Fed Watch: Potentially Very Bad Policy

Tim Duy does his best to shoot down the trial balloon Treasury floated yesterday:

Potentially Very Bad Policy, by Tim Duy: Incoming data confirms that the economy slid into the heart of the recession in the fourth quarter. The ISM nonmanufacturing report posted a stunning decline in service sector activity. Like its manufacturing cousin, the underlying details were simply depressing, with the drop in the employment component setting the stage for a particularly week labor report later this week. ADP reported a sharp drop in private employment in November; this report has been underestimating declines in recent months, suggesting the possibility of a blowout number. Auto sales fell off a cliff in November, and I doubt December is looking much better. TheBeige Book provided grim anecdotal evidence consistent with the data.

Unfortunately, we will have more months of such data. With the economy already a year into recession, with the worst still ahead, not behind, policymakers will become increasingly desperate to do “something.” And that is exactly when some of the worst policy will evolve.

In the heat of the moment, we love crisis managers. But actions taken by crisis managers, who would argue that something just needs to be done, can yield very bad outcomes over the longer run. As much as I respect incoming administration members Timothy Geithner and Larry Summers, their efforts at crisis management during the Asian Financial Crisis left long lasting effects on the global financial system. During the Asian Financial Crisis, US Treasury officials thought it best to use the IMF as a club to beat struggling economies into submission. As a result, foreign policymakers around the world thought it best to accumulate massive reserves that fundamentally altered the path of capital formation in order to make the IMF irrelevant. Quietly watching while the US current account deficit expanded validated the global perception of the US as consumer of last resort and further aggravated global imbalances. And if you don’t believe those imbalances are at or near the heart of the current crisis, I urge you to read Brad Setser. Separately, the Federal Reserve in 1998 took on the job of financial market guardian with the LTCM unwind, thereby setting an expectation that the Fed would always prevent anything very bad from happening. But after taking on the responsibility, the Fed never followed through on oversight. Shouldn’t Citi’s off-balance sheet entities have raised more questions?

In all honesty, I hold Geithner and Summers less to blame for the aftermath of the Asian Financial Crisis than the Federal Reserve. Arguably, they never had the chance to offset the negative outcomes of their crisis management efforts; the stage was soon taken over by the Bush Administration, which set about eviscerating Treasury. And it is to Geithner’s credit that while at the helm of the New York Federal Reserve he tried to get ahead of the challenges in the CDS market. Overall leadership at the Federal Reserve, however, should have worked to correct the moral hazard they infused into the financial system.

This is not to deny the importance of crisis management, but to point out that when the crisis is over, you need to be able to correct for the excesses of your actions. With that in mind, crisis managers need to be wary of taking actions that they cannot revoke when necessary.

Which brings me to the trial balloon Treasury floated today; leaking plans to stem the decline in the housing market:

The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.

The key word here is “temporary,” implying a sunset clause. This is a program, however, that screams permanency. Once the federal government defines a right to low rate mortgages, they will find it very hard to reverse their position. (The Treasury may think they can make an arbitrage profit now, but just see what happens when the relative yields flip.) Why? Because at some point in the future, revoking the right will create classes of winners and losers, especially if it results in a steep rise in mortgage rates. And the losers will fight tooth and nail to prevent that rise; just imagine the army of lobbyists from home builders and realtors that will descent on Washington. (Separately, Calculated Risk questions whether or not the Treasury can meaningfully impact housing prices via the rate mechanism.) Moreover, it seems difficult to imagine that this program can be limited to those buying a home; why should those seeking to refinance be excluded? Wanting to stay in your own home is something the government should discourage?

The Fed has already stepped onto this dangerous ground by announcing plans to bring down mortgage rates by buying agency debt in large quantities. A reversal would threaten their political independence (which perhaps was lost long ago). To be sure, the Fed has always altered interest rates as a tool of monetary policy, and rate increases have always drawn the ire of politicians. But the Fed could always argue that the impact on home mortgages was simply an indirect consequence of their efforts to stem inflation in the economy as a whole. Now their actions are directly targeted at housing itself; they have announced they have the power to set mortgage rates. Politically, this is very different. At some point in the future, interest rates will need to rise, and I worry at that time the Fed will learn just how hard it is to taken away what Americans view as a God given right – government support for the housing market. Just think about trying to take away the home mortgage deduction.

Perhaps I worry too much. Perhaps it really will be temporary. Consider, however, who is behind this proposal:

The Treasury plan is similar to ideas previously floated by the National Association of Realtors and the lobby group for home builders...

I can only think of Adam Smith’s warning:

The proposal of any new law or regulation which comes from [businessmen], ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

What is the alternative? Stop focusing on the housing market. Stick to policies that will be revocable when necessary. There are virtually unlimited opportunities for good policy in education, infrastructure, and health care, to name a few (Rebecca Wilder fears there may even be too many). The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers.

Final thought: Neither the Fed or Treasury would be in this position if the latter simply provided agency debt with the full backing of the US government. Then when mortgage rates needed to rise at some point in the future, neither agency would have to take responsibility for the resulting damage to the housing market. Simple versus complicated.

Comments

[dWj]

"A strong conviction that something must be done is the parent of many bad measures."
-- Daniel Webster

I think Calculated Risk is even more pessimistic on this than is appropriate, though; as one is planning to live in a house for a long time, the resale value takes on ever reduced significance, so for people looking to buy and hold, this could make a significant difference. How big a pool of buyers that constitutes is a fair question. The proposal feels like a bad idea, regardless.

[a]

"policymakers will become increasingly desperate to do “something.” And that is exactly when some of the worst policy will evolve."

Exactly. All along the way - with bailouts and stimulus - the theorists and the policymakers have tried to "do something" - and have just made the problems worse.

"I can only think of Adam Smith’s warning:"

Oh, so Adam Smith said something. I guess we're supposed to listen. Physicists don't say "read Einstein" when they want to explain the Theory of Relativity. Mathematicians don't see "read Gauss" when they want to explain quadratic reciprocity. Biologists don't say read Crick and Watson to understand DNA. But *philosophers* will say "read Kant" or "read Wittgenstein". And *political scientists* will say "read Machiavelli" or "read Mill". So I'd suggest that this is pretty good evidence that economics is not a science, or at least certainly not a science like the others; it's more like philosophy. In a science theory trumps theorist. Not so in economics (or philosophy).

"Stick to policies that will be revocable when necessary. There are virtually unlimited opportunities for good policy in education, infrastructure, and health care, to name a few..."

Wait a minute. Krugman blames the 1937-38 recession on a reversal of government "New Deal" policy, by raising taxes and cutting spending. So why does Duy think stimulus is as reversible as all that? Once you start to stimulate, you may not be able to stop without then forcing the economy into the very problems you were trying to avoid. Of course we will still stimulate, because it is "doing something".

says...

Physicists don't quote Einstein? That's pretty stupid. So is the statement about Guass. Of course mathemticians say to read Guass when it is pertinent, and of course they wouldn't cite him when it's not. (As you may have noticed, they even have theorems named after him that are still used!).

If you are smart, you will listen. The converse is true as well...

The statment about Krugman makes no sense. Because it was reveisible it's not? Huh? And what does that have to do with Duy's point? (You still don't quite get this whole stabilization thing do you? Krugman keeps laughing at people like you - as well he should - that's probably part of the reason for the ascerbic nature towartds him.)

Same old tune, night after night, like a broken record.

[calmo]

Do you have the stats (esp trends) on how long people live in their houses dWJ?
My understanding is that their expectations have been dropping for decades. Houses have become the main (and only?) vehicle for "climbing the (wealth) ladder". The idea that you stayed in the same ones for decades belongs to an earlier generation, yes? What else could "starter home" mean?
CR is conservative when he is not correct which is not often...and I think he is somewhat cheery, not overly pessimistic on this one.

So many posts from Tim lately...makes me a tad anxious...like the airline pilot's increasingly frequent and urgent reporting to the passengers "still maintaining altitude" and some of the passengers needing a different distraction than that...whiskey say.The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. Hope so Partial monetization of the deficit...prolly only partially acceptable to PBoC, BoJ, and other holders of Tbills...would you expect a flight from "quality" to gold by the fleet of foot in this case? Of course it is only temporary...so we could try it for a couple of weeks without any real damage seeing how we can "demonetize" in the future? Any demons in that "demonetize" thingie? Hope not

[a]

"Of course mathemticians say to read Guass when it is pertinent..."

Obviously, you know nothing about mathematics. I guess you're stupid (to use your own terminology, not mine). There is, in fact, a time when mathematicians say, "read Disquisitiones Arithmeticae". (You've heard of that? Probably not. Go google it, and maybe you'll learn something today.) The advice is given because DA is particularly well written and it is to impress on a young mathematician the importance of style, not (unless the mathetician is a great admirer of Gauss, which does happen) to learn about quadratic reciprocity.

"...and of course they wouldn't cite him when it's not. (As you may have noticed, they even have theorems named after him that are still used!). "

Ah, so my comment about "reading Gauss" now turns into a question of citing Gauss when he first proved a theorem. You have the logic of a snail. Keep it up! You impress me!

"Because it was reveisible it's not?" Krugman explains the recession of 1937 by saying that stimulus was taken away, and he says this was an error. So it would seem that stimulus is not as reversible as Duy would make it out - once you put it into the system, it may be difficult to take it out.

"Krugman keeps laughing at people like you." I don't tend to laugh at people, even when I think they're very wrong, but - hey - maybe Krugman does. Don't know.

"that's probably part of the reason for the ascerbic nature towartds him.)"

An amateur psychologist! Gosh, you don't seem to have an understanding of mathematics, and your psychology is little better.

[mmckinl]

Tim Duy says ..."Quietly watching while the US current account deficit expanded validated the global perception of the US as consumer of last resort and further aggravated global imbalances. And if you don’t believe those imbalances are at or near the heart of the current crisis, I urge you to read Brad Setser. "

Bass ackwards ... It was the shadow banking system that snowballed this crisis. The demand for dollars is to replace leveraged derivatives losses by the banks. The same banks that assured the rating agencies that the models were risk diversified while paying loan brokers to sign up anyone that could fog a mirror to a home loan that would inevitably blow up.

There is, as I understand it, remedy for trade imbalances and unfair trading practice in the GATT, that the Bush administration never took advantage of. The tools were all there to avoid this calamity, including the ability of the Fed to qualify brokers and tighten loan qualifications.

Setzer gets this one bass ackwards.

[Noni Mausa]

Dear a,

Often a quote accomplishes several things a bald statement would not. It allows for elegant statement of a widely known truth (instead of our own less polished prose); it places the topic in historical context (he lived in the time of the American Revolution and saw America become a nation); and in this case it helps remind the Smithophiles that the father of the invisible hand did not believe that hand to be an unambiguously benign one, but often damaging to the individual and to society.

Noni

[a]

Noni Mausa - yes, all true.

"In this case it helps remind the Smithophiles that the father of the invisible hand did not believe that hand to be an unambiguously benign one, but often damaging to the individual and to society."

I guess my point would be that economics is different from a science because in economics you can have such a thing as a Smithophile, who seems to think that what Smith said (whether or not the hand is not an unambiguously benign one) is more important than what is the case. I'm not, by any means, trying to drag you into a conversation you may or may not want, but I think this is an important difference. Would you agree that 1/ it *is* a difference, and/or 2/ that it is a difference *relevant* to whether economics is a science? Again, I'm not trying to drag you into a conversation that you may not want, so please feel free to ignore if you want.

[ken melvin]

Knew the law was really politics; now, we see clearly that the fed and treasury are want to act on the basis of politics. Recall trying to salvage broken balloons?

[paine]

"This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers."

true enough
but uncle backing the paper without charging a risk premium
or far more likely too low a premium

if the target is the spot mortgage rate rising and fueling the rise in resets

then a payroll tax rebate of monster proportions
provides employed households with a cash flow eenhancement
that will lighten all nut burdens
not just prop house lot values

[ken melvin]

Find the lobbyist responsible, prolly NAR, and shoot them.

[OhNoNotAgain]

"Wait a minute. Krugman blames the 1937-38 recession on a reversal of government "New Deal" policy, by raising taxes and cutting spending. So why does Duy think stimulus is as reversible as all that? Once you start to stimulate, you may not be able to stop without then forcing the economy into the very problems you were trying to avoid."

This is only true if you ignore the fact that:

1) The stimulus provided by WWII *did* get us out of the problem, indicating that the problem with the stimulus was that it was too *small*, not too big.

2) The initial stimulus provided by the New Deal *was* working. By 1937, unemployment had gone down by approximately half, GDP had recovered, and prices were almost back to what they were in 1929. In other words, given the trends, the New Deal would have eventually succeeded in doing what it set out to do.

[a]

Thanks for your points 1/ and 2/.

Maybe "given the trends" the New Deal would have eventually succeeded. But the fact remains - or are you disputing the fact? - , when the stimulus was taken away, the economy fell back in recession. This would seem to indicate that stimulus may not be as reversible as all that.

As to 1/ maybe it was the stimulus of WWII which got the U.S. out of depression. I think it depends on what factors were important - was it the stimulus part, or whs some other feature of WWII that was important? Maybe it was the U.S. blowing up the competition's factories, which meant it could sell its products after the war without too much problem. You are not - I presume - suggesting we involve ourselves in another world war in order to restart the economy?

[ndd]

OnNoNotAgain: Loved the rejoiner about WW2 ... "Oh, so stimulus DOES work!"

Tim Duy is a treasure, with a firm grasp of reality. Are you sure he is an economist?

[paine]

the size of the long term gub deficit vs the recovery fast deficit
might be signifigant
bill vickrey in the mid 90's
figured the USA had a chronic deficit
in private investment's net supply of securities
about equal to the nominal growth rate of gdp

we might need in addition
in a recovery
an additional deficit
of about 6% of gdp
and for a push to hyper employment
another 6%
look to a total defict optimun
of maybe 15 % of gdp

for fast path??

try a 2 trillion plus deficit next fiscal year

doable??

historical reference point:

check out the deficit %s for 1940-1944

[paine]

put the pub sec on total tax rebate
and full borrowing

[OhNoNotAgain]

"Maybe "given the trends" the New Deal would have eventually succeeded. But the fact remains - or are you disputing the fact? -"

No, I'm not disputing the facts, but rather the conclusion that you're drawing from them. Although the economy had rebounded quite a bit by 1937, we were still dealing with pretty significant unemployment and businesses that were, for political and other reasons, reluctant to invest. In other words, things were much better by 1937, but not good enough to begin instituting austerity measures. And again, this was due to the New Deal stimulus measures not being large enough. I believe they were only around 3% of GDP. Given the depth of the economic troubles that we were facing, that seems a bit too small to me.

"As to 1/ maybe it was the stimulus of WWII which got the U.S. out of depression. I think it depends on what factors were important - was it the stimulus part, or whs some other feature of WWII that was important? Maybe it was the U.S. blowing up the competition's factories, which meant it could sell its products after the war without too much problem."

That would only hold true if you make some assumptions, namely:

1) The axis production facilities would have produced better products at a lower price than the equivalent American factories, and would have had the type of economy and stable political environment to take advantage of such an edge in production. Access to oil, for example, would have been a big issue for both Japan and Germany, whereas we did not have such a problem. The same holds true for many other natural resources, and even human resources. You'll remember that the Axis countries tended to like using slave labor as a cost-saving device.

2) Increasing unemployment, and the collapse of aggregate demand as a result, was not the driving cause of the Great Depression. One of the hallmark features of WWII is the fact that it represented actual full employment of our workforce. Full employment will cure any deflationary scenario, guaranteed. Of course, government control also prevented inflation from becoming an issue under such circumstances. But, in my eyes, the employment picture is key.

"You are not - I presume - suggesting we involve ourselves in another world war in order to restart the economy?"

No, and I find that to be a rather insidious take on this subject that comes up way too often. One can use WWII as an economic example without endorsing war.

[kharris]

OK, first it is worth noting that the "quoting Smith means economics is not science" business employs a completely nutso implicit definition of science. The fact that one batch of writers tends to quote to make a point while batches of writers don't may be evidence of something, but it is a nonsensical standard for putting the writings of one batch into a pile labeled "science" and writings of the batch in a pile labeled "not science". Second, since the issue of whether economics is a sciences isn't really germain to the original post, we have at least some justification in thinking that a raised it because "economics isn't science" is a's favorite pony and he wanted to take if for a ride.

I realize that slapping labels on things and then arguing endlessly about who is right and who wrong is a great hobby, but like a lot of hobbies, it is quote boring to watch.

As to the the thing about the duration of stimulus, well, we have a logic to fall back on, and theory and the results of historical research. To start with logic, if the output gap is wide, removing stimulus is probably a bad idea. Sudden removal of stimulus is probably a bad idea. And so on. The progress of the business cycle is a pretty helpful guide.

[groucho]

"Maybe it was the U.S. blowing up the competition's factories, which meant it could sell its products after the war without too much problem. You are not - I presume - suggesting we involve ourselves in another world war in order to restart the economy?"

War is the natural outcome of various mercantilist trade policies. Nixon giving up the gold self-correcting mechanism, just exacerbated the global trade situation to an unprecedented degree.

Now we have collapse with extraordinary govt intervention to try and stop the avalanche from it's natural path. The interventions will divert the forces from some actors but towards others.

Compare this distortion to the domestic currency debasement scheme which rewards a few at the expense of the many. Distortion on top of distortion yields a broken system where productivity and reward are separated and eventually a collapse of the system is inevitable.

How much longer does the US have before total collapse?

[a]

"In other words, things were much better by 1937, but not good enough to begin instituting austerity measures. "

Right. So you're saying the stimulus measures shouldn't have been reversed? That is (which I thought was my point, but maybe you think it's your point?), Duy's assumption that stimulus is easily reversible is not clearly true. I guess it's easily reversible as a possiblity, but in practice you may not want to do it.

"That would only hold true if you make some assumptions..." IMHO you're stating your case a tiny bit too strongly.

"Increasing unemployment, and the collapse of aggregate demand as a result, was not the driving cause of the Great Depression." I'm surprised by the "not", especially since you later write, "But, in my eyes, the employment picture is key." Am I misunderstanding something here?

[Hedges]

The big mistake was forcing citizens to save for their future using inflation hedges (homes). Denied any possibility of safely storing their long term savings in FDIC insured deposits (inflated away), this forced citizens to vote to maintain the value of their inflation hedges (zoning, subsidized mortgage rates, mortgage interest write offs). When they found that they could vote to maintain the value, they decided to try and vote to continuously increase the value. The Ponzi scheme worked for awhile, then collapsed as all Ponzi schemes eventually do.

Of course, savings in the form of inflation hedges cannot be used to make capital goods, so capital had to be imported. The collapse of the Ponzi scheme destroyed the importation of credit, so there is now danger of total collapse. Public borrowing is temporarily bringing in some capital, but at a much reduced rate. There really is no long term substitute for a public preference to buy capital goods with their savings. There is no plan to restore the circular flow, only prop up inflation hedges with public borrowing and forced savings.

[a]

"The fact that one batch of writers tends to quote to make a point while batches of writers don't may be evidence of something, but it is a nonsensical standard for putting the writings of one batch into a pile labeled "science" and writings of the batch in a pile labeled "not science"."

It's not so much a question of being a standard. I'd just say it's striking that some subjects (these are the ones which almost all people admit to be sciences) don't use this methodology, and there are others (such as economics) which do.

"Second, since the issue of whether economics is a sciences isn't really germain to the original post, we have at least some justification in thinking that a raised it because "economics isn't science" is a's favorite pony and he wanted to take if for a ride. "

It's not by any means my *favorite* pony. (Sadly) I'd say I more inclined to the more neutral questions, "Is economics a science?" or "What's the methodology which economics uses or should use?" But, based on what I have read on this blog (and even more the comments), it has struck me that scientists and mathematics do not quote past authorities in the same way as economists or political scientists or philosophers do, and this may be a useful manner of explaining the difference between them. OK, it was a bit off-thread, 'tis true, I confess.

[Dwight]

who was it who counselled, 'don't just do something, stand there.'?

[cent21]

I'm reminded of the silly policies wrought in the New World by royal and feudal barrons over favored industries, the history of which I know only by reading Michener's Carribean many years ago.

Question: Isn't the crux of this issue the same as the interest rate spread above Treasuries? Notes were made about the implicit guarantee of Fannie and Freddie bonds by the treasury having failed to close he interest rate spread between treasuries and the bonds.

Ergo, rather than trying to dally specificly with setting a mortgage interest rate, a cleaner approach is through the degree of govt guarantee for those bonds.

As well, perhaps the govt needs to keep an eye not only on the depression of the 1930s but also the Weimar Republic circa 1919. That is, be careful when you wish to close the gap between treasuries and other paper, as the outcome might be an over-supply of treasuries.

[im1dc]

ndd says..."Tim Duy is a treasure, with a firm grasp of reality. Are you sure he is an economist?"

That is a truly insightful, not to mention hilarious, on many levels, imho.

Thanks for the chuckle ndd.

[rufus]

Duy: “What is the alternative? Stop focusing on the housing market. Stick to policies that will be revocable when necessary. There are virtually unlimited opportunities for good policy in education, infrastructure, and health care, to name a few (Rebecca Wilder fears there may even be too many). The Fed can support the economy, if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers.“

I agree with Tim that the Fed developing and utilizing a program is less desirable than utilizing the broader tools at their disposal. Perhaps Tim drafted this ahead of the current announcements that major CB’s are enacting further rate cuts today. While I would have preferred Tim’s argument to be made juxtaposed to this new information, I believe it is worth examining now.

http://economistsview.typepad.com/economistsview/2008/12/bernanke-federa.html

Bernanke: “Consistent with the historical mission of the Federal Reserve, the third component of our policy response has been to use all our available tools to promote financial stability, which is essential for healthy economic growth.”

(But not to use them to their fullest extent, makes no sense.)

Bernanke: “Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited. Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. ... We will continue to explore ways to keep the effective federal funds rate closer to the target.

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective.”

Relative to Duy’s discussion of the pitfalls of enacting and retracting ‘special programs’, why has the Fed chosen to leave the primary 'arrow' in the 'quiver' as yet unexpired? This is not a time for the Fed to apply it's tools in moderation. Why should the Fed not use its primary tool to the greatest extent? I understand Bernanke’s argument that future reductions in the FFR have an obvious limit, but we are not there yet.

I do not understand the lack of lockstep movement with the rest of the CB’s in at least making a ¼ point or 2/10 point adjustment. Are Bernanke and the Fed saving this for a ‘rainier’ day? The employment and manufacturing data suggests it’s already pouring. So while I agree with the implicit argument I find in Tim’s column (reading between many lines), that the Fed should expunge its primary tool completely prior to reaching for the less desirable ‘second arrow’, apparently Bernanke does not agree. However at one time it appeared he did.

http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

Bernanke: “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.“

Undoubtedly the time will come to emphasize secondary measures and programs. However, the key rate is not yet close enough to zero to call it quits or pause with rate cuts. Yes, real rates are already in the negative range (and have been), but until they are out of ammunition the Fed should keep firing its primary ‘arrow’. What is difficult to understand is why Bernanke and the Fed have opted to maintain the current ‘buffer zone’ at 1% given the nature of the current crisis.

[rufus]

^Gratuitous quotation sources

http://economistsview.typepad.com/economistsview/
2008/12/bernanke-federa.html

http://www.federalreserve.gov/BOARDDOCS/SPEECHES/
2002/20021121/default.htm

[Patricia Shannon]

Can anybody link me to the comment yesterday of the IT person who said he/she is ready to commit suicide? I left him/her a msg, and wanted to see if there was a reply.
Thank you.

[im1dc]

If the following doesn't argue convincingly for Keynesian stimulus nothing will convince the naysayers.

The real world is in trouble, big time and 'doing something' is better than sitting back and watching a Depression develop, imo.

Bank cuts UK rates to 57-year low..."The Bank of England has cut interest rates by one percentage point, from 3% to 2% - the lowest level since 1951."

http://news.bbc.co.uk/2/hi/business/7764741.stm

ECB cuts eurozone rates to 2.5%..."The European Central Bank has delivered a record rate cut, lowering the key interest rate for the 15 countries that use the euro to 2.5% from 3.25%."

http://news.bbc.co.uk/2/hi/business/7764441.stm

World economy 'weakest since 30s'..."The United Nations says the world economy faces its worst downturn since the Great Depression. It expects world economic output to shrink by as much as 0.4% in 2009, due to a slump among developed countries - particularly the US and in Europe. This would mark the world economy's first year of contraction since the 1930s, the UN said."

http://news.bbc.co.uk/2/hi/business/7757506.stm

[im1dc]

IMO:

Today 'doing something' is standard Keynesian economic policy, not an unknown new fangled policy like it was in 1930, so it makes sense that we focus solely on getting the greatest bang for our buck.

'Our Professor Krugman' has written that the discussion today ought to be over the size of stimulus and the best places to spend it to ensure the greatest good for the greatest number of taxpayers.

I wholeheartedly agree and support his diagnosis and prescription.

To do that, imo, we must STOP SoT Paulsen and George W. Bush from continuing to give the $700 Billion rescue funds to Paulsen's Wall Street friends and the Republican's largest campaign donors from Wall Street.

The focus was supposed to be on Main Street not Wall Street. That is how the $700 Billion rescue package was sold to Congress and the American Electorate. Nothing can be done to reverse what SoT Paulsen did with the first tranche of $350B so let it be.

But we must stop Paulsen and Bush from further policy mismanagement.

Congress must put strings on the next $350 Billion tranche to ensure there is concurrent oversight from and by the incoming presidnent-elect's Administration, i.e., the people who will be in charge of cleaning up the Bush Administrations policy mistakes.

[ECONOMISTA NON GRATA]

"....... 'The Fed can support the economy', if necessary, by engaging in quantitative easing with unsterilized purchases of a set number of Treasuries on a weekly basis. This might partially monetize the deficit, but they can demonetize in the future. This maintains their position as supporting the economy as a whole, not a specific interest group. The latter is fraught with political dangers....."

As my third grade teacher used to say, "they can, but they may not..!" There are severe unintended consequences in monetizing the deficit. Re-leveraging in order to re-establish a discredited model for economic growth would be great folly. We are currently suffering through the consequences of "Foolish Capitalism", and I'm being charitable, re-inflating synthetic asset classes to collateralize (justify) economic growth is unconscionable, not sustainable and represents a great deal of ignorance on the part of those who would advocate such policy.

Such advocates should be denounced for what they are. Fools....!

My best regards,

Econolicious

[don]

mmckinl says...
"There is, as I understand it, remedy for trade imbalances and unfair trading practice in the GATT,"
What might those be? Please cite the ones that would prevent official intervention in currency markets, which is by far the largest source of curent imnbalances.

[bakho]

People keep forgetting that the goal of the Bush administration has always been to do favors that enrich their wealthy patrons. Bush would be delivering a ripe plum to an important political constituency. The fact that it would be bad policy may not even have been considered.

[OhNoNotAgain]

"Right. So you're saying the stimulus measures shouldn't have been reversed?"

Yes, but that isn't the same thing as saying that the stimulus was not reversible, which implies a time horizon of "never". What I'm saying is that, given the size of the stimulus vs. the size of the problem, it was still too early in 1937 to reverse course, and that the trends indicated that it would be reversible if given adequate time. The better alternative would have been to have a properly-sized stimulus to start with, and we would probably not even be having this conversation.

"I'm surprised by the "not","

That "not" wasn't supposed to be there. I do that a lot, i.e. re-arrange sentences and then forget to take out certain parts. It just so happens that it was the most important part in this instance. :-)

[a]

"Yes, but that isn't the same thing as saying that the stimulus was not reversible, which implies a time horizon of "never"."

OK. I can accept that my reading of Duy was a bit harsh.

[change]

Well, I for one hope that they continue flooding the system with liquidity while bailing out sinking ships and in general keeping the whole kit and kaboodle afloat, until the tempest ceases and sunny skies return!

Then they can maintain relaxed banking regulation, re-inflate asset prices, pursue a massive trade imbalance, outsource more jobs, keep rates low low low, keep wages low low low, encourage household debt and debt-fueled consumption, enhance the flow of capital into the financial sector and away from the real, productive economy even more. Now THIS is change you can believe in!

As long as nothing fundamental changes, then we will soon assemble on deck, pull out all the stops, sound the bugles, and sing hosannah while sailing on to prosperity and good times!

[gordon]

Tim Duy: "Neither the Fed or Treasury would be in this position if the latter simply provided agency debt with the full backing of the US government".

Hmmm. That proposal sounds like the US Treasury using Fannie Mae and Freddy Mac as the Mortgage Lending Dept. of a commercial bank. Interestingly, Tim Duy's suggestion looks to me as though it would succumb to the same objections that he raises to the Treasury proposal: it would be hard to raise rates later.

But why? Banks, after all, vary their rates all the time. The problem seems to be the political exposure (the Treasury being the Treasury, after all). So why not set up this new Bank-like function as a separate, new agency? It would be capitalised by the Treasury, for sure, but it wouldn't be encumbered by a mountain of unsaleable "assets" and interbank obligations which drastically reduce its ability to lend to creditworthy Main St borrowers. The money could flow to where it's needed.

Every time I feel like giving up, a post or a commenter gets me going again by inching towards the same idea.

[oc bear]

These policies cannot be make in a vacuum. We are making a number of assumptions about the refinancing of this debt much as underwater homeowners did in 2006. In light of this article http://www.theatlantic.com/doc/200812/fallows-chinese-banker I'd be thinking twice about spending money I didn't have.

[bakho]

Do remember that the Bush Administration is sitting on data that no one else has. I really hope that Obama does a data dump to expose the corruption. Bush only asked for the bailout money in the first place because his patrons saw one last chance to loot the treasury.

Who will write the truth about the most corrupt administrations in history?

[cent21]

Gordon - I didn't read down to that last comment re: support the agency debt as a treasury obligation; which was what I'd reiterated (from a Barrons article a while back).

I suspect we couldn't un-do this move and home mortgages would forever be a federal government function. But as for interest rates, it would simply pull the treasury rate towards the mortgage bond rate, and move both in tandem after they align.

[gordon]

Cent21, I guess that might happen if the US Treasury put a real lot of money into mortgages. My idea was more a limited (I don't know how much would be appropriate, but not open-ended) amount of money into its new "bank", tell the mgt. what rate of return they expect, and leave them to it, as an independent agency. Under this structure, I don't really see that the Treasury rate and the mortgage rate would necessarily move in lock-step.

[Lafayette]

TD: The plan, which is in the development stage, would temporarily use the clout of mortgage giants Fannie Mae and Freddie Mac to encourage banks to lend at rates as low as 4.5%, more than a full point lower than prevailing rates for standard 30-year fixed-rate mortgages.

The key word here is “temporary,” implying a sunset clause. This is a program, however, that screams permanency.

Couldn't agree more.

One of the most important ways of the young to establish families is in first ownership of housing, which augments total demand for residential premises. This is also essential to upward movement in the housing market, because it is first-owners who typically spark the movement onward to larger premises by other owners as well.

It it could be a role of mortgaging GSE's to assist in the entry-level ownership process by means of lower than market rate loans. Why hand over that role to banks and other credit institutions? Look what a mess they've made of it already with stupid subprime loans.

At least the GSE's would make sure that the loan applications were supported by solid worthiness documentation.

Besides, the GSE's could also offer lease/purchase agreements to first-time families, allowing them to build their realty equity slowly over time.

It would seem to be all goodness for GSE's to assume the role of assisting entry-level buyers to get onto the realty merry-go-round.

[gordon]

I don't know why I wrote "bank". I meant bank.

[Lafayette]

The art of economics

kh: OK, first it is worth noting that the "quoting Smith means economics is not science" business employs a completely nutso implicit definition of science.

Economics started life as a philosophy. It became a science when we started applying statistical analysis to the data at hand. One needs to understand the difference between the two, science and philosophy, to comprehend its full versatility -- that is, what economics is and does. It is, in fact, a mixture of both.

Which constitutes the fundamental flaw in current economic thinking , that economics is some "independent science". It is not so independent and, in terms of behaviour, depends upon other sciences - certainly sociology and the psychology of behaviour. Who can otherwise explain the phenomenon of, for instance, "collective frenzy" that occasionally overcomes market actors.

Philosophy is the "rational investigation of the truths and principles of being, knowledge, or conduct". This definition certainly carries the art of economic analysis beyond econometrics. Which will disappoint a great many who practice the art of economics, since econometrics is their stomping grounds.

The foretellers will always abound in economics. How we love to show and tell the world what will happen. Surely prognostication in a subject as fascinating as economics has its need. But I wonder about its merit.

Forecasters go in and go out of fashion. Mostly, however, forecasting economic behaviour is also intuitive, like looking into a crystal ball. To understand what the numbers are telling us, we must understand the collective motivation of those agents lurking behind the numbers. People like you and me. We are not as rational as the science of economics would have us be.

And the real art of economics is explaining it to ordinary people. It is one reason, I suggest, that the last Nobel Laureate in the "science" was thus honored. Not just his scientific reasoning, which was surely work worthy of merit, but his continual contribution to the art of economics by means of explanation.

And explaining the art is a commendable challenge for all who care to indulge. What would debates be without it?

[ken melvin]

Applied and theoretical.