Should Deregulation be Blamed?

Sebastion Mallaby says deregulation is not the cause of the financial crisis. Jamie Galbraith would disagree (more direct disagreement here and here):

Goodbye, Conservatives. Hello, Predators, by James K. Galbraith: Back in the Reagan days, Republicans talked economics. We had problems; they had solutions. Tight money would cure inflation. Low taxes would stimulate saving and hard work. Small government would "crowd in" investment; free trade would make us efficient. Smart people believed this, and they had Milton Friedman to back them up. I never thought they were right-but they were serious. They were coherent. And they argued with passion and conviction, which commanded respect.

But now, real economic conservatives have disappeared from the Republican stage. ... Bush is a bread-and-circuses reactionary with a clientele of lobbies. McCain gets his economic ideas from Phil Gramm, the ultimate architect of the Enron culture, of libertine speculation and financial disaster. ... This crowd deregulates and privatizes not because they think it might work out for the public... What they care about is putting their friends in charge.

Under Bush, oil and gas, drug companies and defense contractors, insurers and usurers, banks and big media control the government of the United States. John McCain..., as chair of the Senate commerce committee,... presided over Lobby Central; notoriously, his campaign is run by lobbyists ... and until last week his policy could be summed up in slogans: he was a "free market" man, a "deregulator." ... Bush and McCain are the predator state writ large...

On the morning that Lehman Bros. and Merrill Lynch fell,... the ... Dow Jones average fell 504 points... As stocks crashed, suddenly people remembered that modern markets cannot exist without a cop on the beat. Every important market out there, from fresh food and safe drugs to autos and air travel to housing and health care, depends on government to maintain trust, and without it, none of them would survive. Without regulation, predators take over, and when they do, trust eventually collapses. Every important market is in peril now, precisely because of the predators in power these past eight years. And none more immediately than finance.

The Bush-Paulson bailout exposed the predator state in detail. Deregulation and desupervision were the origin of this crisis: the 1999 Gramm-Leach-Bliley Act repealing Glass-Steagall, and the Gramm-authored loophole legitimating credit default swaps in 2000. Bush's financial regulators brought chainsaws to press conferences, a clear signal to sub-prime hustlers that "anything goes." "Liar's loans," "neutron loans" and "toxic waste" became financial terms of art. ...

It seems unlikely that John McCain, the regulation-wrecker, will become, overnight, the man who would turn vice to virtue on Wall Street. But even suppose he were serious. Who would trust him? No one with money on the line.

This is McCain's deeper problem. If he is elected, under his leadership, trust cannot be restored. ... Restoring trust requires a government of trustworthy people. Team McCain doesn't have any, and some, especially Gramm, inspire the opposite. It wouldn't matter what their policies were or pretended to be. Nothing they attempted would work.

The ... choice in this election is well-defined. One party believes that the government serves no public purpose. The other believes that it must. One party has turned the government over to lobbies, to cronies and to big donors. The other is beginning to realize that a real government must be rebuilt. One party would keep the same crowd in office; the other would have to begin by clearing them out. No one can say there is no difference between the parties this year, and the basic issue in this election is really just as simple as that.

I thought the best part of Sebastian Mallaby's article came when he provided this link: "There's a vigorous argument about whether Calomiris's number is too high." As to his main argument, "that deregulation is the wrong scapegoat," I don't think it was deregulation of any particular sector that caused the problems we are having in credit markets, I think it was lack of effective regulation of the shadow banking sector in general (i.e. the regulations that did exist in the shadow banking sector were not directed at the right issues, thus, it's possible to believe, as I do, that some of the deregulation was warranted while still believing that needed regulation was missing). The shadow banking sector should be under the same regulatory umbrella that traditional banks are subject to, and extended the same sorts or privileges within the Federal Reserve system in return (deposit insurance of some type, and lender of last resort functions in return for regulatory restrictions). There is no guarantee this would have stopped the credit crisis from developing, but I don't think the conclusion we should draw from the present experience is that these markets weren't free enough. Hopefully, we can use what we've learned as the crisis has unfolded and also use what we've learned from regulating the traditional banking sector to devise a regulatory structure that will improve the stability of credit markets.

Comments

[hari]

What Galbraith advocates and analyses is to the point about GOP and McBush deregulatory regime...1999 events under Gramm, in particular, may be directly responsible for the evolution of the credit crunch and subprime massacre.

Of course, academic economists are unwilling to understand the role of oversight regulations in a globalized money market. They are still in despair to admit their libertarian lobby for free market capitalism - during the period in q'.

What they dont acknowledge and recognize (still) is globalized revolt against American laissez faire capitalism and its deregulated influence in world markets - principally thru unregulated investment banks and hedge funds and their leveraging of global financial markets with CDS and rest of the garbage.

I know for a fact now that irrespective of academic reluctance to accept the role of regulatory control/audit of fianncial markets, EU will impose its own regime on US transnationals and demand licensing of rating agencies and official oversight of markets.

Recall Rogoff's and other's demand for contraction of financial institutions market...to focus on those institutions which can be regulated under Fed supervision.
If this doesn't happen with a restructuring of the current hi street model, it may have to be imposed from credit suppliers of the American super-structure. Don't be surprised with foreign demands for accountability and legal responsibility under G-8 to regularize global financial markets/system.

[paine]

punchy horse shit
like the gibber of a beaten fighter

to extend sab mal-a-prop's final figure
back to the apologists for free form
corporate
globe wide
hi fi fiddle faddle

far worse to let this fight go on as scheduled
then let uncle entering the ring
with the right hand of marketeering
tied behind his back
and able to punch back
with only the left hand of regulation

[Ninja Zombie]

This article is utterly misleading. The article tries to create a mental link between republicans and deregulation. Then it mentions specific acts of deregulation between two sentences containing Bush:

"The Bush-Paulson bailout exposed the predator state in detail. Deregulation and desupervision were the origin of this crisis: the 1999 Gramm-Leach-Bliley Act repealing Glass-Steagall, and the Gramm-authored loophole legitimating credit default swaps in 2000. Bush's financial regulators"

The name of the president who actually pushed these acts of deregulation does not appear in the article, and it also doesn't actually mention any acts of deregulation by Bush (hint: deregulation is one of Bush's many broken campaign promises, like humble foreign policy and small government).

[Conflict of Interest]

The lesson would seem to be that regulations written by the lobby groups representing the regulated industries don't work.

[hari]

What happened to Gailbraith's piece - which started this thread this morning? I thought his ideas were really to the point and worth consideration in this thread.

[Mark]

As the accompanying piece by Kevin Drum dejectedly acknowledges, this train wreck had many fathers. For some, the whiz bang financial industry was undoubtedly more appealing than the brutish polluting manufacturers.

[hari]

Bloomberg reports flight from commodities market and their index funds, as the financial crisis leads to recession.
Merril is forecasting $50/barrel oil - remember not long ago we're discussing return to $70-75/Barrel based on commodity traders forecast.

Disinflation spiral is underway and the rummaging banks in EU seems to have mainly invested their hard earned savings into real estate mortgage funds in US institutions. Fortis, Hypo, UBS, are all capitulating to sinking values on their inititial large purchases in mortgage derivatives.

This is now looking like a fiancial massacre indeed!

[realpc]

" One party believes that the government serves no public purpose. The other believes that it must."

Yes, all very simple, no thinking required. If any party believed government serves no public purpose, that party would not exist.

Neither party thinks the government serves no purpose, and neither party thinks the government should manage the economy. And no one is sure exactly how to regulate the economy or how much regulation is needed.

It is NOT true that one party has it all figured out and the other is a bunch of crooks and dummies. But if all you read is Galbraith and Krugman you would think so.

[ken melvin]

Couldn't recommend this from 60 mins (from CR) more. The part from say 9-10 mins is simply too funny.


http://calculatedrisk.blogspot.com/2008/10/60-minutes-wall-streets-shadow-market.html

[rufus]

While it may be more accurate to say that deregulation (i.e. the GSLB) did not directly cause the current financial crisis, and that the lack of regulation over the inception and growth of the shadow banking system is more to blame, the reality seems to be that there were a number of contributing factors to the current crisis. As was pointed out in another thread proper valuation and allocation of risk as well as agency issues in the brokering, lending, and securities markets also contributed to the current crisis. No one probably wants to hear that there is no single policy or person to blame. Vengeance is the theme of the day, and somewhat understandably so from the electorate’s/taxpayer’s point of view.

However I think the acid test for GSLB or any other contributing factor is to simply ask the question, would the current crisis have occurred (or occurred to the same magnitude) if factor A, B, C, etc. had not been present?

Assessing blame is not as important as understanding and identifying the various contributing factors so that changes can be made to ensure the crisis (in this particular form) cannot occur again.

[rufus]

hari says...
"Disinflation spiral is underway..."

I definitely agree that "disinflation" (deflation) is on the horizon. This seems to be the inevitable conclusion of the current global asset write down and ensuing financial crisis we are experiencing as Bernanke referenced in a foreboding speech back in 2002. (This is also why I would not be surprised to see a rate cut at the next FOMC meeting).

Worth the read in terms of identifying where we go from here (note includes footnote refernce numbers for notes not cited here. See www.federalreserve.gov)

http://www.federalreserve.gov/boarddocs/speeches
/2002/20021121/default.htm

Remarks by Governor Ben S. Bernanke
Before the National Economists Club, Washington, D.C.
November 21, 2002
Deflation: Making Sure "It" Doesn't Happen Here

"Since World War II, inflation--the apparently inexorable rise in the prices of goods and services--has been the bane of central bankers. Economists of various stripes have argued that inflation is the inevitable result of (pick your favorite) the abandonment of metallic monetary standards, a lack of fiscal discipline, shocks to the price of oil and other commodities, struggles over the distribution of income, excessive money creation, self-confirming inflation expectations, an "inflation bias" in the policies of central banks, and still others. Despite widespread "inflation pessimism," however, during the 1980s and 1990s most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon. Although a number of factors converged to make this happy outcome possible, an essential element was the heightened understanding by central bankers and, equally as important, by political leaders and the public at large of the very high costs of allowing the economy to stray too far from price stability.

With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem--the danger of deflation, or falling prices. That this concern is not purely hypothetical is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation--a decline in consumer prices of about 1 percent per year--has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors. While it is difficult to sort out cause from effect, the consensus view is that deflation has been an important negative factor in the Japanese slump.

So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself. Over the years, the U.S. economy has shown a remarkable ability to absorb shocks of all kinds, to recover, and to continue to grow. Flexible and efficient markets for labor and capital, an entrepreneurial tradition, and a general willingness to tolerate and even embrace technological and economic change all contribute to this resiliency. A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape. Also helpful is that inflation has recently been not only low but quite stable, with one result being that inflation expectations seem well anchored. For example, according to the University of Michigan survey that underlies the index of consumer sentiment, the median expected rate of inflation during the next five to ten years among those interviewed was 2.9 percent in October 2002, as compared with 2.7 percent a year earlier and 3.0 percent two years earlier--a stable record indeed.

The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

Of course, we must take care lest confidence become over-confidence. Deflationary episodes are rare, and generalization about them is difficult. Indeed, a recent Federal Reserve study of the Japanese experience concluded that the deflation there was almost entirely unexpected, by both foreign and Japanese observers alike (Ahearne et al., 2002). So, having said that deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether. Accordingly, I want to turn to a further exploration of the causes of deflation, its economic effects, and the policy instruments that can be deployed against it. Before going further I should say that my comments today reflect my own views only and are not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee.

Deflation: Its Causes and Effects
Deflation is defined as a general decline in prices, with emphasis on the word "general." At any given time, especially in a low-inflation economy like that of our recent experience, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.1 Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.

However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero.2 Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."

Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy. First, when the nominal interest rate has been reduced to zero, the real interest rate paid by borrowers equals the expected rate of deflation, however large that may be.3 To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10 percent per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10 percent real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10 percent greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive. Capital investment, purchases of new homes, and other types of spending decline accordingly, worsening the economic downturn.

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value. When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard.4 The financial distress of debtors can, in turn, increase the fragility of the nation's financial system--for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default. Japan in recent years has certainly faced the problem of "debt-deflation"--the deflation-induced, ever-increasing real value of debts. Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930-33--a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.

Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.5

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible.

However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero. In the remainder of my talk, I will first discuss measures for preventing deflation--the preferable option if feasible. I will then turn to policy measures that the Fed and other government authorities can take if prevention efforts fail and deflation appears to be gaining a foothold in the economy.

Preventing Deflation
As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place. Beyond this commonsense injunction, however, there are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation.

First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero.6 Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times.

Second, the Fed should take most seriously--as of course it does--its responsibility to ensure financial stability in the economy. Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks.

Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates (Orphanides and Wieland, 2000; Reifschneider and Williams, 2000; Ahearne et al., 2002). By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails.

As I have indicated, I believe that the combination of strong economic fundamentals and policymakers that are attentive to downside as well as upside risks to inflation make significant deflation in the United States in the foreseeable future quite unlikely. But suppose that, despite all precautions, deflation were to take hold in the U.S. economy and, moreover, that the Fed's policy instrument--the federal funds rate--were to fall to zero. What then? In the remainder of my talk I will discuss some possible options for stopping a deflation once it has gotten under way. I should emphasize that my comments on this topic are necessarily speculative, as the modern Federal Reserve has never faced this situation nor has it pre-committed itself formally to any specific course of action should deflation arise. Furthermore, the specific responses the Fed would undertake would presumably depend on a number of factors, including its assessment of the whole range of risks to the economy and any complementary policies being undertaken by other parts of the U.S. government.7

Curing Deflation
Let me start with some general observations about monetary policy at the zero bound, sweeping under the rug for the moment some technical and operational issues.

As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject's oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8 Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.9 There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time--if it were credible--would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.

Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).

Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.10 Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding.11 For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt.

To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly.12 However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window.13 Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral.14 For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.15

The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.16

I need to tread carefully here. Because the economy is a complex and interconnected system, Fed purchases of the liabilities of foreign governments have the potential to affect a number of financial markets, including the market for foreign exchange. In the United States, the Department of the Treasury, not the Federal Reserve, is the lead agency for making international economic policy, including policy toward the dollar; and the Secretary of the Treasury has expressed the view that the determination of the value of the U.S. dollar should be left to free market forces. Moreover, since the United States is a large, relatively closed economy, manipulating the exchange value of the dollar would not be a particularly desirable way to fight domestic deflation, particularly given the range of other options available. Thus, I want to be absolutely clear that I am today neither forecasting nor recommending any attempt by U.S. policymakers to target the international value of the dollar.

Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation. A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly. Indeed, consumer price inflation in the United States, year on year, went from -10.3 percent in 1932 to -5.1 percent in 1933 to 3.4 percent in 1934.17 The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market. If nothing else, the episode illustrates that monetary actions can have powerful effects on the economy, even when the nominal interest rate is at or near zero, as was the case at the time of Roosevelt's devaluation.

Fiscal Policy
Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.18

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

Japan
The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points.

First, as you know, Japan's economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan's overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan's long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve.

In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.

Conclusion
Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures. Moreover, as I have discussed today, a variety of policy responses are available should deflation appear to be taking hold. Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.19

[rufus]

Correction (This is also why I would be surprised to see a rate cut at the next FOMC meeting). The nominal rate is already negative.

[anne]

Reading italics on the Internet is too difficult to begin with, but reading a large section is italics worse than too difficult and simply not worth an effort.

[anon]

While deregulation is partly to blame here, it seems the key factor present in all these financial and economic calamities is a government that artificially props up asset prices to induce further credit expansion.

My reading of history does not suggest that lack of regulation is the primary cause here, but at best an exacerbating factor.

Since nothing we're seeing here really differs from past financial meltdowns, except perhaps in terms of magnitude, there's no reason to think IMO that "this time it's different".

[Winslow R.]

"The name of the president who actually pushed these acts of deregulation does not appear in the article, and it also doesn't actually mention any acts of deregulation by Bush (hint: deregulation is one of Bush's many broken campaign promises, like humble foreign policy and small government)."

Clinton.

Clinton had a recession roaring by the end of his second term.

Add to the list Delong, Summers, and Rubin. All project the image of protecting society's interest while they actively work against those interests once given positions of power. The Republicans leave no doubt whose interests they support.

If someone wants to make the case Delong etc. is just stupid, I'm willing to listen but given he works at U.C. Berkeley I doubt it. Brad has made some timid statements towards an apology but has yet to fully fess up.

Let's get past the myth. Brad etc. admit tsy secs are the 'new gold' which is the foundation of all credit, that can/should only be created by deficit spending. Admit you chose to destroy tne 'new gold' and servely limited its creation and thereby destroyed the global financial system and along with it, quite possibly the global economy.

I can be forgiving.

Really.

[rufus]

anon says...

"My reading of history does not suggest that lack of regulation is the primary cause here, but at best an exacerbating factor."

Agreed, there are multiple exacerbating factors to be considered. I would assume that regulation in multiple forms and fashions (e.g. temporary ban on short selling, raising standards for mortgage lending, or other initiatives) is coming. I believe it is important to consider what scale and scope of regulation should occur to help prevent future crises but not impair recovery.

[Winslow R.]

"While deregulation is partly to blame here, it seems the key factor present in all these financial and economic calamities is a government that artificially props up asset prices to induce further credit expansion."

Just the opposite. Given our current monetary/fiscal tools that work from the top down through assets, it is government's failure to prop up asset prices that is to blame.

Redesign the monetary/fiscal tools to work from the bottom up through people instead of assets. Prop up labor/entrepreneurs not assets.

[Anonymous]

I just can't believe we still talk about "deregulation" in a general sense. Out of context, deregulation is neither good nor bad. It is, in fact, meaningless in a vacuum. Most would agree that competition acts as an enhancer of efficiency in many situations. Deregulation does necessarily enhance competition. Obviously, deregulation that leads to monopoly does not enhance competition. Anyone who spouts "deregulation" as a salve for all problems is clearly an idealogue who should be ignored.

I strongly believe that there is an emerging consensus that the specific financial deregulation that led to "high" levels of leverage was a disaster. If you look at crises over the last few hundred years in both LDCs and established powers, you will note a very strong correlation between high leverage levels in the banking sector (or shadow banking system) and the severity of the crisis. It is a personal opinion that severe crises should be avoided, but feel free to disagree with me.

[rufus]

Winslow R. says...
"'The name of the president who actually pushed these acts of deregulation...'"

"Clinton"

To clarify this is incorrect, GSLB was republican sponsored and passed sans veto as the republican controlled house and senate had sufficient votes to override. The other act was passed after Clinton had left office.

[rufus]

It is not my intention to call for regulation. Rather, I assume it will be a reactionary result to the current crisis. What is important is that regulation not be given disproportionate weight such that it stymies recovery.

[Winslow R.]

"To clarify this is incorrect, GSLB was republican sponsored and passed sans veto as the republican controlled house and senate had sufficient votes to override"

Clinton isn't going to veto because he will be overridden?

Speculation and rubbish.

[rufus]

Anonymous says...
"Anyone who spouts "deregulation" as a salve for all problems is clearly an idealogue who should be ignored."

At the same time evolution of the entire shadow banking system without sufficient oversight/regulation is a risk multiplier.

If no one is minding the store, what is to prevent those with incentive from pilfering the till?

[anne]

The Senate vote on repeal of the Glass Steagall bill was 54-44, not enough of a vote to have overcome a Democratic filibuster attempt or a President veto. Only a lone North Carolina Democrat voted in favor of repeal.

[anne]

The attitude toward Glass Steagall in 1999 was such the Citigroup openly broke the law before passage, defying the Congress and President on repeal. Whether the repeal was warranted or not is not the question, but the dictating of law by American bankers. Citigroup was never sanctioned for openly breaking a Federal law.

[rufus]

anne says...
"The Senate vote on repeal of the Glass Steagall bill was 54-44"

Thank you for the correction. However, I still contend that placing personal blame is unimportant short of prosecution. Identifying and preventing the same cascade of contributing factors should be the goal.

Afterall what measure of justice should we expect for those 'guilty' of 'causing' the current crisis, that which was handed out to Enron or LTCM principles?

[anne]

While I have no opinion on whether repeal of Glass Steagall was warranted, for an American bank to have been allowed to openly break Federal law set an intolerable tone against financial company regulation and possibly against government regulation in general that was a result of decades of Republican campaigning against regulation that was by 1999 too largely accepted by Democrats.

[Bruce Wilder]

realpc: "It is NOT true that one party has it all figured out and the other is a bunch of crooks and dummies."

No, that's not true, as you say. What is true, is that the Republican Party is mostly "crooks" or "dummies", or both. But, the Democratic Party, which includes some crooks and some dummies (and some both), does not have "it all figured out."

Welcome to the messiness of the real world.

The political parties are not symmetrical mirror images, for good or bad. Nor, are they static. The Republican Party of twenty years ago or twenty years hence, will not be identical with the Party, today. The Democratic Party, which, today, has a mixed race candidate for President, was once the Party of white supremacy.

Passion and desire motivate politics. The Parties are alike in that both are complex coalitions of people seeking office and power. But, as soon as you depart from that abstract formulation, and include how their members and supporters see the world, and how they think power should be wielded, and toward what ends, the Parties could scarcely be more different from one another.

Politics is not show business for ugly people, or sports for clumsy people. The Spectacle is a Means, not the End. It is not the Red Sox v the Yankees, nor are Brad and Angelina running for office.

Krugman, at his most partisan, is at his best. It is when he is clearest. He is clear about what he wants for the country, and why; and about what he doesn't want, and why.

The journalist-pundits and other commentators, who pretend to be "objective" and non-partisan in their assessments frequently just succeed in being incompetent or deceptive or both.

Nick Rowe, a Canadian, wrote about the financial crisis, "The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong." Was he being "objective" and "non-partisan"? I don't think so. I think he was disguising his preferences, and his determination to hoist deception, ignorance and stupidity onto his audience. He suspended his critical reasoning skills in the interest of Olympian detachment, and those critical reasoning skills remained suspended for the remainder of his piece, although he, himself, scarcely seems to have noticed.

I watched Pat Buchanan this morning on some roundtable political punditry show. He appeared to think Sarah Palin qualified for the Vice-Presidency, and, by extension, the Presidency, on the basis of her undoubted charm and beauty, never mind the authoritarianism, ignorance and stupidity. This was the best case, by a man, who supported Spiro Agnew and Dan Quayle. I did not agree with him -- obviously -- but he told me all I needed to know.

In my lifetime, there has never been, in a Presidential election, or Congressional election, a clearer, starker choice. There's a minimum of ideological overlap between the Parties. On policy or on symbolism, on style or substance, character or content, the Parties are a contrast.

Hold your nose and vote Democratic, or be damned. That's your choice.

[rufus]

Enforcement is as, if not more, important than the rules so that in an economic sense punishment is sufficient given probability of occurrence to nullify rule breaking incentives.

[Bruce Wilder]

rufus: "Afterall what measure of justice should we expect for those 'guilty' of 'causing' the current crisis, that which was handed out to Enron or LTCM principles?"

Try not to re-elect them?

[rufus]

Bruce Wilder says...
"Try not to re-elect them?"

I am bemused only because beyond the surface this is more difficult than it would seem, as one of your above posts would imply.

I know what criteria I am using for casting a vote it's what criteria others would consider that scares/dumbfounds me, like don't vote for that known terrorist 'Obama Bin Trodden'
:)

[donna]

One party believes its purpose is to serve them, the other party believes government should serve us ALL.

That's the difference.

[donna]

And if the Southern Republican voters ever actually figure out how badly they've been screwed by the people who run the Republican party, Bush and his friends are going to need that big ranch in Paraguay.

[brilliance]

quoted, "This was the best case, by a man, who supported Spiro Agnew and Dan Quayle."

I am insulted by these never-ending slurs against Dan Quayle. Dan Quayle was the most entertaining vice-president in the history of the nation. Quayle was dim-witted, incompetent, and hilarious. He was an unintentional comedic genius. Quayle and Quayles comedic genius are to be treasured and beloved, like Laurel and Hardy, or Jerry Lewis.

[hari]

Rufus - thanks for reproducing *Helicopter Ben*.

I agree it does not serve policy to pass blame here. What's mandatory is to recognize financial system was not regulated by the Fed and/or SECs regulatory arms. If it was, in light of 1999 decision to deregulate, can you imagine what the headlines may've read! The mass academic economist's culture was for deregulation also. There was no one q's consequences of such a greedy and fraudulent derivatives market development either!

In other words, American capitalism can't have its cake and also eat it - irrespective of its inherent domestic policy inconsistencies - which has brought about the current instability in the credit markets.

We all know it could have been avoided with a bit of oversight and supervision by Fed.

However, the discussion, right this night, in Europe, is what follows the current malaise? As you know financial instituions are going belly up - also here - after much hesitation and whatnot....

The crisis of confidence is raging as markets are unable to digest either Fed or Treasury policy action. Let alone the inability of EU to deal with the crisis now looming in its banking sector - without a federal budget and no legal power! Each member country is now fraught with the problem of solving its own financial *toxicants* - domestically.

It's gratifying Fed/Treasury have today signalled policy coordination with ECB and other CBs to counteract the downturn and consequences of global recession and deflation.

[bakho]

There is a lot of blame to go around. However, the CDS were critical to the bubble. Without the CDS to take the risk out of investing the mortgage market risk would have been better assessed. However, if you can buy a credit default swap, it doesn't so much matter how risky the mortgage market is, you are guaranteed your money. The onus then falls to the CDS to assess the risk of the paper they are backing. Since the CDS market was unregulated, it was possible to "insure" more paper than there was money to pay out.

[rufus]

hari says...
"Rufus - thanks for reproducing *Helicopter Ben*."

What strikes me as ironic is that at the time this speech was given the Fed appeared mostly concerned with deflation as it relates to exponential growth in productivity. My! How things have changed. In hindsight, the hubris reflected in the speech with regards to the strength of the financial system is less ironic and more discomforting.

At the time, concerns by Greenspan et al, regarding ongoing evolutions in the banking system and mortgage market were relegated to footnotes and after thoughts in the speeches.

[hari]

*All fundamentalism is blind and dangerous* - Willem Buiter

"With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. The wide spread adoption of these models has reduced the costs of evaluating credit worthiness of borrower, and in competitive markets, cost reductions tend to be passed through to borrowers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgage counts for roughly 10% of the number of all motgages, up from 1 or 2 percent in early 1990s."

Alan Greenspan/Fed - Fourth Annual Community Affairs Research Conference, Washington, D.C. April 8, 2005.

[hari]

Borrowed from *The Origin of the Crisis* by Willem Buiter,
FT/Oct 2 2008.

[Easy Money]

The Helicopter Ben speech was the gong heard around the world that the monetary authority in charge of the world's reserve currency would debase it to save asset prices. That was a bell going off for speculation around the world - it no longer made sense to invest in the real economy.

The "savings glut" was another ludicrous notion used to mislead us all, along with "investment deficit." Sure, investors could not all find easy financial asset gains, but that was caused by everyone wanting to leech off the Fed induced credit boom, rather than invest in the real economy.

And all the discussion of the proximate causes of the crisis misses that fact once easy money and credit are so easily available, smart people will find a way. Delusional to think market players will not find a way around regulators and regulations.

[paine]

this is a topic best addressed
by contending policy plans

we approach this with cow bladders at the ready
and no more
if we try to portion out blame
institutionally
or by party
plenty to go around
and for that matter
the choice between the two big party
white house tickets
only looks clear if you extrapolate
your own hopes and fears

despite the well chosen thoughts
of our very own bruce wildone

policy range
will be dictated
by the real markets
of the global economy
tht is unless in getting obama
we get a stealth FDR
who as soon s he's in office
turns his back on wall street
our foreign "wars" and uncle's role
in the global economy
and adopts a new paradigm
for our domestic economy
if not if he merely re acts intelligently
and prudently to each crisis
he won't be acting
all that diffrent from the president air pirate
parallel universe

best guide post :

ob's answers to questions that start

"in light of the 700 billion dollar bail out and the global economic down turn blah blah blah ....how must we reduce our domestic agenda"

if he counters
"we must brush aside
these merely paper constraints .."
and for symbolic effect
throws bob rubin
and larry ziffle off the white house balcony
then maybe may be maybe
we'll take a differnt path ahead

otherwise.. its the dlc rides again
--- if now in sheeps' clothing --
and hilly clinton in black face
without
the bulging eyes
bolderish head
and baggy pant suit

[kthomas]

"and for symbolic effect
throws bob rubin
and larry ziffle off the white house balcony"

I would love that. Right into a vat of tar, adjacent to the bin of feathers.

[paine]

btw
i agree with baykooo

give the palme d'or
to that shameless fairy dust called CDS

see to hook em
you gotta have
more then a claim to
the latest
PERPETUUM M0BILE SPONDOOLICUM

lot inflation was not enough
even with the utter mazification
possible with derivatives .....simply not enough

a novelty evolute from the rock of ages
ie a weird complexity was not enough

some one had to add
the illusion of unsinkability too

err that is
for the rubes' rubes to swallow trillions worth anyway

then
again
this debacle brings on the musical question

at the brink of he cataract
who's not a rube ???

on judgement day
even the carney in chief
the Devil himself
proves to be
nothin but a rube

LONG RUN:
only God's not a rube

[hari]

I sort of second your positive motion for global action.
What's holding up BO from annoucing his Economic Team for (potential) cabinet posts - before Tue debate?

McBush have lost their marbles...

but the q's how is BO
going to outsmart marine pilot
on a crash-dive to preempt?

[Cynthia]

60 minutes has put together a bang-up piece explaining how shadowy bankers did some dirty dancing with deregulated derivatives and turned a molehill of a mess on Main Street into a mountain of one on Wall Street...

http://calculatedrisk.blogspot.com/2008/10/60-minutes-wall-streets-shadow-market.html

[Bruce Wilder]

hari: "I sort of second your positive motion for global action.
"What's holding up BO from annoucing his Economic Team for (potential) cabinet posts - before Tue debate?"

For one thing, it would be against the law. There's actually a legal constraint on candidates: the candidates cannot legally promise to appoint any specific person to any specific post, prior to the election.

The best the candidates can do -- and they do this ad nauseum -- is form campaign advisory teams and designate campaign surrogates.

[dd]

Zero out CDS now: it's a zero sum game and the Feds happy exercise is legitimacy is yet another front as false as Bush's Made in USA photo op. (http://www.bloomberg.com/apps/news?pid=20601087&sid=aggIxIogKZjg&refer=home) Zero it and then zero out the leverage. It's all zeroes. Really. The hedge fund collapse will zero it out with tax and regulatory arbitraged wealth zeroed into oblivion but the wealthy will have the sweet smell of taxes not paid in the past and losses that balance out the once happy gains.
CDO is a mess and a fraud. Which is why Hank has no stomach to bailout homeowners; because that will reveal the sham CDOs that are filled with nonexistent mortgages of nonexistent mortgagors on nonexistent homes somewhere in the deserts of Nevada and California and the swamplands of Florida.

[dd]

No worries on CDS. The industry representative tells us all went well at the settlement auction and everything is fine:
Fannie, Freddie Debt Valued as Low as 91.51 Percent
http://www.bloomberg.com/apps/news?pid=20601087&sid=a4omvrx7V6uI&refer=home
``The very high participation rate in this protocol and its success in settling a significant number of credit derivative trades on the two GSEs constitute a major achievement for ISDA and for the industry,'' Robert Pickel, ISDA's chief executive officer, said in a statement.

Who needs regulation when there is industry owned ISDA fixing the market?

[Julio]

paine:

"best guide post :

ob's answers to questions that start

"in light of the 700 billion dollar bail out and the global economic down turn blah blah blah ....how must we reduce our domestic agenda"

if he counters
"we must brush aside
these merely paper constraints .."
and for symbolic effect
throws bob rubin
and larry ziffle off the white house balcony
then maybe may be maybe
we'll take a differnt path ahead"

I thought in the first debate Obama did a pretty good job of this given the usual constraints on a candidate. He said he might have to "postpone" some of his spending, but reiterated his commitment to carry out his plans regardless.

(And, WH balcony is too low. Obelisk.)