Category Archive for: Monetary Policy [Return to Main]

Thursday, December 03, 2009

Fed Watch: Bubbles and Policy

Tim Duy discusses the type of bubble-popping strategy the Fed ought to pursue:

Bubbles and Policy, by Tim Duy: The Wall Street Journal carried a front page article today detailing changing views at the Federal Reserve regarding the policy treatment of emerging bubbles of speculative activity. Much of the ground has been well tread. Is monetary policy or regulatory policy the best mechanism to address bubbles? I tend to favor the latter category, should we have a regulatory environment that is not essentially captured by those policymakers are supposed to regulate. Interest rate policy is a rather blunt weapon that kills indiscriminately. For instance, I am sympathetic with the view that interest rates were not necessarily too low during the build up of the housing bubble. Indeed, relatively low rates of investment (equipment and software) growth suggests that real rates were actually too high. But capital flowed to housing instead of more productive investment activities because that was the path of least resistance. Policymakers could have chosen to put some grit on that path by, for example, aggressively evaluating lending standards with regards to products such as "Liar's Loans," etc., but chose to follow a hands off approach.
What caught my attention in the article was this passage:
Yet the question of whether and how to tackle bubbles before they burst is becoming a growing concern amid fears of new bubbles developing in commodities markets and in emerging economies. Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did.
I think it is important to recognize what bubbles should be the focus of Federal Reserve concerns. After all, the Fed is charged with maintaining price stability and maximum sustainable employment in the United States. Why should the Fed be concerned with housing prices in Hong Kong or stock prices in Brazil and China? Don't those bubbles fall under the responsible of foreign central banks? It seems clear that in such cases, the extent of the Fed's concerns should be limited to the regulatory arena. Are US based banks lending into those bubbles, thereby setting the stage for negative feedback loops? If so, raise capital requirements on that lending, tighten underwriting standards, etc. Just don't derail the US recovery by raising rates to pop a bubble in Brazil.
I will admit that oil prices can be a bit more tricky. The gains in oil prices seem silly given ongoing evidence that the world is awash in oil. From the WSJ:
Café owner Ken Kennard sees the glut in the global oil market as a potential environmental threat to this sleepy seaside tourist hub.
Mr. Kennard is worried about a fleet of oil tankers -- almost 40 in all, each packing hundreds of thousands of barrels of crude and oil-derived products -- that have anchored several miles off the coast of southeast England in recent months.
The heavy traffic stems from a near-record excess oil supply, a byproduct of the recession, that is prompting producers to stash oil offshore until they can find customers. The excess supply hasn't stopped oil prices from surging almost 80% this year and padding the pockets of big oil producers like Royal Dutch Shell PLC and the Organization of Petroleum Exporting Countries.
To be sure, some of the rise in the price of oil is attributable to the decline in the Dollar, a natural consequence of low US interest rates and an important channel for the transmission of monetary policy. But it is not clear that higher oil prices necessarily yield additional core inflationary pressure given the current institutional arrangements between labor and management. The recent experience has been that individuals were not able to convert high inflation expectations in 2008 into higher wages. Instead, the opposite occurred as consumption sunk and unemployment skyrocketed. All of which means the Fed would need to think long and hard about leaning against the oil price increase if that entailed contractionary monetary policies; the costs are potentially high relative to the benefits. Here again, though, regulators need to be carefully evaluating the nature of lending into the oil space.
My views on this topic have shifted somewhat over the past two years. In early 2008, I was concerned that the Fed's rush to lower rates was contributing to destructive oil price bubble. But, in retrospect, nations that pegged to the Dollar and thus imported the Fed's easy policy were just as much, if not more, to blame, as those central banks failed to maintain policies appropriate for domestic conditions.
In short, the Fed does need to be aware of the full set of consequences of their policy stance. But bubbles abroad should not prevent the Fed from adopting the right policy stance for the US economy. Indeed, many of the bubbles discussed now clearly should not be the responsibility of the Fed.

Wednesday, December 02, 2009

"The Wrong Jobs Summit"

Brad DeLong says the wrong people are meeting at the jobs forum:

The wrong jobs summit, by Brad DeLong, Commentary, The Week: The White House is hosting a jobs summit this week. I, however, cannot but think that ... it will be the wrong people talking about the wrong things.

Let me back up. Ever since the 1930s, economists trying to analyze the determinants of spending have focused on two of the economy’s markets: the market for liquidity and the market for savings. ...
For the government to boost jobs, it must to do something to change the balance of supply and demand in either the market for liquidity or the market for savings. In general, the ... Federal Reserve ... acts to tweak supply and demand in the market for liquidity. The president and Congress act to tweak supply and demand in the market for savings. ...

Right now, if you ask the decisive members of congress—by which I mean the Blue Dog Democrats in the House, or the most conservative Democrats and most liberal Republicans in the Senate —why the president and the Congress are not doing more to reduce unemployment and boost spending and income, the answer you’ll get is ... well, you probably wouldn't get an intelligible answer.

But if you did get an explanation for the lack of congressional action it would go something like this: Attempts to ... boost spending would (a) increase the national debt burden on future taxpayers and (b) lead to a large decline in bond prices and a boost in interest rates. Why? Because businesses would try to increase their liquidity to support higher spending, driving up interest rates, which, in turn, would cause businesses to cut back on investment, thus neutralizing most or all of the stimulative policies.

Similarly, if you were to ask the Federal Reserve why it isn’t doing more to reduce unemployment and boost spending and income, the answer you would get is this: Spending is in no way constrained by a shortage of liquidity..., indeed we have “flooded the zone” with liquidity. As a result, the Fed is disinclined to pursue additional tweaks ... in ... liquidity because it fears such efforts would fuel destructive inflation in the future without boosting employment and spending in the present.

Both of these arguments are comprehensible... But they cannot both be true at the same time. Either the economy is so awash in liquidity that the Federal Reserve cannot do much to boost spending—in which case additional spending by the government won’t generate any substantial rise in interest rates. Or additional government spending will crowd out investment...—in which case the economy is not awash in liquidity, and quantitative easing by the Federal Reserve could do a lot right now to boost spending and employment.

It appears that what we have here is a failure to communicate. ...

Thus we need a jobs summit right now. We need the White House's National Economic Council and key congressional “centrists” on one side and the Federal Reserve Open Market Committee on the other to meet. Those two groups seem to have very inconsistent views of the economic situation. ... Something has to give. If they could reach agreement on whose view ... is likely correct, then a rescue plan—entailing either more government spending or greater liquidity—would become obvious.

Until that “jobs summit” is convened, others are moot.

Saturday, November 28, 2009

"Independent Does Not Mean Unaccountable"

As you might guess given my recent posts defending Fed independence, I agree with this:

The right reform for the Fed, by Ben Bernanke, Commentary, Washington Post: For many Americans, the financial crisis, and the recession it spawned, have been devastating... Understandably, many people are calling for change. ... As a nation, our challenge is to design a system of financial oversight that will ... provide a robust framework for preventing future crises...
I am concerned ... that ... some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures ... would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution's ability to foster financial stability and to promote economic recovery without inflation. ...
The proposed measures are at least in part the product of public anger over ... the rescues of some individual financial firms. The government's actions... -- as distasteful and unfair as some undoubtedly were -- were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity...
Moreover, looking to the future, we strongly support measures -- including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system -- to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is "too big to fail" -- while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.
The Federal Reserve ... did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems. ... There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks...
This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed's unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.
Of course, the ... ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance...
Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities... Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation. ...
 Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

While I agree on the independence and regulation statements, one thing I do wonder about is why there is such widespread acceptance of the idea that we have to live with institutions that are so big that their failure is a threat to the financial system and the economy. The notion seems to be that large, dangerous firms are inevitable, so we need special procedures in place that we hope will allow them to fail without the problems spreading and creating a devastating domino effect. The concern seems to be mainly about having the procedures and authority to allow orderly dissolution of large, dangerous firms rather than preventing these firms from getting too large and too interconnected to begin with.

We need procedures for orderly dissolution in any case -- we didn't think firms were systemically important before the crash, so we need to be ready (e.g., recall the many, many statements that the crisis would be "contained"). But what is the minimum efficient scale (MES) for financial firms? That is, what is the smallest size at which economies of scale and economies of scope are fully realized?

There has been some discussion of this (e.g. Economics of Contempt versus The Baseline Scenario), but it doesn't seem to me that this question is very close to being settled. I want to know how the MES relates to the minimum size where a bank becomes systemically important. If the MES is smaller than the size where banks become systemically dangerous, break them up - their size adds nothing but risk. But if the MES is greater than the minimum dangerous size, then we have a tradeoff to make -- safety for efficiency -- and we may or may not want to force firms to reduce their size and connectedness. It depends upon the tradeoff.

But until we know what these tradeoffs are -- and I don't think we have a good sense of this -- it's very difficult to determine if the costs of breaking up banks and reducing their connectedness are greater than the benefits. I suspect that if the MES is greater than the minimum safe size, then the extra safety from reducing bank size and connectedness would be worth the loss of efficiency, and I'd like to push that position much more than I have to date. But without knowing the MES, the minimum threatening size, the minimum threatening degree of connectedness, and the costs and benefits of reducing size and connectedness, it's hard to do so with confidence.

Wednesday, November 25, 2009

Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes

At MoneyWatch:

Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes, by Mark Thoma: There is a lot of concern about the future course of the economy, and there are two separate worries that are getting confused. The purpose of this post is to distinguish between the two sets of worries, and to discuss whether the worries are justified. ...

Tuesday, November 24, 2009

Fed Watch: Ahead of Black Friday

Tim Duy says -- correctly -- "that a significant portion of policymakers are simply clueless":

Ahead of Black Friday, by Tim Duy: We are embarking once again into that time of the year when reporters around the world become entranced and enthralled with that orgy of consumerism that defines Christmas in America. Soon we will be tracking the ups and downs of holiday sales with a zeal that is unmatched by any other regular economic event. Weary reporters - those who clearly disappointed their editors at some point during the year - will be dispatched to local big box stores across the nation to record the lines forming in anticipation of 5am openings on the fabled Black Friday. We will be bombarded with hundreds if not thousands of conflicting reports regarding the amount and patterns of holiday shopping, leaving overworked and underpaid analysts awash in data as they desperately try to quantify, once and for all, the "true" state of consumer spending - and thus by extension, the true state of the economy - in America.

Oooo, how I have come to loathe this exercise. And yet, here I am again, fretting over the financial state of US households in between checking off items on the Thanksgiving shopping list. It is like a car wreck - you don’t want to watch, but you can't take your eyes off it.

Car wreck is something of an appropriate comparison. Recently I have begun using charts of this sort to depict the current economic environment:



Not fancy econometrics, I know - most of my audiences are not interested in unit root tests.  The point, obviously, is that even as activity creeps upward, the gap between the past and current trajectory of consumer spending is likely still widening. Much, much faster growth is necessary to close that gap. And households as of yet are seeing nothing to convince them their fortunes are set to change, that some Christmas miracle awaits. To be sure, Bloomberg trumpeted today's data:

Confidence among U.S. consumers unexpectedly rose in November as a brightening outlook masked growing concern over joblessness.

How much did the outlook brighten? The story continues:

The Conference Board’s confidence index increased to 49.5 from 48.7 the prior month. The New York-based Conference Board’s index, which focuses on the labor market and purchase plans, averaged 58 in 2008 and 103.4 in 2007.

Not much brighter. Indeed, Economix more accurately reports the dismal mood of consumers, noting:

Over the last 30 years, the index has averaged about 95. In November, it was 49.5, up from 48.7 the previous month.

Yes, for three decades the Conference Board measure of confidence has averaged nearly twice current levels. This tells us something about the strength of consumer spending. Using the parallel measure from the University of Michigan:


Real year over year growth in the 1% range is not going to bring households back to trend anytime soon. To be sure, given the dependence of household on debt financed spending, it is arguably correct that past trends were unsustainable, that the only possible outcome from this mess was a permanent shock to the level of household spending. That, however, is likely cold comfort to the millions of Americans - those not employed by Goldman Sachs, of course - who are just now realizing that their standard of living has shifted permanently lower. Lacking sufficient income gains and the ability to use debt to cover up their relative poverty, households are not seeing a path to a brighter future. And they will increasingly look for someone to blame. No wonder the knives are sharpening for Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke. They are the public faces for an Administration that now owns this economy.

And where are policymakers as we slog through the final month of 2009? The Administration is poised to do virtually nothing:

The White House is lukewarm about proposals by congressional Democrats to introduce broad legislation to create jobs, instead favoring targeted measures that would be less likely to inflate the deficit, administration officials said.

There is as yet no agreement within the White House or in Congress on how to try to curb the U.S. jobless rate. But the differences in opinion suggest that rifts could emerge among Democrats as they wrestle with how to beat back the highest unemployment rate in a generation.

...Hamstrung by the nation's $1.4 trillion deficit and his pledge not to raise taxes on middle-class Americans, Mr. Obama is keen to avoid any measures suggestive of a second, big-ticket stimulus.

Indeed, the failure of the Administration to take bold moves early in the year now cripples it in any attempt to take bold action now. Apparently, the best we can expect now is a "Cash for Caulkers" program that will dribble money into the economy, ensuring that we do little if any better than limp along.

Likewise, monetary policymakers too are caught in the headlights. As has already been widely noted, the minutes of the most recent FOMC meeting reiterated the Fed's eagerness to reverse, not extend, policy:

...Overall, many participants viewed the risks to their inflation outlooks over the next few quarters as being roughly balanced. Some saw the risks as tilted to the downside in the near term, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation. To keep inflation expectations anchored, all participants agreed that it was important for policy to be responsive to changes in the economic outlook and for the Federal Reserve to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.

Read that carefully and realize this: An apparently not insignificant portion of the FOMC believes that there is a terrible risk that banks loosen their credit standards and increase lending at a time when, even if the economy posts expected gain, unemployment remains at unacceptably high levels. Silly me, I thought increased lending was the whole point of the exercise to lower interest and expand the balance sheet. That whole credit channel thing. If not to expand lending during a credit crunch, then what else are they expecting?

I am in shock that this sentence made it into the minutes. One can only conclude that a significant portion of policymakers are simply clueless. Or, more disconcerting, they have lost all faith in the ability of financial institutions to channel capital into activities with any hope of financial returns.  Has the Fed now embraced the view that they manage the economy through little else then fueling and extinguishing bubbles?

At this juncture, only St. Louis Fed President James Bullard is signaling a willingness to at least keep the option of ongoing balance sheet expansion alive:

Federal Reserve Bank of St. Louis President James Bullard wants the Fed to continue to buy mortgage-backed securities beyond the March 2010 cutoff to give policy makers more flexibility as they seek to shepherd the economy toward recovery.

"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.

Mr. Bullard will be a voting member on the interest-rate-setting Federal Open Market Committee in 2010. In its statement after the November FOMC meeting, the central bank reiterated that it will continue to monitor its asset-purchase programs "in light of the evolving economic outlook and conditions in financial markets."

Maybe if unemployment continues to rise Bullard's vote will matter next year. Maybe.

Considering what all this means in light of Black Friday, I tend to think Phil Izzo at the Wall Street Journal is on the right path:

New reports Monday didn’t paint an encouraging picture. The Conference Board released a survey of spending intentions that showed U.S. households expect to spend an average of $390 this season, down 7% from estimates of $418 last year. That number is especially distressing because consumers were unusually pessimistic last year as the financial crisis went into full swing just as holiday shopping was getting underway.

“Job losses and uncertainty about the future are making for a very frugal shopper. Retailers will need to be quite creative to entice consumers to spend, both in stores and online this holiday season,” said Lynn Franco, director of the Conference Board Consumer Research Center.

A separate report from retail-tracking firm NPD Group indicated consumers may not be flocking to the mall for Black Friday. Just 32% of respondents said that they expect to begin their holiday shopping on Thanksgiving weekend or earlier.

Still, more broadly, whether sales gain 2% or 4% this holiday season may have great influence on the animal spirits that govern equity markets, I doubt it would alter much what should be our overall assessment of the economy: Economic activity is now increasing, something for which we should all be thankful this weekend. The alternative would be very unpleasant. But that growth should not lull us into policy complacency with regards to the very real economic stress felt across the nation. By all forecasts, it simply falls far short of what is necessary to restore confidence among households. 2.8% just won't cut it.

"Interest Rates at Center Stage"

Like Tim Duy in the post above this one, David Altig is also puzzled by analysts who, to quote from the FOMC minutes highlighted in Tim's post, that "banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially":

Interest rates at center stage, by David Altig: In case you were just yesterday wondering if interest rates could get any lower, the answer was "yes":

The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end.

"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. ...

The intuition behind this point really is pretty simple. When the economy is struggling  ... the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:

"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. ..."

Demand also appears to be quite weak:

"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."

This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:

The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Not everyone is buying my story, of course, and there is a growing global chorus of folk who see a policy mistake at hand:

Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.

Last weekend, Liu Mingkang, China's banking regulator, criticised the US Federal Reserve for fuelling the 'dollar carry-trade', in which investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets abroad.

The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:

But the quantity of bank lending is decidedly not on the rise:

There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?

If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?

Monday, November 23, 2009

"Bad Forecasters Can be Good Policymakers"

Marty Ellison and Thomas Sargent defend the FOMC:

Bad forecasters can be good policymakers, by Martin Ellison and Thomas J. Sargent, Vox EU: The value of the Federal Reserve’s Open Market Committee (FOMC)1 has recently been questioned in a highly provocative paper by two professors at the University of California, Berkeley. The two professors are husband-and-wife team Christina and David Romer, who are amongst the most influential economists in the world today. Christina Romer is Chair of the Council of Economic Advisers in the Obama administration and a co-author of Obama’s plan for recovery, and David Romer is the author of a very popular macroeconomic graduate textbook. Their paper was published in The American Economic Review, arguably the most influential journal in economics.

The Romers criticize the FOMC because of its poor performance in forecasting economic developments. Specifically, the Romers show that the FOMC is even worse at forecasting than its underlings, the staff of the Federal Reserve System. This is surprising because the FOMC should have all the advantages when forecasting. The FOMC has the staff forecast available when preparing its own forecast and the FOMC presumably knows its own policy objectives and preferences better than anyone else. Despite this, the Romers find that:

  1. It is best to ignore the FOMC forecast when predicting inflation or unemployment.
  2. The FOMC makes larger forecast errors than the staff.
  3. Monetary policy reacts when the FOMC forecast differs from the staff forecast

The Romers use these findings to paint a bleak picture of the FOMC as "not using the information in the staff forecasts effectively" and accuses that the FOMC "may indeed act on information that is of little or negative value". In their opinion, the evidence is sufficiently damning to warrant a radical restructuring of the role of the FOMC in policymaking:

"a more effective division of labor within the Federal Reserve System might be for the staff to present policymakers with policy options and related forecast outcomes, and for policymakers to take those forecasts as given. With this division, the role of the FOMC would be to choose among the suggested alternatives, not to debate the likely outcome of a given policy."

These criticisms are understandable in a world where consumers, workers, policymakers, and researchers perfectly understand the workings of the economy. In such a context, it is difficult to justify the apparently poor forecasting performance of the FOMC. Our defense of the FOMC therefore rests on asking what happens if the FOMC doubts how much the staff understands about how the economy works (Ellison and Sargent 2009). In our view of policymaking, the staff uses state-of-the-art but imperfect economic models to produce the best possible forecasts, but these forecasts are not taken at face value by the members of the FOMC. Instead, the FOMC suspects that the staff's model is imperfect and wants policies that will work well even if the staff model is misspecified.

Continue reading ""Bad Forecasters Can be Good Policymakers"" »

Saturday, November 21, 2009

Fed Watch: The Fed in a Corner

Tim Duy:
The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.
The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence.
Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:
First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.
The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.
To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed's independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.
The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed's desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.
Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.
Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?
Now the Fed's relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:
An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.
The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn't credibility be consistent with a 4% inflation target? And wouldn't such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.
What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:
It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”
But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.
Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.
I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start. Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.

Friday, November 20, 2009

"Threatening the Fed's Independence"

I agree with this:

Threatening the Fed's independence, by By Alan S. Blinder, Commentary, Washington Post: The Federal Reserve's performance in this ... crisis deserves separate grades. For the early crisis period, from the summer of 2007 until a few weeks after the Lehman Brothers failure in mid-September 2008, the Fed's response was uneven. ... But the Fed deserves extremely high marks for its work since then. It has hit the bull's-eye regularly under very trying circumstances.
In academia and in the financial markets, the overwhelming attitude is: Hurrah, and thank goodness, for Ben Bernanke, who gets kudos for his boldness, creativity and smarts.
But not in the political world. The Fed is extremely unpopular in Congress and is facing hostile and potentially detrimental actions from both sides of the aisle. ... Christopher Dodd ... would clip the Fed's regulatory wings substantially.
Worse, legislation that just proceeded through the House Financial Services Committee could imperil the Fed's ability to conduct an independent monetary policy. With more than two-thirds of the House co-sponsoring the so-called Paul bill, prospects for floor passage unfortunately look good.
The ... bill would subject the Fed's monetary policy decisions and its dealings with foreign central banks to audit by the Government Accountability Office (GAO) -- which normally acts on requests from Congress. Under current law, these aspects of Fed business have been explicitly ruled off-limits (though the rest is auditable).
Is this extension of the GAO's reach, and hence that of Congress, a good idea? If you believe we'd get better monetary policy with decisions made by Congress in open debate, or heavily influenced by congressional opinion, it certainly is. But how many actually believe that? Very, very few. ...
The ... GAO is already authorized to examine most aspects of Fed operations. It can audit the Fed's special financial arrangements for Bear Stearns, AIG, Citigroup and Bank of America -- to name the most prominent examples. ...
But a congressional audit of monetary policy -- remember, the GAO works for Congress -- could easily develop into something quite different. ... It is entirely predictable that some in Congress will be unhappy with the Fed's decisions... Would we welcome a critical GAO audit of monetary policy, which members of Congress could use to browbeat, perhaps even to intimidate, members of the Fed's rate-setting body, the Federal Open Market Committee? ... Would we like Congress to override the Fed's decisions and set monetary policy -- which is its constitutional right? I think and hope not.
An independent monetary policy ... is one of the great and enduring achievements of the Progressive Era. ... Passage of the Paul bill would be a step away from independent monetary policy and a step toward ending the Fed as we know it. That is a step we should not take.

Monday, November 16, 2009

"Sudden Financial Arrest"

Ricardo Caballero says that when there is a sudden failure of the financial system, governments should not let "fuzzy moral hazard reasoning" stop them from providing "massive" amounts of "credible public insurance and guarantees to financial transactions and balance sheets." He argues that "it is neither credible nor desirable to refuse to assist the private sector":
Sudden financial arrest, by Ricardo Caballero, Vox EU: “Sudden cardiac arrest (SCA) is a condition in which the heart suddenly and unexpectedly stops beating. When this happens, blood stops flowing to the brain and other vital organs…. SCA usually causes death if it’s not treated within minutes….”  – US National Institute of Health
There are striking and terrifying similarities between the sudden failure of a heart and that of a financial system. In the medical literature, the former is referred to as a sudden cardiac arrest (SCA). By analogy, I refer to its financial counterpart as a sudden financial arrest (SFA).
When an economy enters an episode of SFA, panic takes over, trust breaks down, and investors and creditors withdraw from their normal financial transactions. These reactions trigger a chain of events and perverse feedback-loops that quickly disintegrate the balance sheets of financial institutions, eventually dragging down even those institutions that followed a relatively healthy financial lifestyle prior to the crisis. In this article I draw on the parallels between SCA and SFA to characterize the latter and to argue that a pragmatic policy framework to address SFA requires a much larger component of systemic insurance than most policymakers and politicians currently support.

Continue reading ""Sudden Financial Arrest"" »

Fed Watch: Should the Fed Be Doing More?

Tim Duy:

Should the Fed Be Doing More?, by Tim Duy: Monetary policy looks to be at a protracted standstill - or even arguably becoming less accommodative as purchases of long dated securities draws to a close - despite incoming information that points toward persistently high unemployment rates and an ongoing disinflationary environment. Is policy stability the consequence of changing economic conditions, a perceived ineffectiveness of nontraditional policy, or a willingness of policymakers to be constrained by conventional policy limitations in the absence of impending financial doom? My sense is that all three elements are in play.
It is pretty clear that economic conditions changed dramatically mid-year as inventory correction and policy stimulus brought the recession to a close, at least if measured by growing output. To be sure the sustainability of the gains are in question. I hold little hope that growth could have be sustained in the absence of the policy efforts to date, and the Administration is likely starting to realize that it underplayed its hand this year, offering far to little stimulus to effect stabilization from the all important jobs perspective. Calculated Risk sees growing potential for a second stimulus package (in spirit if not in name), the support for which will gain as concerns about midterm elections grow. Still, from the perspective of monetary policymakers, positive growth after such a long recession could only be met with a sigh of relief and, perhaps inevitably, a willingness to pause and assess the implications and impact of policy to date.
The problem with pausing, however, is that a combination of maximum sustainable growth and price stability are in fact the Fed's objective, we seem to be falling short on both measures. Unemployment continues to climb, nonfarm payrolls continue to fall, and core-PCE inflation continues to decelerate. Moreover, Fed forecasts suggest that these trends will continue for literally years. Leaving aside inflation fears that seem to be largely contained in a handful of what I think are crowded trades (gold and TIPS), what should the Fed be doing on the basis of actual, incoming data? Have they truly hit the limits of policy? This brings be to an ongoing debate between Paul Krugman and Scott Summner, with the recent participation of Joe Gagnon.
A starting point for further analysis is Krugman's assertion that conventional policy has been brought to a standstill. Zero is zero:

Continue reading "Fed Watch: Should the Fed Be Doing More?" »

Saturday, November 14, 2009

"The Ghost in the Recovery Machine"

Robert Shiller:

The ghost in the recovery machine, by Robert J Shiller, Commentary, Project Syndicate: The International Monetary Fund’s October World Economic Outlook proclaimed that, “Strong public policies have fostered a rebound of industrial production, world trade, and retail sales”. The IMF, along with many national leaders, seem ready to give full credit to these policies for engineering what might be the end of the global economic recession.
National leaders and international organisations do deserve substantial credit... But one also suspects that world leaders have been too quick to claim so much credit for their policies. After all, recessions generally tend to come to an end on their own, even before there were government stabilisation policies. ...
Economic theorists long ago developed models that describe how recessions end on their own. ... Some of these factors, rather than just the actions taken by governments and multilateral organisations, plausibly played a role in the current economic improvement. Unpredictable human psychology also plays a role. Such factors, indeed, matter very much for the economic outlook, and for judging the success of the recovery programme.
One can start with the stock-market turnaround since March of this year, which has been stunning. ... Moreover, this same sharp turnaround occurred in many countries – and for many assets, including oil prices, gold, and, in some countries, residential real estate.
Any solid understanding of the causes of this turnaround is likely to prove elusive. ... A market boom, once started, can continue for a while as a sort of social epidemic, and can foster inspiring “new era” stories that are spread by news media and word of mouth. The stories themselves help magnify the boom, becoming part of the feedback that sustains it.
The agreements reached at recent G-20 meetings stand as one of these stories, for they suggest a new era of international co-operation and economic professionalism – a narrative that has probably been exaggerated in the psychology of recovery.
The G-20 story is particularly salient in the developing world, for the international recognition that the G-20’s expanded role has given to developing countries is highly resonant psychologically.
Beyond that, stories of highly profitable banks paying huge bonuses to their executives have also inspired people to think that things are not so bad in the business world. Anger at these profits and bonuses only tends to increase the contagion of the story.
But any such speculative boom is inherently unstable... It was, in fact, an excessive speculative boom in the stock market and the housing market that got us into this financial mess in the first place.
To be sure, governments and multilateral institutions made some reasonable attempts to restore confidence. But they did not “engineer” a recovery. They got lucky, and the G-20, as well as the governments that instituted stimulus packages, are currently in a honeymoon period of apparent success.
Where our still-ailing world economy goes from here is as uncertain as the speculative markets that played such an important role in both the financial crisis and the recovery. We can only wish that formulating economic policy were as clear-cut as, say, mechanical engineering. It is not: a host of poorly understood natural cyclical factors play a role, and so do the vagaries of human psychology.

He may not want to give much credit to policy, but I would not have wanted to go through this crisis without the aggressive monetary and fiscal policy measures that policymakers put into place (and given the state of the labor market, even more was and is needed).

Thursday, November 12, 2009

Why The Federal Reserve Needs To Be Independent

At MoneyWatch:

Why The Federal Reserve Needs To Be Independent, by Mark Thoma

Wednesday, November 11, 2009

"The Fed Is Already Transparent"

Anil Kashyap and Frederic Mishkin are worried that the Ron Paul proposal to audit the Fed will "cripple policy making":

The Fed Is Already Transparent, by Anil Kashyap and Frederic Mishkin: Under the banner of increasing Federal Reserve transparency, Congressman Ron Paul has sponsored a bill that would subject the Fed's monetary policies to an audit by the Government Accountability Office (GAO). The bill is a veiled attempt to undermine the Fed's independence. If it passes, it will cripple policy making...
Weakening the Fed's independence now might raise the risk of inflation, which would cause borrowing costs to rise and would lower prospects for a strong economic recovery. ...
Fortunately, Congress is considering an amendment to the bill that would prevent the negative consequences of the original Paul legislation. This amendment, put forward by Rep. Mel Watt (D., N.C.) would change the focus of the bill by instructing the GAO to audit the new lending facilities at the Federal Reserve that were authorized under the 13(3) "unusual and exigent circumstances" clause of the Federal Reserve Act. The 13(3) lending authority, which had not been used by the Fed since the Great Depression, was the basis for many of the most controversial decisions made during the crisis, including the rescue of AIG and the establishment of new lending facilities.
This audit would involve oversight of the operational integrity of these facilities' accounting, internal controls, and protection against losses. It would also disclose the borrowers from these facilities one year after the facilities are closed. The audit would produce new, important information that is not otherwise available and would play to the strengths of the GAO. And the amendment would exempt the Fed's normal monetary policy actions from the audit.
We strongly support an amendment of this type because it will increase the Fed's accountability without compromising its monetary independence. We also believe that the lag in disclosing the names of borrowers would enable Congress to have appropriate oversight over these facilities without compromising their effectiveness. Earlier disclosure would diminish the efficacy of these facilities because of the so-called stigma problem: If borrowing from emergency lending facilities is immediately made public, the markets would know that the borrowers might have financial difficulties, which would make it harder for the borrowers to operate.
No one can be fully comfortable with all the unprecedented actions that the Fed has taken to limit the damage from the financial crisis. We appreciate the frustration of the public and members of Congress who want a better understanding of what has happened. ... But the Paul bill, as originally written, won't help with these goals and will only stifle the recovery.

I think one of the problems the Fed is facing is that people do not feel like the Fed is operating on their behalf, they don't think that the Fed's actions are in their best interests, and they don't feel like they have any way to do much about it.

So how could we fix this? One way would be to have each party choose a candidate for Fed chair during presidential election years, and then have the public vote for the candidate of their choice at the same time they pick the president (but this seems likely to mimic the presidential outcome independent of the particular candidates). The Fed governors could all be elected in this way, and then serve their usual 14 year terms without the possibility of reelection. The hope is that this would give voters some sense of control over the process.

I don't think that proposal is all that good, but the point I am trying to make is that one of the Fed's most valuable attributes, its independence, also causes the public to feel as though it has very little say in how policy is conducted, and this leads to distrust of the Fed's motives and actions. Why should the fate of the entire economy be decided by twelve people who aren't accountable to anyone? If we can somehow get the public more vested in the process without sacrificing the Fed's independence, that would be helpful. But most of the ways that I can think of to implement accountability through the ballot box also undermine independence, and for me independence is an important attribute to preserve.

Monday, November 09, 2009

"Not All Bubbles Present a Risk to the Economy"

Frederic Mishkin says there's no reason to worry that a new bubble is inflating:

Not all bubbles present a risk to the economy, by Frederic Mishkin, Commentary, Financial Times: There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no. ...
Asset-price bubbles can be separated into two categories. The first and dangerous category is ... “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.
Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. ... Indeed, this is what the recent crisis has been all about.
The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fueled by a feedback loop between bank lending and rising equity values... This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. ...
Because the second category of bubble does not present the same dangers ... as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. ... Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. ...
But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense... At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.

I've mostly heard the worries expressed in terms of inflation. I think the risks are asymmetric. Raising rates too soon and sending the economy tumbling back into a recession is much more costly than an outbreak of inflation that persists until the Fed can bring it back under control.

Saturday, November 07, 2009

"A New Approach to Gauging Inflation Expectations"

Good news for those worried about inflation: A new measure of inflation expectations indicates that "longer-term inflation expectations remain near historic lows, in the neighborhood of 2 percent":

A New Approach to Gauging Inflation Expectations, by Joseph G. Haubrich, Economic Commentary, FRB Cleveland: This Economic Commentary explains a relatively new method of uncovering inflation expectations, real interest rates, and an inflation-risk premium. It provides estimates of expected inflation from one month to 30 years, an estimate of the inflation-risk premium, and a measure of real interest rates, particularly a short (one-month) rate, which is not readily available from the TIPS market. Calculations using the method suggest that longer-term inflation expectations remain near historic lows. Furthermore, the inflation-risk premium is also low, which in the model means that inflation is not expected to deviate far from expectations.

Policymakers at the Federal Reserve and other central banks continually face the “Goldilocks” question—is monetary policy too tight, too loose, or just right? It would help if the central bank knew what real interest rates and expected inflation actually were, but these are not easy to observe. Visible indicators of these factors, such as Treasury inflation-protected securities (TIPS), survey measures of expected inflation, and nominal interest rates, are useful, but none of them alone quite tells the whole story. Nominal interest rates change with both real rates and expected inflation; survey measures ask about only a few horizons, and measures of inflation expectations coming from inflation-protected securities conflate expectations with risk premia. Uncovering a purer measure is possible, but it takes a careful combination of the available data and the application of economic theory.

This Economic Commentary explains a relatively new method of uncovering inflation expectations and real interest rates and describes what light those numbers can shed on the current status of the U.S. economy.

People’s expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whether they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that, in the aggregate, affect the entire economy: whether they wait for the milk to go on sale or buy it before the price goes up.

Real interest rates also play a key role in many economic decisions. When businesses invest—or don’t—in plants and equipment, when families buy—or don’t—a new car or dishwasher, they are making judgments about the real return on the object and the real cost of borrowing. As such, real interest rates can be an important guide to monetary policy. As Alan Greenspan once explained,1 keeping the real rate around its equilibrium level (which is determined by economic and financial conditions), has a “stabilizing effect on the economy” and it helps direct production “toward its long-term potential.”

Continue reading ""A New Approach to Gauging Inflation Expectations"" »

Wednesday, November 04, 2009

Brad DeLong: Slouching Toward Sanity

Brad DeLong says government action during the crisis may have prevented another Great Depression:

Slouching Toward Sanity, by J. Bradford DeLong, Commentary, Project Syndicate: In America today ... the Republican congressional caucus is just saying no: no to short-term deficit spending to put people to work, no to supporting the banking system, and no to increased government oversight or ownership of financial entities. And the banks themselves are back to business-as-usual: anxious to block any financial-sector reform and trusting congressmen eager for campaign contributions to delay and disrupt the legislative process.
I do not claim that policy in recent years has been ideal. If I had been running things 13 months ago, the United States Treasury and Federal Reserve would have let Lehman and AIG fail – but I would have discounted their debt for cash at face value, provided that the debt also came with sufficient equity warrants. That would have preserved the functioning of the system while severely punishing the banking and shadow-banking systems’ equity holders...
If I had been running things 19 months ago, I would have nationalized Fannie Mae and Freddie Mac and ... shifted monetary and financial policy from targeting the Federal Funds rate to targeting the price of mortgages. Ever since 1825, the purpose of monetary policy in a crisis has been to support asset prices to prevent the financial markets from sending to the real economy the price signal that it is time for mass unemployment. Nationalizing Fannie and Freddie, and using them to peg the price of mortgages, would have been the cleanest and easiest way to accomplish that.
Nevertheless, policy over the past two and a half years has been good. A fundamental shock bigger than the one in 1929-1930 hit a financial system that was much more vulnerable to shocks than was the case back then. Despite this, unemployment will peak at around 10%, rather than at 24%, as it did ... during the Great Depression... Nor will we have a lost decade of economic stagnation, as Japan did in the 1990’s. ...
It is worth stepping back and asking: What would the world economy look like today if policymakers had acceded to the populist demand of no support to the bankers? What would the world economy look like today if Congressional Republican opposition to the Troubled Asset Relief Program program and additional deficit spending to stimulate recovery had won the day?
The only natural historical analogy is the Great Depression... That is the only time when (a) a financial crisis caused a widespread, lengthy, and prolonged reinforcing chain of bank failures, and (b) the government neither intervened nor passed the baton to a consortium of private banks to support the system as a whole.
It is now 19 months after Bear Stearns failed ... and industrial production stands 14% below its peak in 2007. By contrast, 19 months after the Bank of the United States ... failed on December 11, 1930 ... industrial production ... was 54% below its 1929 peak.
Opponents of recent economic policy rebel against the hypothesis that an absence of government intervention and support could produce an economic decline of that magnitude today. After all, modern economies are stable and stubborn things. Market systems are resilient... A 54% fall in industrial production between its 2007 peak and today is inconceivable – isn’t it? ...
The problem, though, is that all the theoretical reasons to think that depressions as deep as the Great Depression simply do not happen to market economies applied just as well to the 1930’s as they do to today.

But it did happen. And it could have happened again.

[Traveling: Preset to post automatically.]

Wednesday, October 28, 2009

Woodford on Financial Markets

Part of an interview of Michael Woodford:

Q&A: Economist Woodford on Fed and Rate Expectations, RTE: ...Given the importance of financial stability for the wider economy, do you think financial stability should play a greater or explicit role in the Federal Reserve’s policy strategy?
Woodford: No doubt, the Fed should give greater attention to financial stability than it did in the past. One should try and set up a framework to safeguard financial stability, and it may very well be that ... central banks should play a key role. But, ideally, one would be scrutinizing the risks developing and adjust capital requirements accordingly, rather than using monetary policy to respond to these risks. You’ve got to realize that pretending you can do everything with one tool means you won’t do any of them too well.
Should the Fed be more reactive — leaning against the wind -toward sharp moves in asset prices, such as house prices and equities? Should the Fed include a broader range of asset prices in its policy strategy?
Woodford: I’m not too sympathetic of that way of putting things. Using monetary policy to prevent certain moves in asset prices wouldn’t be a terribly effective tool. And to the extent that it would be effective, it’d involve important costs for the rest of the economy. It’d be particularly bad for the Fed to be saying “we have a view on where asset prices should be, and we’re going to get them there by using monetary policy.” Instead, the focus of the Fed’s investigation should be on what kind of risks financial institutions get themselves into — not on asset prices as such.
The Fed has downgraded the role of money and credit aggregates in its policy strategy. Given the more recent developments, do you think it’s now time to reconsider, or reverse the move?
Woodford: The issue that deserves more attention is monitoring risks to financial stability and identifying possible systemic risks. Unfortunately, traditional monetary and credit statistics aren’t that closely related to the things you really ought to be measuring. For example, lending by non-bank entities has played an important role in the recent real-estate euphoria. Given the emergence of new kinds of institutions and financing arrangements, you cannot simply revert to the old statistics people used to look at decades ago. There should be more research on understanding which measures are in fact the valuable indicators.

The last section is important. Many people have said that we cannot tell when a bubble is inflating (and thus when risks are increasing), but how hard have we actually tried? Have we seriously looked at data on, to name just one element of what I have in mind, leverage cycles? Do we know how leverage cycles relate to crises, that kind of knowledge that years of hard work by a variety of researchers brings about? Some people likely know the answer to this, or at least have some idea about this, but it's not data you'll find in standard sources such as FRED. As another example, what about measures and data on the degree of financial market connectedness? This can be measured in principle, but little effort has been devoted to doing so. Even traditional measures such as P/E ratios and Q-ratios haven't received the attention they deserve.

Until we dig in and try seriously to develop new empirical measurements that can monitor and identify risks, measures intended to inform us when risks are increasing to dangerous levels, we won't know if we can identify bubbles or not. I understand that financial theory says such predictions are impossible, and this has led people to shy away from such work, but that result relies upon assumptions that may not be true. The crisis has revealed the shaky foundation those models rest upon, so it's no  longer an excuse for not trying, or, as in the past, for dismissing work along these lines as unimportant and a waste of time.

Monday, October 19, 2009

"Fed Chief Cites Trade Imbalances’ Role in Crisis"

Ben Bernanke:

Fed Chief Cites Trade Imbalances’ Role in Crisis, by Edmund Andrews, NY Times: Ben S. Bernanke, the chairman of the Federal Reserve, said on Monday that global trade imbalances played a central role in the global economic crisis and warned that the both the United States and fast-growing Asian nations needed to do more to prevent them from recurring.
“We were smug,” Mr. Bernanke said of the United States, saying the American financial regulatory system was “inadequate” at managing the immense inflows of cheap money from China and other countries that had huge trade surpluses.
Though the Fed chairman acknowledged that trade imbalances have declined sharply as a result of the crisis, mainly because trade itself plunged, he warned that American foreign indebtedness will aggravate the imbalances once again unless the United States reduces its soaring federal budget deficit.
“The United States must increase its national saving rate,” he said. “The most effective way to accomplish this goal is by establishing a sustainable fiscal trajectory, anchored by a clear commitment to substantially reduce federal deficits over time.” ...
By the same token, he said, Asian countries needed to rely less on exports and more on their consumption at home for their economic growth. One way to increase Asian household consumption, he said, would be for countries like China to increase social insurance programs and reduced the uncertainty that currently hangs over many consumers. ...
With the Asian economy expanding at an annualized rate of 9 percent in the second quarter of this year, and China’s economy expanding at rates of more than 10 percent, Mr. Bernanke said, “Asia appears to be leading the global recovery.”
But the Fed chairman warned that the United States-led crisis was fueled in large part by huge inflows of cheap money to the United States from countries like China that were trying to recycle dollars from their huge trade surpluses.
The Fed chairman noted that global trade and financial imbalances have narrowed considerably since the crisis began... But he cautioned that the imbalances could widen out again as economic growth revives. While the United States has to tighten its belt by saving more and consuming less, China and other Asian countries need to increase their consumer spending in order to promote faster domestic economic growth.
Mr. Bernanke avoided what was in many ways the elephant in the room: the value of the United States dollar. The dollar has dropped sharply in recent weeks against the euro and the Japanese yen, which has helped increase American exports by making them cheaper in some foreign markets. But the dollar has not budged in more than a year against China’s renmimbi...

There were three important factors in the crisis, global imbalances (Bernanke's savings glut), low interest rate policy by the Fed, and the failure of markets and regulators to provide the checks and balances necessary to prevent the crisis from occurring. The global imbalances combined with the Fed's low interest rate policy led to the massive build up of global liquidity looking for a safe, high return home, and the market and regulatory failures allowed the extra liquidity and the false promise of high, safe returns to concentrate risk in the mortgage markets.

Bernanke focuses on two of these causes of the crisis, global imbalances and regulatory problems (market failures get less attention), but he does not focus on the Fed's role in the crisis at all. So let me say that I hope the Fed is more willing to consider popping bubbles as they inflate than it has been in the past. But that is not the main point I want to make.

The crisis, according to Bernanke, occurred when the excess global liquidity overwhelmed financial markets -- it was too much for either regulators and markets to handle. Think of a hurricane hitting a city that is so strong and powerful that it overwhelms levees and other flood/damage control mechanisms. That's essentially Bernanke's explanation, the shock was too big for the mechanisms we had in place to control the damage. One solution to the hurricane problem is to hope that such large shocks don't happen again and simply rebuild the same defenses as before, and another response is to recognize that such shocks will occur every so often and to build the stronger defensive measures needed to get ready.

Bernanke acknowledges that the defenses, i.e. the regulation of financial markets, need to be strengthened, but he seems to place a lot of emphasis on reducing the size of future shocks (reduce the budget deficit, have Asian countries consume more to reduce imbalances, etc.). I think that is fine, we should reduce the danger as much as we can, but we need to accept that global imbalances are possible, that a shock of this magnitude could and probably will happen again at some point in the future, and we need to make sure that markets don't fail like they did this time (i.e. we need to fix the bad incentives in these markets). But more importantly, we need to strengthen our regulatory defenses in anticipation of the next big shock. If it's fair to blame the government for not having levees, etc. ready for Katrina, if we insist that the defenses need to be strengthened going forward, then the same argument can be made in financial markets. Despite our best efforts to reduce the chances that a large shock will occur through deficit reduction and higher domestic saving rates, we should expect that global imbalances will rear their head again at some point, and the system cannot be overwhelmed again like it was this time.

For that reason, I'm a bit disappointed in Bernanke's willingness to point fingers at external causes and say other countries must change their consumption habits, or to blame budget deficits, at a time when financial regulation is coming onto the legislative agenda (though he didn't say anything about the exchange rate). Those are important problems and I don't mean to dismiss them, but right now financial regulation is being considered by congress, and it's essential that we get the regulations in place that can withstand the next big shock. Blaming external forces for the crisis will make it easier for opponents of regulation to blame China and other countries, and that gives legislators an excuse to give in to pressure (e.g. campaign contributions) from the financial industry to go soft on regulatory changes.

Update: Paul Krugman comments on Bernanke's remarks: America’s Chinese disease (not quite what you think).

Wednesday, October 14, 2009

"Reviewing the Recession: Was Monetary Policy to Blame?"

David Altig says "it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate" due to a failure to base monetary policy rules on models that include a well developed credit channel:

Reviewing the recession: Was monetary policy to blame?, by David Altig: In a recent speech given at the University of South Alabama, Federal Reserve Bank of Atlanta President Dennis Lockhart added his voice to what is now the general consensus: "I agree with all who are declaring that a technical recovery is under way."
There is still much work to be done, of course, not least the continuing examination of just what led to the recession and how a repeat performance can be avoided. One theme of this examination appeared in last week's Financial Times:
"It is certainly true that the most recent bubble, its bursting and the Fed's actions in the aftermath have inspired existing critics and recruited new ones. The first charge is that interest rates under Alan Greenspan, [current Fed Chairman Ben] Bernanke's predecessor, were kept too low for too long, contributing to a bubble of easy credit."
Here is an exercise that that I find intriguing. Suppose we try to estimate, as closely as we can, the actual interest rate decisions of the Federal Open Market Committee (FOMC) over the period spanning the beginning of Greenspan's tenure to the present. It turns out that by using an approach based not only on measures of inflation and actual output relative to potential but also on the lagged fed funds rate, you can actually get pretty darn close to statistically describing what the FOMC did:
I'm going to resist the temptation to call this approach a "Taylor rule." The estimating "rule" used here does in fact include realizations of inflation and a measure of the output gap (that is, a measure of how different gross domestic product is from its potential). These are the essential ingredients of the Taylor rule, but not the source of the close fit evident in the chart above. Over the period covered by the chart, you could have done a pretty good job mimicking the actual federal funds rate outcomes in any given month using knowledge of the previous month's rate. (If you are interested in the details of the estimating rule, you can find them here.)
The interpretation of the tendency for today's federal funds rate to generally follow yesterday's rate—sometimes referred to as interest rate smoothing—is controversial. Glenn Rudebusch (from the Federal Reserve Bank of San Francisco) explains:
"Many interpret estimated monetary policy rules as suggesting that central banks conduct very sluggish partial adjustment of short-term policy interest rates. In contrast, others argue that this appearance of policy inertia is an illusion and simply reflects the spurious omission of important persistent influences on the actual setting of policy."
Rudebusch is decidedly in the second camp, but for our purposes here the exact interpretation may not be that important. Though I am glossing over some not insignificant caveats—such as the difference between final data and the information the FOMC had to react to in real time—the chart above suggests that whatever the underlying structure of policy decisions, after the fact the FOMC appears to have behaved in an extraordinarily consistent way over the period extending from the late 1980s. This observation, in turn, suggests to me that there was nothing all that unusual about monetary policy in 2003 once you account for the state of the economy.
Which leads me to my main point on the chart above: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with "proven" success as it set interest rates through the dawning of the new millennium.
There is, of course, the possibility that the pattern of the funds rate depicted in the chart above was incomplete all along in the sense that whatever variables are explicit and implicit in the estimated rule, they did not include information to which the FOMC should have responded. In calmer times, the story would go, not including potentially pertinent information was not much of a problem. Eventually the missing-data chickens could come home to roost. The prime omitted variable suspect would, of course, be some sort of asset prices.
Scratch any gathering of macroeconomists these days and out will bleed a steady stream directed at incorporating credit and financial market activity into thinking about the aggregate economy. The necessity of proceeding with that work was emphasized by no less an authority than Don Kohn, vice chairman of the Federal Reserve Board of Governors, speaking at just such a gathering of macroeconomists last week:
"It is fair to say, however, that the core macroeconomic modeling framework used at the Federal Reserve and other central banks around the world has included, at best, only a limited role for the balance sheets of households and firms, credit provision, and financial intermediation. The features suggested by the literature on the role of credit in the transmission of policy have not yet become prominent ingredients in models used at central banks or in much academic research."
I will admit that economists were not exactly ahead of the curve with this agenda, but prior to 2007 it was not at all clear that detailed descriptions of how funds moved from lenders to borrowers or how short-term interest rates are transmitted to longer-term interest rates and capital accumulation decisions were crucial to getting monetary policy right. Models without such detail tended to deliver policy decisions not far from the sort depicted above, and, as I noted, they seemed to be working quite well in terms of macroeconomic outcomes.
Thus far, one of the lessons from models in which financial intermediation is taken seriously is that interest rate spreads or stock prices or other asset prices do become part of the policy rate recipe. Your response might well be something along the lines of "duh." You are entitled to that opinion, and I won't push back too hard. But it is yet far from clear that the financial crisis can be explained by a misstep in the setting of the federal funds rate caused by the failure to make whatever adjustments might have been indicated by the inclusion of pertinent financial variables in implicit rate-setting rules of thumb. Furthermore, early versions of research I have seen that combines capital regulation policy and interest rate policy suggest that the macroeconomic consequences of getting the former wrong may be much greater than the consequences of getting the latter wrong. To me, that conclusion has the ring of truth.

I have advocated targeting a price index that includes asset prices as part of the policy rule, but I share the view that this likely would not have been enough by itself to stop the crisis from occurring. Targeting a broader price index might have tempered the downturn some, or even quite a bit -- it sounds like I am more optimistic than David along about how well this might work -- but changes in regulation must be an essential component of reform if we are going to prevent problems from reoccurring in the future.

However, I think that not having models with detailed descriptions of the credit transmission mechanism was costly. The New Keynesian model that is used to inform monetary policy decisions relies upon wage and price rigidities to explain how changes in monetary policy and/or financial market conditions are transmitted to the broader economy. Thus, the price/wage rigidity transmission channels must serve as a proxy for the effects that work through credit (or other) channels, and it is not evident to me that they are adequate proxies for this task (e.g. what would a government spending multiplier look like within a model that had a richer set of connections between financial markets and the real economy?). Whether or not having such models would have prevented the crisis is an open question, and I won't push back too hard against David's view of this, but not having such models once this crisis hit did, I think, make it more difficult for us to evaluate the appropriate policy response. Not having the models we needed led to uncertainty from policymakers that showed up in the seemingly, if not actual ad hoc and trial and error nature of many of the policy responses.

Tuesday, October 13, 2009

The Bank Lending Channel

Many economists, Ben Bernanke foremost among them, have argued that monetary policy has effects that are independent of the traditional interest rate channel (where an increase in the money supply lowers the real interest rate and induces more investment and consumption spending). The alternative models include a "credit channel" for monetary policy, which is often further divided into financial accelerator models and bank lending channel models.

One class of models within the bank lending channel branch relies upon a difference in the availability of credit for large and small firms. If smaller businesses have fewer sources of credit than large firms (who can issue bonds, stocks, commercial paper, etc.), then a credit shock induced by policy or some other factor will have an asymmetric negative effect on the activity of large and small firms. Since smaller firms have trouble getting credit from non-bank sources, a disruption in bank credit can cause them to contract their activities much more than large firms. (If all firms have perfect substitutes for bank credit, e.g. borrowing from foreigners on the same terms, then monetary policy cannot affect real output through the bank lending channel. The point of this research is that some firms do not have close substitutes for bank credit, and therefore monetary policy can have real effects.) According to this, there's some evidence that these effects are operable:

Credit Tightens for Small Businesses, NY Times: Many small and midsize American businesses are still struggling to secure bank loans, impeding their expansion plans and constraining overall economic growth...
Bankers worry about the extent of losses on credit card businesses as high unemployment sends cardholders into trouble. They are also reckoning with anticipated failures in commercial real estate. Until the scope of these losses is known, many lenders are inclined to hang on to their dollars rather than risk them on loans to businesses in a weak economy...
Bankers acknowledge that loans are harder to secure than in years past, but they say this attests to the weakness of many borrowers rather than a reluctance to lend.
“Banks want to lend money,” said Raymond P. Davis, chief executive of Umpqua Bank, a regional lender based in Portland, Ore. “The problem is the effect that the recession is still having on us. Some of these businesses are still trying to come out of it. For them to go to a bank, if they are showing weak performance, it is harder to borrow.”
As the financial crisis has largely eased in recent months, big companies have found credit increasingly abundant, with bond issues sharply higher.
But for ... many smaller companies,... borrowing remains tough. ...

Recall this graph posted here not too long ago (discussed further at the source):


It may be hard to see at first glance, but the graph shows the "disproportionate effect the recession has had on very small businesses." In 2001, only 9% of the job losses came from small businesses, while in the current recession - where credit problems are a much larger factor - small business accounts for 45% of lost jobs. Part of the discussion of the graph notes this comment from William Dudley, the president of the Federal Reserve Bank of New York:

In a speech yesterday,... he said:

"For small business borrowers, there are three problems. First, the fundamentals of their businesses have often deteriorated because of the length and severity of the recession—making many less creditworthy. Second, some sources of funding for small businesses—credit card borrowing and home equity loans—have dried up as banks have responded to rising credit losses in these areas by tightening credit standards. Third, small businesses have few alternative sources of funds. They are too small to borrow in the capital markets and the Small Business Administration programs are not large enough to accommodate more than a small fraction of the demand from this sector."

It will take more careful analysis to make the case that the bank lending channel has been important in this recession, but it is suggestive.

Monday, October 12, 2009

Paul Krugman: Misguided Monetary Mentalities

We need to avoid thinking and acting in ways that got us into trouble in the past:

Misguided Monetary Mentalities, by Paul Krugman, Commentary, NY Times: One lesson from the Great Depression is that you should never underestimate the destructive power of bad ideas. And some of the bad ideas that helped cause the Depression have, alas, proved all too durable: in modified form, they continue to influence economic debate today.
What ideas am I talking about? The economic historian Peter Temin has argued that a key cause of the Depression was ... the “gold-standard mentality.” By this he means not just belief in the sacred importance of maintaining the gold value of one’s currency, but a set of associated attitudes: obsessive fear of inflation even in the face of deflation; opposition to easy credit, even when the economy desperately needs it, on the grounds that it would be somehow corrupting; assertions that even if the government can create jobs it shouldn’t, because this would only be an “artificial” recovery.
In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs.
But we’re past all that now. Or are we? ...[A] modern version of the gold standard mentality ... could undermine our chances for full recovery.
Consider first the current uproar over the declining international value of the dollar. The truth is that the falling dollar is good news. For one thing, it’s mainly the result of rising confidence: the dollar rose ... as panicked investors sought safe haven in America, and it’s falling again now that the fear is subsiding. And a lower dollar is good for U.S. exporters...
But if you get your opinions from, say, The Wall Street Journal’s editorial page, you’re told that the falling dollar is a ... sign that the world is losing faith in America (and especially, of course, in President Obama). ...
And ... there are worrying signs of a misguided monetary mentality within the Federal Reserve system itself. In recent weeks there have been a number of ... Fed officials ... calling for an early return to tighter money... What’s ... extraordinary ... is the idea that raising rates would make sense any time soon. After all, the unemployment rate is a horrifying 9.8 percent and still rising, while inflation is running well below the Fed’s long-term target. This suggests that the Fed should be in no hurry to tighten — in fact, standard policy rules ... suggest that interest rates should be left on hold for the next two years or more, or until the unemployment rate has fallen to around 7 percent.
Yet some Fed officials want to pull the trigger on rates much sooner. To avoid a “Great Inflation,” says Charles Plosser of the Philadelphia Fed, “we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.” Jeffrey Lacker of the Richmond Fed says that rates may need to rise even if “the unemployment rate hasn’t started falling yet.”
I don’t know what analysis lies behind these itchy trigger fingers. But it probably isn’t about analysis, anyway — it’s about mentality, the sense that central banks are supposed to act tough, not provide easy credit.
And it’s crucial that we don’t let this mentality guide policy. We do seem to have avoided a second Great Depression. But giving in to a modern version of our grandfathers’ prejudices would be a very good way to ensure the next worst thing: a prolonged era of sluggish growth and very high unemployment.

Saturday, October 03, 2009

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop

Has Federal Reserve policy been able to break the "adverse feedback loop"?:

Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop by Danielle DiMartino Booth and Jessica J. Renier, Economic Letter, Vol. 4, No. 7, September 2009, Federal Reserve Bank of Dallas: An adverse feedback loop takes hold when a weakening financial system and a slowing economy feed off each other. A crisis or shock curtails lending, hobbling the real economy; the more production and employment falter, the more lending contracts, causing further harm to the economy. The result is a downward spiral of business and financial activity.

The Federal Open Market Committee (FOMC) warned of the danger in late January 2008, when few analysts recognized that a recession had begun the previous month. It noted “the especially worrisome possibility of an adverse feedback loop; that is, a situation in which a tightening of credit conditions could depress investment and consumer spending, which, in turn, could feed back to a further tightening of credit conditions.”[1]

The financial crisis validated the FOMC’s concern, igniting what has become the worst post-World War II economic downturn in terms of length and, by some measures, depth and breadth. Housing market troubles began in 2006 and deepened well into 2009. As the economy sank into recession, an October 2008 Fed survey found that two-thirds of banks had tightened standards for the highest-quality residential mortgages and over three-quarters had reined in business lending. The credit contraction sent spending down and unemployment up, exacerbating threats to the financial sector and dimming prospects for stability in housing.

Arresting the adverse feedback loop could prove to be the seminal challenge of early 21st century monetary policymaking. Since sounding the alarm in January 2008, the Fed has taken a series of actions—many unprecedented—to prevent additional damage to financial markets and restore lending activity. These policies have had some success in loosening the grip of the adverse feedback loop and may have finally positioned the economy for growth. Still, doubts linger. The risk remains that the actions may prove insufficient to put the economy on a clear path to rising employment and stable prices.

Continue reading "Fed Policy in the Financial Crisis: Arresting the Adverse Feedback Loop" »

Thursday, October 01, 2009

Fed Watch: Hawkishness Dominates

Continuing with the same theme, but with monetary rather than fiscal policy, Tim Duy is worried about unwarranted hawkishness:
Hawkishness Dominates, by Tim Duy: As I await the employment report, I am reflecting on the flow of information over the past week and find myself somewhat dismayed by the apparent policy implications. The spate of FedSpeak in recent days leaves one with the uneasy feeling that monetary policymakers are more willing to use unconventional monetary policy to support Wall Street than Main Street. The most hawkish appear eager to normalize policy at the earliest opportunity possible, and even the dovish, grasping onto green shoots, appear to think they have done enough to support recovery. It is as if the FOMC has concluded that the risks are now entirely one-sided toward inflation. To be sure, Bernanke & Co. have shifted direction often during the past two years. But the FOMC looks to be developing something of a blind spot with regard to downside risks to the economy, suggesting that even if the economy stagnates in a jobless recovery, the bar to further easing is very high.
Governor Kevin Warsh fired the shot across the bow last week, first with a Wall Street Journal op-ed, followed by a speech that included the key paragraphs:
Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative.
"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.
While Warsh does note that weak economic conditions would defer tightening, the message is clear: we are looking to tighten, and will do so aggressively when economic activity firms. Moreover, we will do so preemptively, which means we are looking for opportunities prior to the emergence of very solid data.
Note one of the concerns identified by Warsh:
In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal--and the economy has returned to self-sustaining trend growth--they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.
Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade's debt bubble? Considering the question always draws me back to this chart, which for me epitomizes the difference between the 1990s and the 2000s:
The 1990s saw a remarkable period of sustained, high levels of investment in equipment and software. In contrast, a sustained period of very low interest rates during this decade was barely able to coerce firms to invest in the high single digits. That, in my mind, is a critical problem, reflecting low expected returns to capital investment. In effect, the policy error might not have been low rates. Indeed, rates do not look to have been low enough to stimulate sufficient investment demand to absorb the productive capacity of the nation, the classic Keynesian problem:
This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.
Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.
But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate....
With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.
This line of argument leads one to believe that withdrawing monetary stimulus would be a significant policy error, especially if investment growth remains constrained as we saw this decade. In fact, it would lend additional credence to reports that the Fed needs to do much, much more - a massive, unsterilized expansion of the balance sheet - should they even hope to stimulate sufficient investment demand to absorb underutilized labor. Instead, FOMC members appear to be concerned that stimulative policy will be the root cause of the next financial crisis. That, however, appears to me to confuse monetary with regulatory policy. The former should speak to inducement to invest, while the latter speaks to protecting against significant misallocations of capital.
Following the Warsh speech, Vice Chair Donald Kohn looked to tamp down expectations of an imminent rise in rates:
Although economic conditions have apparently begun to improve--partly in response to the extraordinary steps the Federal Reserve and other authorities have taken--resource utilization is quite low, inflation is subdued, and continuing restraints on credit are likely to constrain the speed of recovery. For that reason, as the FOMC stated last week, exceptionally low interest rates are likely to be warranted for an extended period. Given the highly unusual economic and financial circumstances, judging when the time is appropriate to remove policy accommodation, and then calibrating that removal, will be challenging. Still, we need to be ready to take the necessary actions when the time comes, and we will be.
Still, like Warsh, Kohn looks determined to find an opportunity to remove accommodation. This despite expected high rates of unemployment. From Bloomberg:
Federal Reserve Chairman Ben S. Bernanke said U.S. economic growth next year probably won’t be strong enough to “substantially” bring down the jobless rate, which may remain above 9 percent at the end of 2010.
“Most forecasters including the Fed are currently looking at growth in 2010, but not growth so rapid as to substantially lower the unemployment rate,” Bernanke said in response to questions at a House Financial Services Committee hearing today in Washington. Growth of 3 percent means the rate would “still probably be above 9 percent by the end of 2010,” Bernanke said.
Interesting how the Fed is encouraging expectations of policy withdrawal even though unemployment rates will remain unacceptably high through 2010. And, if above 9 percent at the end of next year, certainly unacceptably high during 2011 as well. Richmond Federal Reserve President Jeffrey Lacker even goes one step further in a Bloomberg interview:
The Federal Reserve will need to raise interest rates when the economic recovery is “firmly” in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.
“I am going to be looking for when growth reestablishes itself firmly enough that it is clear real interest rates need to rise,” Lacker said today in a Bloomberg Radio interview. “I think the growth outlook, particularly the consumer spending outlook, are more fundamental than labor-market conditions.”
Seriously, raising rates even if unemployment is 10%? LACKER SAYS THIS ON THE DAY WE GET CORE PCE INFLATION SLIDING TO 1.3% Y-O-Y! This redefines the term "hawk."
From where does this fear of inflation emanate? That brings us to perma-hawk Philadelphia Fed President Charles Plosser:
Unfortunately, slack was poorly measured and turned out to be not as significant as first estimated. Thus, the Fed's monetary expansion led to rising inflation for the balance of the 1970s. One lesson learned during this episode is that inflation expectations can matter a great deal, and if they become unanchored — that is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability — then inflation can rise quickly regardless of the amount of so-called slack in the economy. The price we paid to regain control of inflation and the Fed's credibility to do so came in the form of the 1981-82 recession and was a steep one.
Consequently, just as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels. The issues of when and the pace at which we unwind the extraordinary measures taken during the financial crisis and recession are ones that are high on my list of priorities and are the subject of ongoing discussions within the Fed.
The experience of the 1970s is such a tired and faulted analogy. To generate a wage-price inflation spiral, you need to explain the mechanism by which rising inflation expectations (which don't exist anyway) get translated into high wages. I do not see that current institutional arrangements in the US allow this; nor do we see it in the data:
One could at least wait for significant - or any, for that matter - year over year gains in unit labor costs before declaring that we are at the doorstep of the 1970's. Moreover, the seeds of that inflation did not sprout overnight; the signs were evident but ignored in the late 1960's. Only in Plosser's mind exists the need for an imminent withdrawal of policy.
Bottom Line: The data this week has not been supportive of a rapid exit from accommodative policy. Indeed, the opposite could very well be the case. Despite this, Fed officials, albeit to varying degrees, are uniformly signaling that the actions to expand the balance sheet are only temporary and will be reversed absolutely as soon as possible, which only undermines the stimulative potential of those actions. This is definitely not quantitative easing, and uncomfortably harkens back to the fear of inflation that constrained policy at the Bank of Japan. It is interesting that Fed Chairman Ben Bernanke has worked so hard to avoid a repeat of that experience yet appears ready to risk repeating it nonetheless.

Saturday, September 26, 2009

"Auditing the Fed"

Bruce Bartlett and Barry Ritholtz on Ron Paul's call for the Fed to be audited:

Auditing the Fed, by Bruce Bartlett: Ron Paul finally got his wish yesterday and the House Financial Services Committee held a hearing on his legislation to audit the Federal Reserve. There were only two witnesses: the Fed's general counsel and Tom Woods, a historian from the Ludwig von Mises Institute. The testimony is available here.
I urge those curious about this issue to read both statements. I think it is abundantly clear that this is a crackpot idea. The Fed is already thoroughly audited in every area except two: monetary policy and dealings with foreign central banks. The only purpose of having additional audits of the Fed is to undermine its independence precisely with regard to these two areas. If Woods presents the best argument for doing so, the argument is very shallow indeed.
Whatever one thinks of the Fed's policies in recent years--and there certainly are grounds for criticism--there is no reason whatsoever to believe that undermining its independence and putting the Congress in control of monetary policy--Ron Paul's goal--would improve matters at all. Indeed, there is every reason to believe that full congressional control of monetary policy would be a disaster. Instead of getting Switzerland-like stability, as Paul foolishly imagines, the more likely result would be Zimbabwe-like hyperinflation.
In the end, I agree with Barry Ritholz that whatever the Fed's failings, those of Congress are vastly worse.  As he put it in explaining why he didn't testify yesterday:
I was invited to testify this week to the House Financial Services Committee about reform and regulation.
I politely demurred.
While I have been critical of the Federal Reserve (especially the Greenspan years), my beef with them has been their judgment and decision-making process. Congress, on the other hand, is a whole different matter. Its not their judgment, but rather, the fact they are owned not by the American people, but by lobbyists, and corporate interests. They have become structurally deformed.
How weird is it for me, who spent so many pages blaming the Fed for a lot of the recent crisis, to find myself in a position of defending them from outside political pressure? The choice we face is the recent Fed regime of secrecy, nonfeasance, irresponsibility, and easy money — versus something possibly likely to be a whole lot worse. ...
If the Fed has been a major source of problems, Congress is much worse. They were the great enablers of the crisis, readily corruptible, bought and paid for by the banking industry. I find Congress to be the worse of two evils — lacking in objectivity, incapable of producing legitimate regulatory review. ...

As I've made clear in the past, I also think that auditing the Fed, or reducing its independence in other ways, is a bad idea. The strange marriage of the populists and libertarians on this issue has given it more momentum that I expected, but hopefully not enough to carry the day.

Thursday, September 24, 2009

Fed Watch: Rushing to the Exits?

Tim Duy is worried that the inflation hawks on the FOMC are gaining too much influence (Update: This was written before the WSJ editorial from Federal Reserve Governor Kevin Warsh saying that the Fed may move faster and more aggressively than people expect, a statement that Tim anticipates in his comments below):

Rushing to the Exits?, by Tim Duy: A missive from a former colleague prompted me to reconsider the Fed's behavior in light of their most recent forecast and the evolution of economic data. That in turn started to shed light on some little pieces of information sitting on my computer that I knew were important, but just couldn't quite see how they fit. And has left me somewhat concerned that the Fed may be more likely than I believed to stifle the pace of the recovery by, at a minimum, halting the growth of policy accommodation.

The Fed gave and took at the September FOMC meeting. Policymakers reiterated support for their near zero rate policy, while offering a slightly hawkish nuance that was noted by Jon Hilsenrath at the Wall Street Journal:

Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.

Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.

The shift in wording, then, appears to be the result of some more hawkish FOMC members, illuminating the smidgen of truth behind a rumor that was circulating earlier this month. From Across the Curve:

I was not planted here at my work station yesterday but roaming through the myriad of emails I receive it seems that one of the reasons for the weakness yesterday was a report by an advisory firm, Smick Medley, that the Federal Reserve at its upcoming meeting would comment on and discus raising rates sooner rather than later.

Given the FOMC's own forecast, any consideration of tightening seems silly:


While the Fed may find it necessary to raise the estimate of GDP growth for this year on the back of a relatively sharp inventory correction, unemployment is almost certain to exceed the range for this year, and even if it didn't, it remains unacceptably high through 2011. Moreover, the downward pressure on pricing has increased in recent months, bringing the core-PCE forecasts into question:


On top of this, the concern of some hawks that inflation expectations will suddenly trigger a wage price spiral seems simply silly unless one can explain how, given current institutional arrangements in the US, price increase will translate into wage increases. Indeed, unit labor costs are giving you the exact opposite story:


And employment compensation for the private sector is likewise trending down:


Sure, one could turn to the commodity markets for inflation signals, but I think the critical price there is oil, which is finding the $72 mark extremely challenging to break through. That may have something to do with reports that quantity supplied to running well ahead of quantity demanded:

Crude oil declined for a second day in New York after a U.S. government report showed a larger-than- expected increase in fuel stockpiles in the world’s largest energy-consuming nation.

Gasoline stockpiles in the U.S. surged 5.4 million barrels last week, the Energy Department said. That’s more than the 500,000-barrel increase forecast in a Bloomberg News survey of analysts. Diesel and heating oil inventories jumped 2.9 million barrels, double what was expected. Crude oil supplies climbed 2.86 million barrels last week.

“The market has a glut of crude oil and refined products right now,” Victor Shum, a senior principal at consultants Purvin & Gertz Inc. in Singapore, said in a Bloomberg Television interview. “If we get a big correction in equities, the loss of optimism in that demand recovery will continue to drive down prices.”

And even if oil broke through the $72 mark, if $150 oil couldn't trigger a wage-price spiral, what is $80 oil going to do? The Fed's seeming eagerness halt monetary accommodation also runs in contrast to forecasts that they really need to be doing much, much more to support growth. From Goldman Sachs (no link):

In recent months, we have argued that the zero lower bound (ZLB) on nominal interest rates represents a meaningful constraint on monetary policy in particular and economic policy in general. Specifically, combining a variant of the Taylor Rule for monetary policy with our forecast for growth and inflation, we have long concluded that the Federal Open Market Committee (FOMC) would want to push its target for the federal funds rate significantly below zero – to levels of -6% or lower – if it had that option.

The -6% number suggests a much, much more aggressive expansion of the balance sheet, while the Fed in contrast is willing to let the current programs play themselves out over the course of the next six months.

So, given the unemployment outlook is sad, wage growth continues to deteriorate, core inflation is falling, and we seem to lack an institutional arrangement to force higher prices, should they even emerge, into higher wages, what is the Fed thinking? Should they really be worried about winding down programs? Are they really confident enough that an inventory correction that will undoubtedly spike GDP numbers will also translate into sustainable growth? Even knowing full while that after the last recession, the US economy languished despite the inventory correction, only to be revived on the back of the housing bubble? In effect, the Fed looks to be putting much weight on the cyclical story playing out, while ignoring the structural story of the necessity of asset bubbles to fuel growth. Pondering this, a little noticed Bloomberg report jumped to mind:

Federal Reserve policy makers are concerned about making “a colossal policy error” leading to higher inflation if they don’t withdraw extraordinary monetary stimulus soon enough, said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor.

“When you talk to committee members you see a little bit more angst than you’d expect,” Meyer said in an interview yesterday at the Kansas City Fed’s monetary policy conference in Jackson Hole, Wyoming. “In public they say they’re confident they’ll get it right, they’re confident they have the tools to get it right. But when you talk to them in private there’s some concern there.”

So, added to the Medley rumor, the pieces start to fall together. Internally, perhaps a wide range of FOMC members believe, in their hearts if not in the data, that they have gone so far that the balance of risks have shifted toward inflation. But this is troubling; the basis for the inflation story falls entirely on the Fed's expansion of its balance sheet. Just a meager $1.3 trillion expansion give or take in the wake of an over $11 trillion decline in household wealth? And the bulk of that expansion is sitting in excess bank reserves? Not really much of an inflation story. But why else are they so eager to withdraw? Just to prove to critics they can? With much fanfare, from Bloomberg today:

The Federal Reserve and U.S. Treasury said they’re scaling back emergency programs aimed at combating the financial crisis, reducing support for firms that now have an easier time getting funding.

The central bank today said it will further shrink auctions of cash loans to banks and Treasury securities to bond dealers, reducing the combined initiatives to $100 billion by January from $450 billion. The Treasury has “begun the process of exiting from some emergency programs,” the chief of the government’s $700 billion financial-rescue fund said separately.

Bottom Line. The Fed is moving toward the exit as they look toward the conclusion of their securities purchases programs. But it is not clear that such a move is justified by their own forecasts or the inflation/wage/employment data. There may be an internal fear they have gone too far, a fear that the hawks can exploit. To be sure, I see no reason to expect the Fed will raise rates for a long time. And the Fed maintains it has policy flexibility, claiming to be ready to revive asset purchases should economic or financial conditions justify. But I now suspect the bar for renewed expansion of Fed accommodation may be much higher than I had anticipated. And that the dominant push for expansion would have to come from financial market conditions, while they would be willing to tolerate persistently high unemployment rates so long as U. Michigan inflation expectations say elevated, regardless of the actual inflation data.

Wednesday, September 23, 2009

As Expected, Fed Keeps Target Rate on Hold

[Money Watch link] After its rate setting meeting today, the Fed announced that it "will maintain the target range for the federal funds rate at 0 to 1/4 percent," and that it "continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." Very few analysts thought the Fed should raise the rate, calls for higher rates came from a few inflation hawks but that's about it, and nobody I know of expected the Fed to change its interest rate policy. So no surprises here.

Of more interest are the Fed's characterization of economic conditions, its plans for the special facilities and other non-standard monetary policy options it has put in place to deal with the crisis, and its exit strategy.

Continue reading "As Expected, Fed Keeps Target Rate on Hold" »

Monday, September 21, 2009

Fed Watch: Even With Growth, A Long, Hard Road

Tim Duy looks forward to the Federal Open Market Committee rate setting meeting later this week:

Even With Growth, A Long, Hard Road, by Tim Duy: The economic backdrop behind this week's FOMC meeting is almost startlingly refreshing. The recession likely ended at some point during the summer, an occasion effectively confirmed this week by the highest authority in the land, Federal Reserve Chairman Ben Bernanke. For those still in denial, industrial production posted its second consecutive gain, and there is little doubt that GDP will post a significant positive reading for the third quarter. Finally, in a seemingly impossible development, the retail sales report suggested that consumers eagerly converged onto the nation's shopping establishments in August. The economic summary paragraph in the upcoming FOMC statement will certainly identify the positive economic developments since their last gathering. But will improving conditions be sufficient to prod the FOMC to adopt language that points in the direction of tighter policy? Almost certainly not. The exit from the recession is clearly much too tenuous - and much too dependent on fiscal and monetary life support - to allow the risk of premature policy withdrawal. Moreover, even if economy activity were on a self-sustaining upward trend, the hole we are climbing out of is so deep that it could literally be years before resources are sufficiently utilized as to allow for significant policy reversal.
Let's start off with the good news. The stabilization of consumer spending that we saw begin earlier this year is supporting an inventory correction story. Firms are no longer chasing spending plans down, which alone gives some boost to final output. Moreover, some restocking is likely occurring; anecdotally, I hear from firms that are surprised to learn that their suppliers are running low on inventories despite weak final sales. Restocking is also a consequence of the "Cash for Clunkers" program, as auto firms look to rebuild depleted inventories. And, the August retail sales report points to sales gains across a wide range of retail stores. All in all, the inventory cycle looks to be making a pretty clear turn, offering support to activity:
In addition, the strength of fiscal stimulus is coming to bear on the economy. And one cannot discount the additional boost delivered by the first time homebuyers credit, which helped support a bottom into the new housing market this summer. Adding everything together, it is not difficult to see why forecasters are looking for growth in the range of 3 to 4% this quarter. Not surprisingly, industrial production numbers are turning:

Continue reading "Fed Watch: Even With Growth, A Long, Hard Road" »

Sunday, September 20, 2009

"What the Economy Needs Now"

Lawrence Mishel of the Economic Policy Institute (link)

Thursday, September 17, 2009

"The Triumph of Central Banking?"

Paul Volcker discusses the usefulness of macroeconomic policy:

Paul A. Volcker In Conversation with Gary H. Stern, Minneapolis Fed (pdf): ...Economic knowledge and central banking
Stern: You’ve obviously been involved for a long time directly with the Federal Reserve, at senior levels, from the mid ’70s and even earlier than that in the Treasury as well. In your view, has macro policy or monetary policy changed significantly over those many years? Or are we still pretty much at the state of knowledge, and is the state of our responses pretty much where it was?
Volcker: [Laughter] It’s interesting you ask that question because I recently commented to some of my economist friends that I’m not aware of any large contribution that economic science has made to central banking in the last 50 years or so.
Our ability to forecast is still very limited. The old issues of the relative role of fiscal and monetary policies are still debated. Markets are certainly more complex, and some of the old approaches toward monetary control seem less relevant. Recent events have certainly illustrated limitations in our understanding of the economy.
The advent of floating exchange rates, which partly reflects a shift in academic thinking, has certainly been important, but the underlying problems of policy seem familiar.
Right now, we are in the midst of a very large unsettled question. Are the unprecedented Federal Reserve and other official interventions in financial markets a harbinger of the future? Is reasonable financial stability really dependent on such government support?
On the technical side, there has been continuing change in the approach of central banks to the market, away from more quantitative approaches like the volume of bank reserves to much more emphasis on precise control of short-term interbank interest rates. The point is that in establishing and conducting policy, you need some means of reaching operational decisions. Those approaches have differed and evolved. But none of that breaks new conceptual ground.
Stern: Well, let me explore that a little further because I happened to be reading some of the [Federal Open Market Committee meeting] transcripts from the 1970s, after the oil price shock but before you became chairman, so neither of us was at the meetings.
Volcker: Well, actually I was at the meetings from 1975 as president of the New York Fed.
Stern: Of course, right. So these transcripts were a little earlier in the ’70s. Anyway, all the talk was about “cost-push” inflation and how monetary policy couldn’t do anything about it. That was not only the consensus in the United States, but Federal Reserve officials who were traveling in Europe and talking with their counterparts heard the same message. Looking back at that from today’s perspective, I think you’d be hard-pressed to find policymakers or economists who would accept that view.
Volcker: No, I think that’s basically true. You know, the clearest articulation of that point of view was in Burns’ farewell speech, “The Anguish of Central Banking,” which was a long lament about how the Federal Reserve couldn’t deal with inflation because of all the political and economic pressures, and wasn’t that too bad. He made that speech at an IMF [International Monetary Fund] meeting about two months after I had become chairman.
So, when I gave my valedictory speech, I called it “The Triumph of Central Banking?” I put a question mark at the end. Somebody ought to write about this, how central banks became so important in the public mind and in their own mind in the past 10 years or so. Independence of central banking became part of the approach in almost every country. And I think you can make a case that it’s been a little overdone, that central banks suffer from hubris, like everybody else.
Stern: I think that might be right, and I want to explore that a little bit, but I would say, you’re personally responsible for that, because not only did you and your colleagues at the Fed succeed in bringing down inflation, but you did so when the general consensus was that nothing could be done about inflation, that we just had to live with it. So I think your success in bringing down double-digit inflation helped to establish the significance of monetary policy and central banks.
Volcker: You know, talking about whether economists have learned anything or contributed to monetary policy in the last several decades, Chairman Bernanke gave a speech at Princeton right after he took office which was an intellectual review of economists’ views of monetary policy.
I don’t recall all the substance of it, but he said basically that economists were ahead of central bankers in understanding important issues, going back to the 1920s and before and certainly in the Great Depression. But he went on to say that there was one area where the policymakers were ahead of the economists.3
It was an interesting comment. I don’t know if he made it because he knew I was in the audience at the time. But he said something to the effect that the academic economists had to learn from central banking about the importance of maintaining a strong sense of price stability. He has translated that into inflation targeting, I guess.
The effectiveness of policy
Stern: You mention that you thought, maybe now, or certainly in the last 10 years, there was a point where we had too much confidence, too high a level of expectations for monetary policy. I’ve been thinking about that as well, because obviously we’ve had a very significant financial shock to the economy, and one of the consequences of that has been a long and deep recession, and high unemployment. You’re familiar with all this. There seems to be a view that policy, both monetary and fiscal, can somehow fix this quickly. I guess I’m very uncomfortable about that.
Volcker: I don’t think it can. I’ve been dealing with this in a political environment. The other day I’d gotten a paper prepared for the presidential advisory board that I’m the chairman of. It talked about housing and mortgages and so forth. It concluded, “We’ve got to do something to support housing,” so it recommended means of spurring mortgage creation.
But then it went on, “We’ve got to do something to support consumption.” There I begin to wonder. We can do something to support consumption, but are we really dealing with the underlying pressures in the economy without permitting a relative decline in consumption to proceed?
Stern: Right.
Volcker: It’s not an easy question, if you try to explain that. Mr. Obama is out there every day having to explain things and would he say, “Well, I don’t think I want to push a big stimulus on consumption”? I don’t think he’s about to say that, but he probably should be saying that.
Stern: The pressure seems to be now from the press I follow, “You’ve got to find policies that will create jobs,” and again, who could object to that? But it’s not obvious that there are a lot of tools that would be effective at that in the short run.
Volcker: No, I think this period we’re going through is kind of a curative process; it’s a purgative. There is something to the old view that you have to have a recession once in a while to deal with the excesses of a boom. And I think we had excesses in this boom, for sure, and we’ve got a really difficult recession. You want to relieve the sharp edges, without any question, but I don’t think it’s been possible to pump it up so there’s no recession at all.
Stern: Yes, and part and parcel of recessions are resource reallocations. And we clearly had too many resources in housing and probably too many in finance and in autos—just to name three obvious places.
Volcker: Exactly. We need a recovery that emphasizes investment and competitiveness, and that ends or reduces our dependence on foreign borrowing. ... [Interview conducted July 15, 2009.]

Tuesday, September 15, 2009

Who Has All the Answers?

Justin Fox:

Hyman Minsky didn't have all the answers, by Justin Fox: Economist Hyman Minsky, who never got much attention while he was alive, has become one of the big celebrities of this financial crisis. In Sunday's Boston Globe, Stephen Mihm has the best account of Minsky's life and significance that I've seen so far. A sample:
Today most economists, it's safe to say, are probably reading Minsky for the first time, trying to fit his unconventional insights into the theoretical scaffolding of their profession. If Minsky were alive today, he would no doubt applaud this belated acknowledgment, even if it has come at a terrible cost. As he once wryly observed, “There is nothing wrong with macroeconomics that another depression [won't] cure.”
But did Minsky really have much to add beyond the crucial insight that financial systems are inherently unstable? His former student Eric Falkenstein, responding on his blog to Mihm's article, isn't so sure:
I was Minsky's TA while a senior at Washington University in St.Louis in 1987, and took a couple of his advanced classes, which regardless of the official name, were all just classes in Minskyism. He was a maverick, but perhaps a bit too much, being a little too dismissive of others, as he hated the traditional Samuelson/Solow Keynesians as much as the Friedmanite Monetarists. He always thought a market collapse was just around the corner. The S&P was 250 when I took his course, it went to 1500 in 2007 and then back to 735 in 2009. Does that prove he was right all along? ...
The problem ... is that his top-down theory is rejected by the data. Aggregate leverage ratios do not closely correspond to business cycles. If Minsky took microeconomics more seriously he could have made his theory more relevant, by noting that crises tend to occur in specific subsets in the economy: in 1990, hotels and Commercial real estate, in 2001, high tech, in 2008, mortgages. The mistake is not one made in aggregate, but in different sectors each recession. By noting these areas, but not the aggregate economy, had too much leverage, and depended on expected future increases in collateral value, he might have been more successful proselytizing his colleagues. But he was a traditional Keynesian, who liked to look at aggregate equations, like Profits=Investment + Deficits + Net Imports.
I think the broader point here is that there is no one Theory That Explains Everything in economics. Neoclassical economics certainly doesn't explain everything. Neither does Minskyism. Nor Austrian business cycle theory. Nor complexity theory. It seems like the best approach would be an eclectic one that takes lots of different economic models into account. But eclecticism doesn't get you far in academia.

There is no grand, unifying theoretical structure in economics. We do not have one model that rules them all. Instead, what we have are models that are good at answering some questions - the ones they were built to answer - and not so good at answering others.

If I want to think about inflation in the very long run, the classical model and the quantity theory is a very good guide. But the model is not very good at looking at the short-run. For questions about how output and other variables move over the business cycle and for advice on what to do about it, I find the Keynesian model in its modern form (i.e. the New Keynesian model) to be much more informative than other models that are presently available (as to how far this kind of "eclecticism" will get you in academia, I'll just note that this is exactly the advice Mishkin gives in his textbook on monetary theory and policy).

But the New Keynesian model has its limits. It was built to capture "ordinary" business cycles driven by price rigidities of the sort that can be captured by the Calvo model model of price rigidity. The standard versions of this model do not explain how financial collapse of the type we just witnessed come about, hence they have little to say about what to do about them (which makes me suspicious of the results touted by people using multipliers derived from DSGE models based upon ordinary price rigidities). For these types of disturbances, we need some other type of model, but it is not clear what model is needed. There is no generally accepted model of financial catastrophe that captures the variety of financial market failures we have seen in the past.

But what model do we use? Do we go back to old Keynes, to the 1978 model that Robert Gordon likes, do we take some of the variations of the New Keynesian model that include effects such as financial accelerators and try to enhance those, is that the right direction to proceed? Are the Austrians right? Do we focus on Minsky? Or do we need a model that we haven't discovered yet?

We don't know, and until we do, I will continue to use the model I think gives the best answer to the question being asked. The reason that many of us looked backward for a model to help us understand the present crisis is that none of the current models were capable of explaining what we were going through. The models were largely constructed to analyze policy is the context of a Great Moderation, i.e. within a fairly stable environment. They had little to say about financial meltdown. My first reaction was to ask if the New Keynesian model had any derivative forms that would allow us to gain insight into the crisis and what to do about it and, while there were some attempts in that direction, the work was somewhat isolated and had not gone through the type of thorough analysis needed to develop robust policy prescriptions. There was something to learn from these models, but they really weren't up to the task of delivering specific answers. That may come, but we aren't there yet.

So, if nothing in the present is adequate, you begin to look to the past. The Keynesian model was constructed to look at exactly the kinds of questions we needed to answer, and as long as you are aware of the limitations of this framework - the ones that modern theory has discovered - it does provide you with a means of thinking about how economies operate when they are running at less than full employment. This model had already worried about fiscal policy at the zero interest rate bound, it had already thought about Says law, the paradox of thrift, monetary versus fiscal policy, changing interest and investment elasticities ina  crisis, etc., etc., etc. We were in the middle of a crisis and didn't have time to wait for new theory to be developed, we needed answers, answers that the elegant models that had been constructed over the last few decades simply could not provide. The Keyneisan model did provide answers. We knew the answers had limitations - we were aware of the theoretical developments in modern macro and what they implied about the old Keynesian model - but it also provided guidance at a time when guidance was needed, and it did so within a theoretical structure that was built to be useful at times like we were facing. I wish we had better answers, but we didn't, so we did the best we could, and the best we could involved at least asking what the Keynesian model would tell us, and then asking if that advice has any relevance today. Sometimes if didn't, but that was no reason to ignore the answers when it did.

Thursday, September 10, 2009

Fed Watch: Riding The Fed Train

Tim Duy looks at how the Fed is likely to respond to recent data that "continues to point to a turning point in economic activity":

Riding The Fed Train, by Tim Duy: It is difficult if not impossible to deny the firming of economic data in recent months. But that firming has been inexorably tied to a host of fiscal and monetary stimulus measures. Fiscal stimulus is dependent upon political will and Treasury's ability to sell debt cheap. And anything less than 4% on the 10-year bond looks pretty cheap historically, especially given the mountain of paper issued by the US Treasury. On the monetary side, the Fed looks poised to sustain that stimulus until a potentially inflationary situation emerges. From policymaker's perspective, that remains a distant threat. What - and how many - global distortions will emerge as a result of the Fed's extended zero-interest rate policy? And what will bring the new house of cards crashing down?
The flow of data continues to point to a turning point in economic activity. The ISM manufacturing report pushed above the 50 mark, rising to its highest level since the summer of 2007 on the back of a surge in new orders. Likewise, the nonmaufacturing counterpart moved higher as well, although the gain was not as dramatic, and overall activity failed to cross the boundary into expansion. Firmer activity in manufacturing suggests that the July gain in industrial production will be repeated this month. Adding to the manufacturing upswing are leaner inventories, with the inventory to sales ratio falling to 1.38 from its cycle high of 1.46 in January of this year. Even that much beleaguered housing sector is showing signs of life, with housing starts apparently bottoming in the spring; the cessation of the freefall is certain to support third quarter GDP. Finally, households are feeling a bit more confident, and that translated into consumption growth in July. Anecdotally, the word on the street is more positive, as summarized in the opening paragraph of the most recent Beige Book:
Reports from the 12 Federal Reserve Districts indicate that economic activity continued to stabilize in July and August. Relative to the last report, Dallas indicated that economic activity had firmed, while Boston, Cleveland, Philadelphia, Richmond, and San Francisco mentioned signs of improvement. Atlanta, Chicago, Kansas City, Minneapolis, and New York generally described economic activity as stable or showing signs of stabilization; St. Louis remarked that the pace of decline appeared to be moderating. Most Districts noted that the outlook for economic activity among their business contacts remained cautiously positive.
All in all, it seems a fair bet that the NBER recession cycle dating team will pin the end of the recession sometime during the summer of 2009.
That said, even the most optimistic bull will note that I just cherry-picked the data. While time and inventory control have come into play, firming activity has been inexorably linked to a host of fiscal and monetary stimulus measures. Consumption and manufacturing have both been boosted by the now concluded "Cash for Clunkers" program; we are now anxiously waiting for the likely painful hangover from that spectacular demolition derby where all contestants won a prize. And, interestingly, despite the car buying binge, consumer credit contracted by a whopping 10% annualized in July, a testament to the mix of restriction to and aversion of credit that continues to weigh on household spending plans. Likewise, housing sales have been supported by the $8,000 tax credit for "first-time" buyers, which has been estimated to fatten real estate agent wallets with the addition of almost 400,000 home sales. Like the Clunkers program, the homebuyer's tax credit is set to expire, threatening to pull the rug out of the housing market just as foreclosure activity looks to be heading higher. Should it be extended? Not just real estate agents and home builders think extension - and enhancement - is a no brainer:

Continue reading "Fed Watch: Riding The Fed Train" »

Thursday, September 03, 2009

Rogoff: Is a Debt Crisis Next?

Ken Rogoff says the debt crisis he has been warning about for many years is still a risk:

From Financial Crisis to Debt Crisis?, by Kenneth Rogoff, Commentary, Project Syndicate: ...How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place?
The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.
For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero.
But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless.
And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable. ...
We are constantly reassured that governments will not default on their debts. In fact, governments all over the world default with startling regularity, either outright or through inflation. Even the U.S., for example, significantly inflated down its debt in the 1970s, and debased the gold value of the dollar from $20 per ounce to $34 in the 1930s. ...
The ... rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years. Most worrisome is America's huge dependence on foreign borrowing, particularly from China... The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening. ...

How Paul Krugman might respond:

So is there anything to worry about? Yes, but the dangers are political, not economic. ... Over the really long term,... the U.S. government will have big problems unless it makes some major changes. In particular, it has to rein in the growth of Medicare and Medicaid spending.
That shouldn’t be hard in the context of overall health care reform. After all, America spends far more on health care than other advanced countries, without better results, so we should be able to make our system more cost-efficient.
But that won’t happen, of course, if even the most modest attempts to improve the system are successfully demagogued — by conservatives! — as efforts to “pull the plug on grandma.”
So don’t fret about this year’s deficit; we actually need to run up federal debt right now and need to keep doing it until the economy is on a solid path to recovery. And the extra debt should be manageable. If we face a potential problem, it’s not because the economy can’t handle the extra debt. Instead, it’s the politics, stupid.

Note also that the bond price data do not show any signs of worry over inflation, default, or crowding out.

One more note. This is Rogoff in June 2008. He argues that there should be no stimulus, the risk posed by deficits is too large, and that interest rates should be raised to prevent inflation:

[P]olicymakers must refrain from excessively expansionary macroeconomic policy ... and accept the slowdown... For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

My own view is that "significantly increasing interest rates" in June 2008 would have been a disaster, and that deficit spending was needed to prevent conditions from deteriorating even further. Opposition to deficit spending from people like Rogoff only served to delay putting this policy in place. (Also: This was prior to Lehman, inflation was being driven by commodity price increases, i.e. by relative price changes which do not pose long-run inflation risks, and had the Fed followed this advice and raised rates, it would have likely reversed course after Lehman further undermining its credibility at a time when credibility was needed the most.)


[I may do more with this later, but since Rogoff's opening line is about economists missing the crisis, note also Paul Krugman's How Did Economists Get it So Wrong? Update: See also Where Does Macroeconomics Go From Here? and Which Economists Got it So Wrong?, both by Brad DeLong.]

Tuesday, September 01, 2009

Triple Time-Inconsistent Policy

The middle of a financial crisis is the wrong time to try to reestablish credibility:

Dumping Russia in 1998 and Lehman ten years later: Triple time-inconsistency episodes, by Guillermo Calvo, Vox EU: In the last decade we have witnessed two major systemic financial crises, namely, the 1998 Russian crisis and the current crisis, the latter initially associated with the subprime mortgage market (henceforth, subprime crisis). A critical event in the subprime crisis was the Lehman Brothers’ episode in September 2008. Lehman’s collapse, coming on the heels of the sell-off of Bear Stearns, took the market by surprise. The ensuing about-face regarding AIG was perhaps less surprising but still added a heavy dose of policy uncertainty.

Many observers have been critical of that erratic policymaking and see it as directly responsible for the worldwide collapse of stock markets and near panic that took place soon afterwards. Repeated bouts of time inconsistency – as I will characterize this type of episode – have also been argued to have triggered the spreading of the Russian crisis across most emerging market economies in August 1998. As the argument goes, the market was aware that Russia was facing an unsustainable fiscal deficit before August but it was expecting that if a run against Russian public debt obligations materialized, the IMF and other multilateral institutions would rise to the occasion and bail them out. One often-heard reason for this was that Russia was “too nuke to fail.” However, the bailout did not happen, Russia was forced to default and, as if coordinated by a magic wand, the JP Morgan EMBI for all emerging markets went through the roof, with the average interest spread exceeding 1500 basis points. This episode raised fears that Brazil – Latin America’s kingpin – would follow suit and collapse, and apparently led the IMF to soften its stance and extend a very generous standby loan to Brazil on the basis, according to rumour, of skimpy fiscal account information – likely lowering IMF’s credibility as enforcer of market discipline.[1]

These episodes are cases of what one might call “triple time inconsistency. First, a public institution is expected to depart from earlier statements and offer a bailout to prevent a major crisis (this is the first round of time inconsistency); then, in an attempt to regain credibility, the bailout is pulled back (the second round) and, finally, having witnessed the wreckage caused by the policy surprise, it resume bailouts of the still-standing dominoes (third round). This seesaw policymaking cannot be right. The initial refusal to continue offering bailouts can only be justified as a warning signal to market players against getting involved in situations in which they will need a bailout. But this “investment in credibility” goes to waste as the policymaker chickens out and bailouts resume.

The example below aims at making these intuitions more precise. I think the effort is worth it, given that the similarity between the episodes highlighted above suggests that the phenomenon is likely to repeat itself unless we better understand it and develop ways to prevent it. I would like to point out, however, that the example focuses on the costs of different rounds of time inconsistency but stops short of addressing the policy uncertainty generated by policies that are not in line with private-sector expectations. The latter is a major task that requires more substantive research.

Continue reading "Triple Time-Inconsistent Policy" »

Thursday, August 27, 2009

"Obama Lucky to Have Bernanke"

Brad DeLong explains why presidents are willing to reappoint Fed chairs that are members of opposing political parties:

Obama lucky to have Bernanke, by J. Bradford DeLong, Commentary, Project Syndicate: William McChesney Martin, a Democrat, was twice reappointed chairman of the ... Federal Reserve by Republican President Dwight D. Eisenhower.

Paul Volcker, a Democrat, was reappointed once by the Reagan administration (but not twice: there are persistent rumors that Reagan's treasury secretary, James Baker, thought Volcker too invested in monetary stability and not in producing strong economies to elect Republicans).

Alan Greenspan, a Republican, was reappointed twice by Bill Clinton. And now Barack Obama has announced his intention to renominate Republican appointee Ben Bernanke...

The reason American presidents are so willing to reappoint Fed chairmen from the opposite party is closely linked to ... confidence of financial markets that the Fed will pursue non-inflationary policies.

If financial markets lose that confidence - if they conclude that the Fed is too much under the president's thumb to wage the good fight against inflation, or if they conclude that the chairman does not wish to control inflation - then the economic news is almost certain to be bad.

Capital flight, interest-rate spikes, declining private investment, and a collapse in the value of the dollar - all of these are likely should financial markets lose confidence in a Fed chairman.

And if they occur, the chances of success for a president seeking re-election - or for a vice president seeking to succeed him - are very low. By reappointing a Fed chairman chosen by someone else, a president can appear to guarantee to financial markets that the Fed is not too much under his thumb. ...

It may or may not be true, especially these days, that what is good for General Motors is good for America and vice versa, but certainly what is good economically for America is good politically for the president.

It is here that Obama has lucked out. Ben Bernanke is a very good choice for Fed chairman because he is intelligent, honest, pragmatic and clear-sighted in his vision of the economy. He has already guided the Fed through two very tumultuous years with only one major mistake - the bankruptcy of Lehman Brothers.

This probably helped with Obama's willingness to reappoint Bernanke:

For years, some of his closest friends did not know that Ben S. Bernanke was a Republican. ... "If you read anything he's written, you can't figure out which political party he's associated with," said Mark L. Gertler, a professor of economics at New York University who has written more than a dozen papers with Mr. Bernanke. Mr. Gertler, who said he did not know his close friend's political affiliation until relatively recently, added: "He's not ideological. I could imagine Ben working with economists in the Clinton administration." Alan S. Blinder, a longtime colleague at Princeton who has advised numerous Democratic presidential candidates, also said he had worked alongside Mr. Bernanke for years without having any sense of his political views. "We wrote articles together and sat at the same lunch table thousands of times before I knew he was a Republican," Mr. Blinder recalled. "We never talked politics." ...

Hope or Evidence?

I think this is a fair response to my contention that Bernanke will be effective at pushing for new regulation of the banking industry. Thinking about it more, it's probably true that it is based more on hope than on evidence:

Ben's Second Term, by  Kevin Drum: What do we have to look forward to from Ben Bernanke's second term as chairman of the Fed?  The New York Times asked a bunch of economists for their predictions. Here's Mark Thoma:
My worry is that as time passes, we’ll forget how bad things were and the desire to impose necessary new regulation will fade. Here’s where I think Mr. Bernanke’s experience will be crucial. He was there at every step in the development of the Fed’s response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he’ll be a forceful and passionate advocate for new regulation before Congress. [Italics mine.]
Boy, do I hope this is true.  But it strikes me as woefully wishful thinking. One of the reasons I opposed reappointing Bernanke is that I'd like to have someone running the Fed who's serious about reregulating the financial industry, both at a macro and a consumer level. ...

Still, I remain hopeful.

Update: Free Exchange also responds:

What will Ben Bernanke do?, Free Exchange: Kevin Drum is collecting predictions about Ben Bernanke's second term. Here's Mark Thoma, for instance:
He was there at every step in the development of the Fed’s response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he’ll be a forceful and passionate advocate for new regulation before Congress. ...
Now, no Fed chairman (or potential Fed chairman) can or will pre-commit themselves to specific policy actions before they're nominated (nor should we want them to, given the importance of Fed independence). At the same time, nomination is the one time that political actors get some kind of say over what they want in a Fed chairperson. It therefore seems like it might be a good idea to ask what a nominee's priorities are ahead of time. ...
In other words, it shouldn't be unclear whether Mr Bernanke is going to forcefully advocate for needed regulatory changes. And maybe it isn't unclear to the president. But there's not necessarily any reason we ought to be flying blind with respect to the chairman's views on issues that will be hugely important during his second term. ...

Update: Tim Duy emails:

Bernanke will run away from financial reform if it means the risk of exposing the Fed to enhanced GAO oversight.  And maybe he should.

[End updates]

Here's Thomas Palley's view of Bernanke's reappointment. Thomas is, you will recall, a "heterodox economist" so it's not surprising that most of his criticism is directed at the profession itself rather than at Bernanke (much of which is in the full version of the article). Unfortunately, heterodox economists didn't do any better than mainstream economists at foreseeing and warning about the crisis. Thus, while I agree that new thinking and change is needed to prevent problems in the future, it's not clear that his call to open the Fed to "alternative economic views" would have done anything to help to prevent the problems we are having:

One Hand Clapping for Bernanke, by Thomas I. Palley, Commentary, Project Syndicate: President Barack Obama's nomination of Ben Bernanke to a second term as chairman of the U.S. Federal Reserve represents a sensible and pragmatic decision, but it is nothing to celebrate.

Instead, it should be an occasion for reflection on the role of ideological groupthink among economists, including Bernanke, in contributing to the global economic and financial crisis.

The decision to nominate Bernanke is sensible on two counts. First, the U.S. and global economies remain mired in recession. Though the crisis may be over in the sense that outright collapse has been avoided, the economy remains vulnerable. As such, it makes sense not to risk a shock to confidence that could trigger a renewed downturn.

Second, Bernanke is the best among his peers. He did eventually come to understand the nature and severity of the crisis, and then took decisive steps that contributed to halting the economic freefall.

That record, combined with doubts that any of his peers would have done better, means replacing him with another mainstream candidate makes little sense.

These two factors justify Bernanke's reappointment, but the faintness of praise is indicative of the deeper problems that his leadership has exposed. Those problems concern the state of economics and economic policy advice.

One such problem is Wall Street's implicit veto over the Fed. After all, a major reason for reappointing Bernanke is to avoid rocking financial markets. ...

In effect, financial markets have established an implicit veto over much of economic policy and the people who can hold top policymaking positions, and it is time to think how we can escape that hold.

A second problem concerns the state of economics. Though Bernanke may be the best in his peer group, the fact is that the economic crisis decisively proved him and his peers to have been wrong. ...

Though circumstances dictate that Bernanke is the best candidate and should be reappointed, the real challenge is to ensure a thorough intellectual housecleaning at the Fed in order to open space for alternative economic views.

The great danger is that reappointing Bernanke will be interpreted as a green flag for a flawed status quo.

That is where public debate and Bernanke's Senate confirmation hearings enter the picture. Those hearings should be an occasion for critical examination of what went wrong, and why.

If that happens, Bernanke's reappointment can serve as a trigger for constructive change rather than an endorsement of a discredited paradigm.

Wednesday, August 26, 2009

"The Dangers Ahead for Bernanke"

At the Room for Debate, we were asked "What’s the biggest challenge Mr. Bernanke faces in his second term?" Here are the answers:

My response:

One important challenge Mr. Bernanke will face is to keep the financial sector recovery on track by not raising interest rates too soon, while avoiding inflation by not raising interest rates too late. It will be a difficult balancing act, particularly with the complications that a large budget deficit adds. I’m quite confident Mr. Bernanke is up to the task.

But the most important challenge is how to restructure the financial sector to reduce its vulnerability to a collapse like the one we just experienced. That’s a task that will require both institutional and regulatory change.

Some of this the Fed can do on its own, but other parts require Congressional approval. As the financial sector has started to show signs of life, we are already hearing protests against regulation. The most prominent objection is that regulation will stifle new financial innovation (never mind that it was this innovation that helped to cause the predicament we are in).

My worry is that as time passes, we’ll forget how bad things were and the desire to impose necessary new regulation will fade. Here’s where I think Mr. Bernanke’s experience will be crucial. He was there at every step in the development of the Fed’s response to the crisis and he will not soon forget the problems he faced (nor repeat his mistakes), making it more likely that he’ll be a forceful and passionate advocate for new regulation before Congress.

For example, the Fed needs the authority to dismantle “too big to fail” financial firms, authority it lacked but very much needed during the crisis. Mr. Bernanke knows first hand how hard it was to manage the crisis without this authority. He’s also seen the consequences of an unregulated shadow banking sector, and he knows how bad incentives and poor market structures created problems that could have been avoided.

There are two other factors working in Mr. Bernanke’s favor. If the financial recovery goes as I expect, his reputation will grow, giving him the authority he needs to persuade Congress to make needed regulatory changes. And just as important, unlike some past Fed chairmen, he’s been able to articulate complex ideas in ways that legislators seem to understand.

Update: This is from Barry Ritholtz. It addresses the view held by many that Bernanke should not have been reappointed because he helped to create the housing bubble (which implicitly assumes the Fed is responsible for the bubble - I think the low interest rate policy after the crash was one source of the liquidity that fueled the housing boom, but not the only source, the global savings glut also played a role, and there were other failures, i.e. false promises of high returns with low risk, that caused the funds to flow into mortgage markets and related securities rather than into other investments):

I am less critical ... regarding the Bernanke renomination [and] his 3 year term as Governor. Let’s not forget that Greenspan was known as the Maestro back then. Congress, which is now pillorying Bernanke every appearance, was adoring of Easy Al’s visage and garbled Greenspeak each and every appearance. AG ran the Fed as an unchallenged stronghold, a fiefdom where he was the central-banker-in-chief as rock star. No one challenged him directly.

That seems to be lost in a lot of the revisionism now taking place. Roach writes “While America’s head central banker deserves credit for being creative and courageous in orchestrating an unusually aggressive monetary easing programme, it is important to remember that his pre-crisis actions played an equally critical role in setting the stage for the most wrenching recession since the 1930s.”

Not exactly. It was Greenspan’s Fed. Under his leadership, the FOMC and its governors were all second bananas to the Wolrd’s most famous banker. In Bailout Nation, I criticize this deference: “The Federal Open Market Committee (FOMC) must take responsibility for following [Greenspan] so obsequiously, especially in the latter years of his reign.”

However much I blame the FOMC, I have a hard time holding them to the same level of accountability as I do Greenspan. He was the master architect, the maestro conducting the monetary policy orchestra.

Second bananas cannot should the blame for what the head of the bunch does. Once they become banana-in-chief, the standards and level of accountability all go up accordingly.

Sunday, August 16, 2009

How Will We Know when the Economy Turns the Corner?

One question I am asked fairly often is how we will know when the economy turns the corner and we are on our way to a solid recovery. My answer is that we will be able to detect upticks in the data, though this may come with a bit of a lag, the important but harder task will be to understand why the data are showing improvement.

In order to be convinced that the economy is on solid footing and headed to better times, I will want to see several things. First, though not necessarily foremost, that banks are being recapitalized with private sector funds, and that this is happening without the aid of government guarantees or other such programs that encourage capital infusions (which is hard to determine while the government programs are in place). Second, I will want to see private sector non-residential investment improving, another sign that private sector funds are moving back into circulation. Presently, this hasn't even started heading back upward, though there are signs the decline is slowing:

And there are other important factors too, e.g. consumption rebounding (though not to pre-crisis debt sustained levels), stabilization in housing markets, and so on. The point is that a self-sustaining recovery will require that the private sector be the primary driver of new economic activity, and that is what I will be looking for.

Once the economy does start to recover, the hard but critical part will be to determine how much of the recovery is self-sustaining (as it will be if private sector funds are driving the activity), and how much is being driven by government stimulus programs. If the recovery is self-sustaining, and we are fairly certain of that, then we can begin to carefully wind down the government programs supporting the economy. But if the recovery is mostly due to government stimulus and there is little sign that the financial and real sectors are attracting robust levels of private sector funds, then pulling back on government programs could be disastrous and plunge the economy right back into recession. In fact, in such a case, we may need to provide even more stimulus to fully bridge the gap until the private sector can support the economy on its own.

So, in answer to the question, we will have a pretty good idea when the economy turns the corner, but it will take awhile to determine why, and we cannot risk pulling back on government programs until we are sufficiently certain that the private sector can support normal economic activity without the government's help.

Update: Nouriel Roubini:

A Phantom Economic Recovery, by Nouriel Roubini, Commentary, Project Syndicate: Where is the US and global economy headed? ... Data from the US ... suggests that the US recession is not over yet. A similar analysis of many other advanced economies suggests that, as in the US, the bottom is quite close, but it has not yet been reached. ...
Moreover, for a number of reasons, growth in the advanced economies is likely to remain ... well below trend for at least a couple of years.

Continue reading "How Will We Know when the Economy Turns the Corner?" »

Thursday, August 13, 2009

The Anti-Greenspan

Dani Rodrik wants the Anti-Greenspan - someone who truly distrusts financial markets and the ideology that surrounds them - to be the next Fed Chair:

Let finance skeptics take over, by Dani Rodrik, Commentary, Project Syndicate: ...Federal Reserve Chairman Ben Bernanke’s term ends in January, and President Barack Obama must decide before then: either re-appoint Bernanke or go with someone else...
 [I]n recent decades central banks have become even more significant as a consequence of the development of financial markets. Even when not formally designated as such, central banks have become the guardians of financial-market sanity. The dangers of failing at this task have been made painfully clear in the sub-prime mortgage debacle. ...
This is a job at which former Fed Chairman Alan Greenspan proved to be a spectacular failure. ... As a member of the Fed’s Board of Governors under Greenspan..., Bernanke can also be faulted...
What hampered Greenspan and Bernanke as financial regulators was that they were excessively in awe of Wall Street... They operated under the assumption that what is good for Wall Street is good for Main Street. This will no doubt change as a result of the crisis, even if Bernanke remains at the helm. But what the world needs is a Fed chairman who is instinctively skeptical of financial markets and their social value.
Here are some of the lies that the finance industry tells itself and others, and which any new Fed chairman will need to resist.
Prices set by financial markets are the right ones for allocating capital and other resources to their most productive uses. That is what textbooks and financiers tell you, but ... there are far too many “market failures” in finance for these prices to be a good guide for resource allocation. ... Implicit or explicit bailout guarantees, moreover, induce too much risk-taking. ... So the prices that financial markets generate are as likely to send the wrong signals as they are to send the right ones.
Financial markets discipline governments. This is one of the most commonly stated benefits of financial markets, yet the claim is patently false. ... If in doubt, ask scores of emerging-market governments that had no difficulty borrowing in international markets, typically in the run-up to an eventual payments crisis.
In many of these cases ... financial markets enabled irresponsible governments to embark on unsustainable borrowing sprees. When “market discipline” comes, it is usually too late, too severe, and applied indiscriminately.
The spread of financial markets is an unmitigated good. Well, no. Financial globalisation was supposed to have enabled poor, undercapitalised countries to gain access to the savings of rich countries. It was supposed to have promoted risk-sharing globally. In fact, neither expectation was fulfilled. ...
Financial innovation is a great engine of productivity growth and economic well-being. Again, no. Imagine that we had asked five years ago for examples of really useful kinds of financial innovation. We would have heard about a long list of mortgage-related instruments... The truth lies closer to Paul Volcker’s view that for most people the automated teller machine (ATM) has brought bigger benefits than any financially-engineered bond.
The world economy has been run for too long by finance enthusiasts. It is time that finance skeptics began to take over.

My view is that Bernanke should be reappointed.

Wednesday, August 12, 2009

My Lucky Day

[If all goes according to plan, this will post at 11:30.]

I was lucky enough to draw jury duty today, and I'm assuming blogging from my iPhone won't be allowed, so I (probably) won't be able to post or talk about the press release from the FOMC meeting today until much later.

Is there anything in the press release that should be noted?

Update: Yahoo, after a long wait a plea bargain settled the case and I've been released. A quick scan of the news reports on the meeting indicate that two statements in the press release (see below) caught people's attention, the statement that "economic activity is leveling out" and the notice that the Fed will "gradually slow" its purchase of Treasury Securities and "anticipates that the full amount will be purchased by the end of October." The first statement is a slight nod toward recent improvements, and the second is an extension of earlier plans to end the purchases in September. This will keep options open, and recognizes that there is still considerable uncertainty about the path the economy will take:

Press Release Release Date: August 12, 2009: Information received since the Federal Open Market Committee met in June suggests that economic activity is leveling out. Conditions in financial markets have improved further in recent weeks. Household spending has continued to show signs of stabilizing but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment and staffing but are making progress in bringing inventory stocks into better alignment with sales. Although economic activity is likely to remain weak for a time, the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability.

Continue reading "My Lucky Day" »

Monday, August 10, 2009

Paul Krugman: Averting the Worst

[Note: The actual column, "Averting the Worst" by Paul Krugman, is here.]


I heard you say that we aren’t going to have a second Great Depression. What saved us?

The answer, basically, is Big Government.

So the government fixed things? Does everyone go back to work tomorrow?

Just to be clear: the economic situation remains terrible. We haven’t yet reached the point at which things are actually improving; for now, all we have to celebrate are indications that things are getting worse more slowly.

We're still skidding towards the cliff, but we'll stop in time? I'll feel better when we're actually stopped, or better yet, headed in the other direction.

The latest flurry of economic reports suggests that the economy has backed up several paces from the edge of the abyss. A few months ago the possibility of falling into the abyss seemed all too real.

So what was so special about the way government reacted?

Probably the most important aspect of the government’s role in this crisis isn’t what it has done, but what it hasn’t done.

Okay, then what didn't the government do that was so special?

Unlike the private sector, the federal government hasn’t slashed spending as its income has fallen. (State and local governments are a different story.) Tax receipts are way down, but Social Security checks are still going out; Medicare is still covering hospital bills; federal employees, from judges to park rangers to soldiers, are still being paid.

All of this has helped support the economy in its time of need, in a way that didn’t happen back in 1930.

This means that budget deficits — which are a bad thing in normal times — are actually a good thing right now.

I can buy that the government had an “automatic” stabilizing effect through its normal expenditures and by supporting increased demand for programs such as unemployment insurance, food stamps, those sorts of things. I can also see how running a deficit is the only way to support these programs. But the financial bailout, surely you aren't going to tell me that was helpful too? Look how it was handled!

You can argue (and I would) that the bailouts of financial firms could and should have been handled better, that taxpayers have paid too much and received too little. Yet it’s possible to be dissatisfied, even angry, about the way the financial bailouts have worked while acknowledging that without these bailouts things would have been much worse.

The point is that this time, unlike in the 1930s, the government didn’t take a hands-off attitude while much of the banking system collapsed. And that’s another reason we’re not living through Great Depression II.

So what you are telling me is that the bailout worked, and was necessary, but we could have bailed out the system in a way that cost taxpayers less and the people responsible for the problems more? You're right about it being possible to be dissatisfied even though it worked. Anyway, since we're talking about poorly structured programs, above when you talked about automatic stabilizers, you didn't mention the stimulus package. Is that because it hasn't helped much yet?

From the beginning, I argued that the American Recovery and Reinvestment Act, a k a the Obama stimulus plan, was too small. Nonetheless, reasonable estimates suggest that around a million more Americans are working now than would have been employed without that plan — a number that will grow over time — and that the stimulus has played a significant role in pulling the economy out of its free fall.

So automatic stabilizers, an imperfect but effective enough financial bailout, and an imperfect but at least helpful stimulus package are all working together to overcome the problems in the economy?

Ronald Reagan was wrong: sometimes the private sector is the problem, and government is the solution.

That's not the only thing he was wrong about.

And aren’t you glad that right now the government is being run by people who don’t hate government?

Speaking of which, how do you think things would have been different if McCain had won the election?

We don’t know what the economic policies of a McCain-Palin administration would have been. We do know, however, what Republicans in opposition have been saying — and it boils down to demanding that the government stop standing in the way of a possible depression.

Yeah, Republicans aren't exactly fans of the stimulus package. They'd reverse it right now if they could.

I’m not just talking about opposition to the stimulus. Leading Republicans want to do away with automatic stabilizers, too. Back in March, John Boehner, the House minority leader, declared that since families were suffering, "it’s time for government to tighten their belts and show the American people that we ‘get’ it." Fortunately, his advice was ignored.

Ignoring Boehner's advice is a good idea in general. Ignoring him saved the day.

I’m still very worried about the economy.


There’s still, I fear, a substantial chance that unemployment will remain high for a very long time. But we appear to have averted the worst: utter catastrophe no longer seems likely.

And Big Government, run by people who understand its virtues, is the reason why.

Fed Watch: The Recovery Edges Forward

Tim Duy reviews the state of the economy in anticipation of the Federal Reserve meeting scheduled for Tuesday and Wednesday of this week:

The Recovery Edges Forward, by Tim Duy: Data flow continues to support those who argue that if the recession is not already over as of July, it soon will be. The July jobs report - while not exactly cheery news for those still losing their jobs - is another clear indicator that the employment picture is turning. Still, excitement over the end of the recession aside, the data also reveal that the economy is recovering in fits and starts, with tell-tale signals that the consumer orgy of this decade is not likely to be repeated.

The July employment report in many ways spoke for itself. Possibly most important is the clear improvement in the pace of job losses:


This serves as confirmation of what we already knew from initial claims - the worst damage to the job market is in the rearview mirror. Other positive signs included a rise in manufacturing hours and stability in aggregate hours. To be sure, not all is perfect. The decline in the unemployment rate was driven by an exodus from the labor force - not exactly a sign of improving conditions. And a key leading indicator of employment, temporary help payrolls, continues to decline. If the recession did in fact end in June, and we see evidence of that end in the July industrial production report to be released this week, the decline in temporary help employment is clearly a disappointment. Indeed, coupled with rising production, it would simply reek of jobless recovery.

Other data supported the notion of weak recovery as well. While industrial activity may be close to turning a corner on the back of inventory reduction and the cash for clunkers program, not all is well in the service sector. The ISM read on nonmanufacturing activity actually edged downward for the month, with declines in not only the headline number, but also business activity, new orders, and employment. Better than the freefall of last year, but nothing to suggest that a V-shaped recovery is imminent.

Perhaps the lack of enthusiasm in the service sector is a reflection of what is clearly a subdued consumer. The June personal income and outlays report reveals that consumer spending declined in for the month:

Continue reading "Fed Watch: The Recovery Edges Forward" »

Tuesday, August 04, 2009

Fed Watch: Is a Jobless Recovery Your Best Friend?

Tim Duy on how the Fed is likely to respond to "the cyclical turn in the US economy":

Is a Jobless Recovery Your Best Friend?, by Tim Duy: Never underestimate the power of money. Especially lots of money coming on top of a cyclical recovery that is almost textbook at least as far as the timing is concerned. To be sure, you can question the sustainability of the recovery, the breadth or health of the recovery, and the nature of job growth. I have questioned all repeatedly and fail to see that the conditions that have dominated the US economic story for the past 25 years - primarily, a continued reliance on consumer spending to propel growth - can continue in the face of massive household debt burdens and stiffer (or, more accurately, realistic) underwriting conditions. But regardless of these concerns, evidence is clearly pointing to a shift in economic conditions for the better. Moreover, I suspect it will take at least two more quarters at a minimum - and maybe closer to two more years - before the more pessimistic or optimistic visions of the future will come into clear view. Until then, it seems likely the appetite for risk will continue to climb, and all the liquidity - liquidity fueled by new guarantees that massive financial institutions are too big too fail - has to go somewhere.

Which is to say that no matter how pessimistic you are in the medium and longer term, you need to recognize the potential for massive moves in markets as risk taking perpetuates more risk taking. And as long as that risk taking flows in directions that do not fundamentally change the US jobs and, by extension, wage picture, it is difficult to imagine the Federal Reserve will do anything but let the party roll on.

The second quarter GDP report (Jim Hamilton and Menzie Chinn at Econbrowser discuss the details) confirmed what was already well known - the pace of deterioration slowed markedly, setting the stage for a growth rebound in the second half of this year. The game now is upping near term growth forecasts accordingly - not a fool's errand at all, considering the inventory correction is running its course and new residential construction is mostly likely at the bottom (seriously, we were never moving to an economy where zero houses would be built). Moreover, as Calculated Risk reports, it looks like we hit the bottom of car sales, with no small boost being provided by the Cash for Clunkers program.  Say what you like about the economic wisdom of this program or its potential to magnify a double-dip by borrowing from future growth, it will goose the third quarter numbers and advance the pace of inventory correction in the auto industry. And, let's be honest, buying new cars is a whole bunch more fun than just writing massive checks to keep the industry afloat.

The July ISM manufacturing report only adds to the cyclical rebound story. The headline number is flirting with the all important 50 mark, while the new orders component surged into expansion territory. Production, export, and import components all gained. Even the employment reading rose higher, although it continues to signal ongoing job declines. All in all, a report that is predicting recovery in a time frame consistent with the deep cyclical plunges of late last year.

On a more somber note, labor market weakness continues to weigh on paychecks, a phenomenon confirmed by the employment cost index for the second quarter. Wages and salaries for private workers climbed a scant 0.2%. To be sure, this raises concerns about the durability of consumer spending going forward, especially when combined with fears of a jobless recovery. Indeed, I have argued that most if not all of the jobs in the manufacturing sector simply are not coming back. My suspicion is that firms will use the recession to expand overseas supply chains wherever possible. Moreover, firms will not be in a rush to hire back without a clear resurgence of growth, which seems unlikely to occur given precarious household debt burdens.

Now comes the tricky part - what does the evolving economic dynamic imply for financial markets? I am increasingly of the mind that although a jobless recovery will be a dreary fate for the American people, it offers the best outcome for financial markets for one simple reason: The jobless recovery offers the greatest probability that the Fed remains on the sidelines. The jobless recovery is what keeps the Fed goose laying the golden eggs.

True, one should be cautious about reading too much into near-term market action. Macro man puts it succinctly:

The problem that some so-called perma-bears have is is recognizing the temporary importance of such asset flow, and how far it can push asset prices. By the same token, the problem that some of the flow-of-funds, risk-on crowd have is is failing to recognize that buying something just because other people do is nothing more than an exercise in greater fool theory. And while the market may well be a voting machine in the short run, as Benjamin Graham observed it is a weighing machine in the long run.

With the Armageddon trade off the table, market participants need to move the mass of money provided by the Fed somewhere, and it is showing up in all the predictable places. US equities, commodities, oil, and foreign exchange. Indeed, without the Fed threatening to raise rates, there is no rush to exit Treasuries, which could explain the failure of the ten year bond to retake the 4% mark even as equities sure higher.

To be sure, these trades might collapse under their own weight, but the probability of finding a self-sustaining move, like the US housing boom earlier this decade, is higher the longer the Fed keeps rates at a rock bottom level. And the farther that money flows from the US the better for financial market participants; too much money close to home would raise the prospect of stronger growth and tighter monetary policy. Andy Xie (hat tip to Big Picture) believes he has found one such place in China:

Chinese stock and property markets have bubbled up again. It was fueled by bank lending and inflation fear. I think that Chinese stocks and properties are 50-100% overvalued. The odds are that both will adjust in the fourth quarter. However, both might flare up again sometime next year. Fluctuating within a long bubble could be the dominant trend for the foreseeable future. The bursting will happen when the US dollar becomes strong again. The catalyst could be serious inflation that forces the Fed to raise interest rate.

When will that bubble burst? Possibly 2012, after the Fed can no longer keep interest rates low:

It is not too hard to understand when the bubble would burst. When the dollar becomes strong again, liquidity could leave China sufficiently to pop the bubble. What’s occurring in China now is no different from what happened in other emerging markets before. Weak dollar always led to bubbles in emerging economies that were hot at the time. When the dollar turns around, the bubbles inevitably burst.

It is difficult to tell when the dollar will turn around. The dollar went into a bear market in 1985 after the Plaza Accord and bottomed ten years later in 1995. It then went into a bull market for seven years. The current dollar bear market began in 2002. The dollar index (‘DXY’) has lost about 35% value since. If the last bear market is of useful guidance, the current one could last until 2012. But, there is no guarantee. The IT revolution began the last dollar bull market. The odds are that another technological revolution is needed for the dollar to enter a sustainable bull market.

However, monetary policy could start a short but powerful bull market for the dollar. In the early 1980s Paul Volker, the Fed Chairman then, increased interest rate to double digit rate to contain inflation. The dollar rallied very hard afterwards. Latin American crisis had a lot to do with that.

The current situation resembles then. Like in the 1970s the Fed is denying the inflation risk due to its loose monetary policy. The longer the Fed waits, the higher the inflation will peak. When inflation starts to accelerate, it would cause panic in financial markets. To calm the markets, the Fed has to tighten aggressively, probably excessively, which would lead to a massive dollar rally. This would be the worst possible situation: a strong dollar and a weak US economy. China’s asset markets and the economy would almost surely go into a hard landing.

Bottom Line: Incoming data continue to confirm the cyclical turn in the US economy. But that cyclical turn is supported by a massive amount of government intervention, in and of itself a testament to the fragility of the recovery. The Fed will be in no rush to withdraw that liquidity - especially if a jobless recovery emerges. Indeed, it is easy to tell a story where the Fed holds rates near zero into 2011. That also means the Fed will not rock any boats. Thus, the jobless recovery is almost a dream come true for those trades dependent on easy Fed policy - which seem to be virtually all trades at the moment. Although there has been talk of the Fed acting preemptively to curtail bubbles, I am skeptical that any such action would be taken with US unemployment staring at double-digits. And there certainly would be no rush to react if low US interest rates fueled bubbles outside US borders; that, after all, would be the responsibility of foreign policymakers.

Sunday, August 02, 2009

"Deep Recession Calls for Healthy Dose of Fiscal Stimulation"

A colleague, George Evans, discusses the need for aggressive policy to combat the recession:

Deep recession calls for healthy dose of fiscal stimulation, by George Evans, Commentary, Register Guard: ...The business cycle, with expansions occasionally interrupted by recessions, is an enduring feature of market economies. Asset price bubbles and crashes also appear to be intrinsic to markets. It is important to recognize that recessions are usually ... a surprise, resulting from large shocks that could not be offset in time by policy.

Economists do, however, have a set of policies to avoid or minimize the impact of recessions and to promote recovery. The standard policy tools for dealing with recessions are two-fold: 1) easing monetary policy by reducing interest rates, and 2) allowing normal fiscal “stabilizers” to work: in recession tax collections naturally decline and unemployment benefits and welfare payments naturally increase. At the federal level this can and should be financed by temporary increases in deficits. ...

When a recession is very large, as now, the usual anti-recessionary policies are insufficient, and aggressive fiscal policies are needed. When recessions are accompanied by a financial crisis, as now, special interventions are required to prevent a complete financial meltdown and ensure that credit remains available. Regulatory reforms are also needed... Experience has shown that recessions precipitated by financial crises are usually longer and deeper than typical recessions.

The reason why aggressive fiscal policies are essential ... is that the adverse shock has been so large that monetary policy is inadequate: cutting short-term interest rates to zero is not enough to ensure recovery. Without sizable fiscal stimulus there is the possibility of a destabilizing spiral of deflation and falling output.

The combination of aggressive monetary easing and sufficiently aggressive fiscal stimulus should be enough to stabilize the economy and eventually lead to recovery. This recovery will raise tax revenues and, with appropriate long-term fiscal planning, debt levels relative to GDP will gradually return to normal levels. As the recovery begins, the monetary authorities will start to unwind current policy ... to prevent inflation from becoming a problem.

It is possible that yet more fiscal stimulus will be needed... If so, additional stimulus should avoid across-the-board temporary reductions in personal income taxes, since these have small aggregate demand effects. More effective are temporary increases in government spending ... and additional funding to states and localities... Temporary investment tax credits to firms can also be effective...

We must avoid retreating to the economics of Herbert Hoover. The argument that government should behave like families in recessions, reducing spending because times are hard, is misguided, because the proximate cause of current high levels of unemployment and low levels of GDP is a collapse of the aggregate demand... This is a Keynesian moment in history, and in this situation, temporary increases in government spending lead to higher incomes and more jobs. Households may anticipate higher future taxes to pay for the deficit spending, but the net effect on GDP and incomes is positive and substantial, and this prevents a dangerous slide into deflation. If the government spending is on infrastructure, broadly construed, then this also lays the foundation for a more productive recovery.

Is the current federal stimulus program sufficient? There is no simple answer. Policy affects the economy after a delay that is long, variable and uncertain. ... The lags and uncertainties make policy difficult.

In this situation the guiding principles are as follows. [T]he biggest risk is a 1930s type depression triggered by a negative feedback loop of deflation, high “real” interest rates after correcting for deflation, and reduced private sector spending. We appear to have avoided this outcome, but ... policy needs to be continually revisited. The Federal Reserve Open Market Committee meets every six weeks to review monetary policy. U.S. fiscal policy should also be reviewed frequently. The next several months may indicate the start of recovery or they may suggest that further action is needed. Finally, we also need a long-term plan to ensure that, after the recovery is under way, total publicly held federal debt will eventually return to its normal range of, say, 30 percent to 70 percent of GDP. ...

Although reasonable people can disagree on the appropriate role and size of government spending, we can agree that spending should be as productive as possible and that tax rates should be set to finance this spending on average. However, whatever the choice of overall level, there is a strong macroeconomic case for maintaining government spending during recessions and for temporary increases in government expenditures in deep recessions.

I should make clear that George cannot be accused of applying old fashioned theory to modern problems. The commentary above is based upon his recent research -- here's a brief description of some of his recent papers:

We examine global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy, the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with aggressive monetary and fiscal policy that guarantee a lower bound on inflation.

And here are links to the papers themselves (the first two are technical, the third was written more for general economists and central bank policymakers):

Thus, this gives a fairly simple policy prescription - guarantee a lower bound on inflation - that is grounded in modern New Keynesian structures augmented with the models of learning that George, Seppo, and others have been developing. In the models with learning, there are stable and unstable regions, and large shocks can push you into the unstable region. The guarantee of a lower bound for inflation prevents inflationary expectations (which are formed through learning) from entering the region where deflationary spirals with falling prices and falling output are possible.

Here's a bit more from the conclusion to the third paper above:

The recent theoretical literature on the zero lower bound to nominal interest rates has emphasized the possibility of multiple equilibria and liquidity traps when monetary policy is conducted using a global Taylor rule. Most of this literature has focused on models with perfect foresight or fully RE. We take these issues very seriously, but our findings for these models under adaptive learning are quite different and in some ways much more alarming than suggested by the RE viewpoint. We have shown that under standard monetary and fiscal policy, the steady-state equilibrium targeted by policymakers is locally stable. In normal times, these policies will appropriately stabilize inflation, consumption, and output. However, the desired steady state is not globally stable under normal policies. A sufficiently large pessimistic shock to expectations can send the economy along an unstable deflationary spiral.

To avoid the possibility of deflation and stagnation, we recommend a combination of aggressive monetary and fiscal policy triggered whenever inflation threatens to fall below an appropriate threshold. Monetary policy should immediately reduce nominal interest rates, as required, even (almost) to the zero net interest rate floor if needed, and this should be augmented by fiscal policy, if necessary, in the form of increased government purchases. Intriguingly, using an aggregate output threshold in the same way will not always successfully reverse a deflationary spiral.

When aggressive fiscal policy is necessary, this will lead to a temporary buildup of government debt. However, government spending and debt will gradually return to their steady-state values. An earlier implementation of the recommended policies will mitigate the use of government spending, and if our recommended policy is already in place at the time of the shocks, the immediate use of aggressive monetary policy can in some (but not all) cases entirely avoid the need to use fiscal policy. Raising the inflation target π* is an alternative way of reducing the likelihood of needing to employ fiscal policy, but this may be undesirable for other reasons.

Saturday, August 01, 2009

Social Insurance and the Severity of Recessions

The question of how bad would economic conditions be right now if there had been no stimulus package and no financial bailout is receiving considerable attention. There's no way to know for sure, but I believe the economy would have been much worse off without these two policy interventions. But without actually running the alternative scenario - something we can't do - there's no way to know for sure.

But one thing I am fairly certain of, and something I don't think is getting enough attention, is the effect that automatic stabilizers have had in helping to ease the impact of the recession for individual households on and for the overall economy.

What are automatic stabilizers? Automatic stabilizers are taxes and transfers (e.g. unemployment compensation and food stamps) that automatically change with changes in economic conditions in a way that dampens economic cycles. For example, when the economy turns downward, the amount spent on food stamps automatically goes up as more people apply (or eligibility rules are eased), and the extra spending the food stamps helps to soften the downturn for the individuals receiving the help and for the businesses and employees where the money is spent (and then the multiplier process spreads the benefits more widely). Similarly, unemployment compensation, which obviously rises as jobs are eliminated, goes up when conditions deteriorate and that also provides a boost to demand. In addition, income tax as a share of GDP goes down in recessions and that helps to offset the fall in GDP as well.

How much worse would things be now if we had followed the advice of the hardcore rightwing and eliminated the welfare state programs that function so effectively as automatic stabilizers? It still wouldn't be like the pictures you see of the Great Depression because we are a much wealthier nation than we were then and thus have more private resources to rely upon. But even so, not everyone has wealth to rely upon and the recession would be much more evident, and the amount of human suffering would be much greater, without the social insurance programs we put in place in the years since the Great Depression -- programs that we, for the most part, now take for granted. I don't mean there is no suffering due to the downturn, there is and I don't want to minimize it - I wish our social insurance programs were even more generous than they are now for that reason - and I don't mean to say there are no signs at all of economic problems, there are, but we shouldn't overlook the important role that social insurance plays during recessions.

I think we can have a debate over the appropriate level and form of social insurance, as I said, I don't think it is generous enough and I would also broaden it to include health care. But I don't think there can be any doubt about the importance and effectiveness of social insurance in helping to limit the impact of economic downturns.

So when we are assessing the effectiveness of government interventions designed to ease the recession, there are two alternative (or baseline) scenarios to think about. One is a world without the stimulus package and without the financial bailout, and that would be bad enough. But the other is a world without the stimulus package, without the financial bailout, and without social insurance, and that would be much, much worse.

Friday, July 31, 2009

The Courage to Click

Brad DeLong asks Do I Dare Click Through on This article by Jonah Goldberg? He then answers "No. I do not. I will remain forever ignorant..."

I dared to click through. Next time, I won't bother, and let me save you the trouble. The argument is that we don't spend enough to fight the threat of asteroids, so we must be spending too much fighting global warming, but one doesn't follow from the other. I see now why I can't remember the last time I read an article by Goldberg.

Maybe this sudden bout of timidity from Brad DeLong is my fault (though there is a sign he is recovering). Last night, I was the one who didn't dare click through on an article, so I sent the link to Brad saying "I just couldn’t read this. Maybe tomorrow." Looks like that may have sent him over the edge:

Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal, by Brad DeLong: Someone Is Saying Something Wrong on the Internet in the Pages of the Wall Street Journal!

My friend Mark Thoma is trying to diminish my quality of life by emailing me links to Donald Luskin writing in the Wall Street Journal:

Luskin: President Barack Obama proposed last month that the Fed act as an overall “systemic risk” regulator, with consolidated supervisory responsibility over “large, interconnected firms whose failure could threaten the stability of the system.” Now William C. Dudley, the ex-Goldman Sachs economist just appointed president of the New York Federal Reserve, has upped the ante.... Mr. Dudley is effectively asking for the power to control asset prices...




The Federal Reserve is not "asking for the power to control asset prices." It already has the power to control--or, rather, profoundly influence--asset prices already. When the Federal Reserve carries out an expansionary open-market operation, the whole point of the exercise is that it boosts bond and stock prices. The Federal Reserve buys bonds for cash. There are then fewer bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes up, and their yields--the interest rates quoted in the financial press--go down. Also by supply and demand, when bonds are yielding less investors are willing to pay more for substitute assets like equities and real estate, and their prices go up as well.

When the Federal Reserve carries out a contractionary open market operation, the same process works in reverse: the whole point of the exercise is that it lowers bond and stock prices. The Federal Reserve sells bonds for cash. There are then more bonds out there for the private sector to hold. By supply and demand, the prices of those bonds goes down, and their yields--the interest rates quoted in the financial press--go up. Also by supply and demand, when bonds are yielding more investors are willing to pay less for substitute assets like equities and real estate, and their prices go down as well.

For Luskin to claim that Dudley is asking for something new--that there is an extraordinary increase in the big, bad government's power to regulate financial markets contained in Dudley's "effectively asking for the power to control asset prices" is to demonstrate a degree of cluelessness that takes my breath away. The Federal Reserve already has the power to control asset prices. It has had this power since its founding in 1913. That's the point. That's what a central bank does. That's what it's for: it's an island of central planning power seated in the middle of the market economy.

If you don't like it, call for its abolition. But don't pretend that it isn't there--don't pretend that "Mr. Dudley... asking for the power to control asset prices" is some wild change in our current system.

Jeebus save us...

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Thursday, July 30, 2009

Fed Watch: More Confirmation of Steady Monetary Policy

Tim Duy sees, among other things, the possibility of another bubble:

More Confirmation of Steady Monetary Policy, by Tim Duy: Green shoots - or, as President Obama says - the beginning of the end of the recession aside, the Fed will not be ready to reverse their accommodative policy stance anytime soon. New York Federal Reserve  President William Dudley said as much in a speech today:

If the recovery does, in fact, turn out to be lackluster, the unemployment rate is likely to remain elevated and capacity utilization rates unusually low for some time to come. This suggests that inflation will be quiescent. For all these reasons, concern about “when” the Fed will exit from its current accommodative monetary policy stance is, in my view, very premature.

The Fed continues to expect that low levels of resource utilization will keep a lid on inflation. While some might object that emerging market economies can have both weak growth and high inflation, those economies still have an important transmission mechanism between higher prices and higher wages that appears to be missing in the US. Indeed, while the press focused on the old news "recession is ending" angle of the Beige Book, the money quote for policymakers was:

The weakness of labor markets has virtually eliminated upward wage pressure, and wages and compensation are steady or falling in most Districts; however, Boston cited some manufacturing and business services firms raising pay selectively, and Minneapolis said wage increases were moderate. Boston, Cleveland, Richmond, Chicago, Dallas, and San Francisco cited a range of methods firms are using to limit compensation, including cutting or freezing wages or benefit contributions, deferral of future salary increases, trimming bonuses and travel allowances, reducing hours, temporary shutdowns, periodic furloughs, and unpaid vacations.

Until economic growth is sufficient to propel wages upward, any residual price pressures are likely to be snuffed out by deteriorating real wage growth. Will the job market improve anytime soon? We get a fresh look at initial unemployment claims tomorrow morning, but the July consumer confidence report from the Conference Board indicates that households see a deteriorating jobs picture:

The share of consumers who said jobs are plentiful dropped to 3.6 percent, the lowest level since February 1983. The proportion of people who said jobs are hard to get climbed to 48.1 percent from 44.8 percent.

Lacking a story that leads to strong wage growth in the near - or even medium - term, the Fed is almost certainly on hold at least through this year and likely well into 2010, allowing the size of the balance sheet to adjust according to the needs of the financial markets while keeping interest rates at rock bottom levels. That doesn't mean all that easy money will not show up somewhere - technical analysts are looking for US equities to explode on the basis of recent market action. But will the Fed lean against such an explosion without clear and convincing evidence that the labor market is poised for strong, sustainable improvement? I doubt it - and for those looking for it, therein lies the ingredients for making the next big bubble.

"Surprising Comparative Properties of Monetary Models"

I need to read this paper:

Surprising Comparative Properties of Monetary Models: Results from a New Data Base, by John B. Taylor and Volker Wieland, May 2009 [open link]: Abstract: In this paper we investigate the comparative properties of empirically-estimated monetary models of the U.S. economy. We make use of a new data base of models designed for such investigations. We focus on three representative models: the Christiano, Eichenbaum, Evans (2005) model, the Smets and Wouters (2007) model, and the Taylor (1993a) model. Although the three models differ in terms of structure, estimation method, sample period, and data vintage, we find surprisingly similar economic impacts of unanticipated changes in the federal funds rate. However, the optimal monetary policy responses to other sources of economic fluctuations are widely different in the different models. We show that simple optimal policy rules that respond to the growth rate of output and smooth the interest rate are not robust. In contrast, policy rules with no interest rate smoothing and no response to the growth rate, as distinct from the level, of output are more robust. Robustness can be improved further by optimizing rules with respect to the average loss across the three models.

Sunday, July 26, 2009

Should Bernanke Be Reappointed?

Nouriel Roubini says:

Ben Bernanke ... deserves to be reappointed. Both the conventional and unconventional decisions made by this scholar of the Great Depression prevented the Great Recession of 2008-2009 from turning into the Great Depression 2.0.

Anna Schwartz has a different perspective:

As Federal Reserve chairman, Ben Bernanke has committed serious sins of commission and omission — and for those many sins, he does not deserve reappointment.

Here's how I see it. It's true that we failed to notice that the patient was getting sick. The signs of disease were there, but we either didn't see the signs or they were misdiagnosed. In fact, there's a case to be made that we saw some of the changes in the patient as signs of improving health. Had we made the correct diagnosis early enough, maybe we could have prevented the patient from getting sick (though it's not clear the patient would have taken our advice, so stronger measures than mere advice may have been required).

And once the patient showed up in the office and was clearly sick, we didn't get it right initially either. We thought the patient needed fluids - liquidity as they say - and the patient did need some of that, but we didn't immediately see that there were also some key nutrient deficiencies and chemical imbalances that were threatening to cause further problems.

Bu we kept at it with tests and other diagnostics, and eventually got a handle on the problem. Once we did, we began to administer the medicine the patient needed. The patient will get better, the deterioration was rapid and turning it around will be difficult - it won't happen fast enough to suit any of us - but what has been done prevented a complete collapse, and is helping to move the patient towards recovery.

So I'm with Nouriel, Bernanke should be reappointed. It's true that the progression of the underlying disease was largely missed, but that's pretty much true across the board, all the doctors missed it. It's also true that there was some dispute over how to interpret the initial symptoms and test results, and what to do to cure the patient. But again that was largely true across the board in the tumultuous period just after the patient began to exhibit clear and serious problems. It's not like everyone except the patient's doctors knew exactly what to do. The uncertainty in that initial period created fear, and the fear made the patient - who needed calm above all else - even worse off.

But as just noted, the doctors who were put in charge - Bernanke in particular - persevered and began to understand more precisely what was going wrong and what was needed, and that allowed them to save the patient from a much, much worse fate. They deserve credit for that. The patient will live, and that wasn't always so clear. In the initial confusion they did what you need to do - they administered wide spectrum drugs and other procedures that were known to abate the symptoms they were observing, and these did help, and that gave them time to find more targeted remedies. They used the time wisely to find and structure better remedies, and once those remedies were ready they used them to attack the various ways in which the disease was shutting down vital systems (not everything they tried worked, but the things that did work helped quite a bit).

There was one scary point, however, and that was when they thought the patient had become strong enough to go without the medicine, and they withdrew it too soon (the Lehman episode). The result was that they almost lost the patient completely, and only quick action saved the day. That's the one point where I think the doctors could have done better. I understand the concerns over the side effects of this medicine, but it was too soon and it created too much unnecessary uncertainty and fear.

But overall, they did the things that needed to be done to make sure the patient did not suffer an even worse, prolonged, debilitating collapse, and those efforts were successful. Failing to diagnose a disease is different from not knowing what to do once you figure it out. The disease was a difficult one to diagnose or it wouldn't have missed so widely, and it wasn't clear at first precisely what was wrong, but in every case, once they understood the problem, they took the proper course of action.

Here's the question I ask myself. If I were to suddenly come down with the same disease, would I want the current group with it's current leadership in charge of bringing me back to health, or would I want a different group led by someone new who thinks they know what to do, but has never actually been through it? I'd want this group, the one with experience. They're likely to have learned enough to spot the disease the next time and head it off all together, one hopes so. But if not and I get the disease, they are also likely to know just what to do - while avoiding the missteps they took the first time - to get me back on my feet as fast as possible (and please don't let politicians second guess them).

Friday, July 24, 2009

Fed Watch: The Debate Continues

Tim Duy looks at the shape of things to come:

The Debate Continues, by Tim Duy: The debate over the shape of the  recovery continues unabated.  Equities, at least this week, are voting in favor of the V-shaped recovery, with the Dow pushing past the 9,000 mark for the first time since January.  Never one to accept good news at face value, Nouriel Roubini predictably took the opposite position:

A “perfect storm” of fiscal deficits, rising bond yields, “soaring” oil prices, weak profits and a stagnant labor market could “blow the recovering world economy back into a double-dip recession,” he wrote in a research note today. “It is getting more likely unless a clear exit strategy from the massive monetary and fiscal stimulus is outlined even before it is implemented.”

Roubini, chairman of Roubini Global Economics and a professor at NYU’s Stern School of Business, predicted that the global economy will begin recovering near the end of 2009. The U.S. economy is likely to grow about 1 percent in the next two years, less than the 3 percent “trend,” he said.

Roubini based his short-term outlook on the worsening condition of the U.S. housing and labor markets, which he called “inextricably linked.” He said a “weak” job market will contribute to another 13 percent to 18 percent drop in house prices, bringing total declines nationally to as much as 45 percent from their peak.

I would add to Roubini's pessimism that  bond market investors as of yet do not share the optimism of their brethren in the equity side of the industry.  The run up in yields that brought a 4-handle to the 10 year Treasury appears to have been stopped dead in its tracks, and that maturity has pulled back to the mid threes.  If the run-up in yields foreshadowed a burst of optimism in equities, the pull back would suggest that this rally has nearly run its course.

 The challenge here is two-fold.  The first challenge is to determine how much of the recent equity run is attributable to the weight of evidence that indicates the worst of the downturn is behind us.  With the Armageddon trade off the table, some gains were inevitable, just as was the rise in Treasury yields.  The more difficult challenge is the strength and pattern of the subsequent recovery.  To be sure, one should not ignore the possibility of a blowout quarter here and there, as GDP data can bounce quickly to bounces in underlying data such as a stabilization in auto sales.  But will such a bounce reflect fundamental underlying strength?  A slow, jobless recovery - my dominant scenario - would most likely produce the seesaw trading we saw in the wake of the tech bubble crash, a pattern that held until the housing bubble gained full traction.  Such an outcome looks consistent with the sentiment of Federal Reserve Chairman Ben Bernanke in this weeks Congressional testimony:

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