government to at least have the determining say in how risk is rated at the outset...

Perhaps this would reduce the frequency, cost, and moral hazard of future bailouts (which seem to be inevitable in the context of democratic capitalism) ?