"Interview with Robert Hall"

The Minneapolis Fed interviews Robert Hall. He covers quite a few topics such as the Fed's exit strategy, looting distressed banks, financial frictions, and the state of modern macro. At one point, he notes that his (zero interest rate) estimate of the government spending multiplier is 1.7:

Interview with Robert Hall, by Douglas Clement, The Region, FRB Minneapolis: ...Thoughts on U.S. Monetary Policy

Region: Perhaps we could start with monetary policy. What is your broad view of the Fed’s efforts over the past few years to stem the crisis using unconventional monetary policy and strategies?

Hall: First of all, I believe you should think of the Fed as simply part of the federal government when it comes to the financial side of its interventions. If you look at how the federal government responded initially, it was the Treasury that was providing the funds. Of course, TARP [Troubled Asset Relief Program] was there using the taxpayers’ money without involvement of the Fed. Also, early in the crisis Treasury deposited hundreds of billions of dollars at the Fed, which the Fed then used to buy assets. So there the Fed was just an agent of the Treasury. It was as if the Treasury took its funds to a broker.

Eventually, the Treasury was impeded from doing that by the federal debt limit. But the debt limit doesn’t apply to funds borrowed by the Fed, so it then started borrowing large amounts from banks by issuing reserves. That is what caused all the confusion about thinking this was somehow part of conventional monetary policy. 

I would distinguish between conventional monetary policy which sets the interest rate and this kind of financial intervention of buying what appear to be undervalued private securities. Issuing what appear to be overvalued public securities and trading them for undervalued private securities, at least under some conditions and some models, is the right thing to do. In my mind, it doesn’t make a big difference whether it’s done by the Federal Reserve, the Treasury or some other federal agency.

Region: And what are your thoughts on the best course for a Fed exit strategy?

Hall: That again gets at this confusion. Traditionally, reserves at the Fed pay zero interest in the United States, so in normal times with positive market interest rates, banks try to unload reserves; when they do so, they expand the economy. That does not happen when interest rates in the market are zero because there’s no incentive for banks to unload reserves. They can’t gain by getting something off their balance sheet if what they buy doesn’t yield any more. And during the crisis, there was no differential, nothing to be gained by unloading reserves.

As the differential reestablishes, which the markets think is going to happen in the next year or so, then that issue comes up. It would be highly expansionary and ultimately inflationary if market interest rates began to rise above zero and the Fed didn’t do something to either reduce the volume of reserves or increase the demand for reserves.

So the Fed has two tools, and Chairman Bernanke has been very clear on this point. He’s given a couple of excellent speeches that have described this fully, so it shouldn’t be an issue, and I think more or less it’s not anymore. The Fed can either leave the reserves out there but make them attractive to banks by paying interest on them, or it can withdraw them by selling the corresponding assets they’re invested in. Selling assets will be timely because those investments will have recovered to their proper values; the Fed can sell them and use the funds to retire the reserves.

So, again, there are two branches to the exit strategy: There’s paying interest on reserves, and there’s reducing reserves back to more normal levels. They’re both completely safe, so it’s a nonissue. The Fed itself is just not a danger. It is run by people who know exactly what to do. And we have 100 percent confidence they will do it. It’s not something I worry about.

Financial Frictions

Region: That’s reassuring, but I believe you do worry about financial frictions…

Hall: I do, I do very much.

Region: Your recent paper on gaps, or “wedges,” between the cost of and returns to borrowing and lending in business credit markets and homeowner loan markets argues that such frictions are a major force in business cycles.

Would you elaborate on what you mean by that and tell us what the policy implications might be?

Hall: There’s a picture that would help tell the story. It’s completely compelling. This graph shows what’s happened during the crisis to the interest rates faced by private decision makers: households and businesses. There’s been no systematic decline in those interest rates, especially those that control home building, purchases of cars and other consumer durables, and business investment. So although government interest rates for claims like Treasury notes fell quite a bit during the crisis, the same is not true for private interest rates.

Between those rates is some kind of friction, and what this means is that even though the Fed has driven the interest rate that it controls to zero, it hasn’t had that much effect on reducing borrowing costs to individuals and businesses. The result is it hasn’t transmitted the stimulus to where stimulus is needed, namely, private spending.

The government sector—federal, state and local—has been completely unable to crank up its own purchases of goods; the federal government has stimulated [spending] slightly but not enough to offset the decline that’s occurred at state and local governments.
 
Region: Yes, I’d like to ask you about that later.

Hall: So to get spending stimulated you need to provide incentive for private decision makers to reverse the adverse effects that the crisis has had by delivering lower interest rates. So far, that’s just not happened. The only interest rate that has declined by a meaningful amount is the conventional mortgage rate. But if you look at BAA bonds or auto loans or just across the board—there are half a dozen rates in this picture—they just haven’t declined. So there hasn’t been a stimulus to spending.

The mechanism we describe in our textbooks about how expansionary policy can take over by lowering interest rates and cure the recession is just not operating, and that seems to be very central to the reason that the crisis has resulted in an extended period of slack.

Region: So to incorporate that in a model seems quite important.

Hall: Yes, and many, many macroeconomists have turned their attention to that. I’ve been following the literature and been a discussant at many conferences of other people’s work on this. In fact, the Fed is giving a conference at the end of next week, and I’ll be presenting my paper on frictions.

Region: Your model is able, I think, to explain a fair amount of the current business cycle by incorporating those frictions.

Hall: I mainly look at, as kind of a thought experiment, how much of a decline in activity occurs when that kind of a friction develops. When private borrowing rates rise and public borrowing rates fall, the difference between them is the amount of friction. I show that that’s a potent source of trouble. I haven’t tried to align it with history prior to the current crisis. That’s an interesting question, but data on historical events aren’t always so easy, so that lies ahead.

Region: And the policy implications? What can and should be done to reduce frictions?

Hall: Good question! Well, it does point in the direction of focusing on things like lower rates for corporate bonds, BAA corporate bonds. They appear to be undervalued private assets, although that’s not been one of the types of assets that policy has seen as appropriate to buy or to help private organizations to buy. That would be one way to turn.

We’ve concentrated on doing that in mortgage-related assets. You can see in the picture that it’s had some effect. Most of the undervalued assets that the Fed has bought have been mortgage related. It’s been kind of an obsession with trying to solve these problems as they arise in home building, but home building is only part of the story. The collapse in other types of investment spending has been equally large. There would be a case for expanding that type of policy to other seemingly undervalued instruments.

That would presumably result in the same pattern you’ve seen in mortgages. That policy has been successful—differentially successful in depressing mortgage rates as opposed to bond rates or other areas.

Equity Depletion

Region: Let me ask you about a paper you wrote in December 2008, on equity depletion, defined as the “withdrawal of equity from firms with guaranteed debt.” We’re all well aware of government bailouts, and implicit or explicit guarantees of financial institutions…
 
Hall: That paper was actually reprinted in a book that just came out, Forward-Looking Decision Making [Princeton University Press, 2010]. It’s the last chapter in this book, which is a compilation of the Gorman lectures I gave at University College London in October 2008.

Region: You had a wonderfully provocative statement in it. You declare that equity depletion “appears to be an unlimited opportunity to steal from the government.”

Could you tell us what you mean by that? Why does equity depletion occur, and how does it constitute an opportunity to steal?

Hall: George Akerlof and Paul Romer wrote a paper published in 1993 in the Brookings Papers that described what they called “looting.” The particular form that looting took was through the ownership of a savings and loan; this was a feature of the savings-and-loan crisis of the late 1980s.

As a “looter,” you would use the savings and loan to attract deposits, pay the deposits as cash to yourself and then declare bankruptcy. Akerlof and Romer described a number of clever ways of doing that to escape the attention of lax regulators, and that’s the type of thing you see in many settings.

One of the big problems encountered recently is that institutions that have become very undercapitalized were still depleting their equity by paying dividends. The government has had to push very, very hard to get these financial institutions to stop paying dividends. Dividends are exactly equity depletion. With a government guarantee, it’s exactly what there’s incentive to do—as described in that paper.

On the other hand, it seems we’ve been much more successful currently than we were in what Akerlof and Romer described as far as preventing the most extreme forms of this conduct.

It’s a danger whenever you have guaranteed financial institutions that have gotten into a very low capital situation. They’ve suffered asset value declines, they’ve become extremely leveraged and they have this very asymmetric payoff to the owner: If they go under, it’s the government’s problem; if they recover, it’s the owner’s benefit. That asymmetry, which is the so-called moral hazard problem, is just a huge issue.

And yet, while we have a lot of institutions in that setting today, we don’t see many of them doing things that Akerlof and Romer described, such as paying themselves very large dividends. It’s been difficult to get them to cut the dividends, but they have not paid out very large dividends or concealed dividends.

So it looks like we’ve been somewhat successful in preventing the worst kind of stealing, but the asymmetry is still potentially a big issue. There are way too many bank failures that should not have occurred and especially should not have cost the taxpayers as much as they did.

Region: Your thoughts about what measures can be taken to curb this moral hazard?

Hall: The most important thing is to be sure that financial institutions that are guaranteed by the government have large amounts of capital so that the danger of them spending the taxpayers’ money rather than their own money is very small. That’s a principle that’s been deeply embedded in our regulations for a long time.

But I pointed out in this chapter the principle of so-called prompt corrective action, which says if capital goes below this mandated level, which is typically around 8 percent, then something has to be done right away before all the remaining capital gets depleted.

We just have not been successful at doing that. We have principles of regulation that allow the regulators to say that a bank is well capitalized even though the markets know that it’s not. Banks have been declared to be well capitalized even when the market value of their debt and the market value of their equity have declined to very low levels.

Regulators seem to ignore something that everyone in the market seems to know, which is that they’re shaky. There seems to be a lack of willingness to pay attention to all the signals that a regulator should pay attention to. All they do is look at certain accounting records, which don’t reflect what people know.

It’s not easy though. There’s been a large amount of discussion of this topic among very knowledgeable financial economists. My colleague Darrell Duffie here at Stanford has been a particular leader. There’s a group called the Squam Lake Working Group, of which he’s a member, that has been advocating ideas like, as a backstop, having long-term debt be convertible to equity. That is what happens in a bankruptcy, but under this strategy it would happen without a bankruptcy. It would happen automatically with certain contingencies and would solve the problem in a very nice way. It would potentially increase the borrowing cost, but it would properly get the incentives right.

A lot of people look to the example of Citibank. Citibank’s long-term debt has been selling at a considerable discount, which is a sign that the market knows that there’s an issue. So instead of doing what we have done, which is give guarantees of short-term debt with government investments, the alternative that the Squam Lake people are thinking of, and I’ve been thinking of too, is to somehow convert Citibank’s long-term debt into equity, which is the same thing that the market is in effect doing. That would eliminate the danger then that the bank couldn’t meet its obligations, in a way that is less burdensome to the taxpayer.

In retrospect, what we did was to save the economy from a tremendous train wreck. But we didn’t do it in a way that was as cheap for the taxpayer as it could have been. And, of course, there have been many examples discussed of this.

This is all in retrospect. And I certainly don’t criticize the people who were doing it at the time, especially Chairman Bernanke. But looking forward now to the next time this happens, convertible debt would be a huge step forward. If people at the Treasury could have just pushed a button to convert the debt, without needing a new law, they would have done it in a second. There’s no doubt about that. They just didn’t have that power.

So we need to give regulators that power through some sort of sensible security design. Regulators could do that, and financial institutions wouldn’t see it as terribly burdensome because the market would know that the probability of this kind of thing happening again is pretty low. And when it does happen again, which will be sometime in the next century, that button would be there to press, and we wouldn’t have the chaos that we had in September of 2008.

Government Spending and GDP

Region: You mentioned earlier the difficulty of stimulating the economy, and I’d like to discuss your work on government multipliers. The federal government’s stimulus package has been a topic of heated debate among economists, in terms of how much stimulus it’s truly provided and whether more is needed. In a recent paper, you analyze basically what happens to GDP when government purchases goods and services.

Would you give us your rough estimate of the size of the multiplier in the current era of very low interest rates, and share your sense of the impact of the current stimulus package?

Hall: The first thing to say, just looking at the big picture, is that when the idea of a stimulus through federal purchases program came up in the current crisis, the thinking was, “That’s feasible. We can increase purchases.” And then the question was how much would it raise GDP. There was a vigorous debate, around here anyhow, on this multiplier question.

The discussion has shifted now because the premise was that we would be able to raise government purchases. But, in fact, government purchases have not increased.

In part that’s because it’s very difficult and time-consuming to actually get the government to buy more stuff. This has been a critique of fiscal policy as long as I’ve been an economist, this notion that it takes so long to get spending up that typically the spending rises only after the recovery has occurred, and it comes at completely the wrong time.

Region: We searched in vain for “shovel-ready projects.”

Hall: Yes, “shovel-ready” turned out not to be. But the other fact is that there’s been a small increase in federal government purchases, but it’s been more than offset by declines in state and local government purchases.

The stimulus bill recognized that that was a danger. We have had these tremendously pinched state and local governments. A lot of them have just had no choice when their tax revenue declined but to reduce spending.

In spite of recognizing that potential when the stimulus program was designed, still the net effect of the crisis and the policy response was for government purchases to decline, not to rise. But by very small amounts. Basically, nothing happened to government purchases. And that was in an environment in which everybody—and certainly Congress was enthusiastic about it—was willing to go for a program with higher purchases. But no matter how hard they tried to turn the knob, it just wouldn’t go very far.

Region: So ARRA [American Recovery and Reinvestment Act of 2009] was for naught?

Hall: First of all, you have to take it apart, as I do in that paper, and ask how much of it went directly into government purchases, which is fairly small, or would stimulate state and local purchases, which was also fairly small.

A lot of it was providing income supplements, and there you get into the question of whether the people receiving the supplements increased their spending or not. That’s a whole other issue; I’m not commenting on that issue. That’s a very difficult question to answer.

To go on to the other part of your question, had there been an increase in government purchases that was successfully achieved, how much would that have increased GDP? The answer I got was around a factor of 1.7, which is at the high end of the range of what most economists were talking about.

I only reached that by thinking very carefully and reading a lot of recent commentary on this question of the implications of having a zero fed funds rate. That turns out to be very important. Others have found that to be true.

So I think that the people who looked at the evidence of what the multiplier is in normal times and said it’s maybe 0.8 or 1.0 (which I would agree with) kind of missed the point. There was a lot of, I think, inappropriate criticism.

Valerie Ramey, in contrast, has focused not on the immediate policy question but raised the scientific question about the long-run multiplier. Her numbers are ones that I respect and agree with. They’re more in the 0.9 range.

But on the issue of multipliers during periods of zero interest rates, because we didn’t have any changes in government purchases during this one time when we’ve reached the zero interest point, we don’t have any good empirical evidence. What we need is a time when interest rates are zero and there’s a big increase in government purchases. That just hasn’t happened.

So we have no way to know through pure practice; we have to use models. The models are very clear that it makes a big difference when we’re at the zero interest rate limit. The normal configuration is that you get this fiscal expansion—the government buys more, but that triggers sort of an automatic response from monetary policy to lean against it. If you shut that down by having interest rates stay at zero, you’ll get a bigger effect. That’s what this literature says and it’s quite a big difference.

Tax Policy

Region: Of course, this raises the issue of taxes, of needing to pay for deficit spending. And I notice the Time magazine cover above your desk about the flat tax. ...

Dynamics of Labor Markets

Region: You’ve also done a great deal of research on labor markets. In 1982, you documented the “importance of long-term jobs” in the United States. I’m not sure that’s still the case.

Hall: It’s still the case. ...

Recessions and Recession Dating

Region: People are wondering when will, or did, the current recession end, but I’d like to ask how you and the NBER [National Bureau of Economic Research] committee you lead decided when it began. ...

Stock Market Valuation

Region: Let me ask about the stock market. Roughly a decade ago, you did a lot of work on eCapital, eMarkets and stock market valuation. Your 2001 Richard Ely lecture was an example of that. And you suggested that investors did seem to be fairly estimating the market’s value if intangible capital was taken into account. Is that accurate? ...

Intellectual Property

Region: You’ve thought and written a great deal, in both technical and lay publications, about the economics of computers and software, as well as venture capital and entrepreneurs. ...

The State of Economics

Region: The past few years seem to have brought about a crisis of confidence in the economics profession, with critics suggesting that macroeconomics has failed in some fundamental way. It’s a topic addressed by [Minneapolis Fed President] Narayana Kocherlakota in our Annual Report this year. Do you agree that the macro profession failed the nation during the financial crisis?

Hall: I don’t. There are two parts to the issue. First, did macroeconomists fail to understand that a highly levered financial system based in large part on real-estate debt was vulnerable to a decline in real-estate prices? No way. Many of us pointed out the danger of thinly capitalized banks. We had enthusiastically backed the idea of prompt corrective action in bank regulation, so that banks would be recapitalized well before they became dangerously close to collapse. We watched in frustration as the regulators failed to take that action, even though they had promised they would.

Second, did macroeconomists fail to understand that financial collapse would result in deep recession? Not at all. A complete analysis of that exact issue appears in an extremely well-known and respected chapter in the Handbook of Macroeconomics in 1999, written by Ben Bernanke, Mark Gertler and Simon Gilchrist. Depletion of the capital of financial institutions raises financial frictions to levels that distinctly impede economic activity. In particular, credit-dependent spending on plant, equipment, inventories, housing and consumer durables collapses. That chapter is an excellent guide to the depth of the current recession.

Region: Thank you for a great conversation.