In Progress — AEI Subprime VI Charlie:
Complete Annotated Transcript
3:18:42 And I think the classic definition of quantitative easing is that the size and composition of a central bank’s balance sheet influences financial markets and the economy over and beyond the level of the policy rate. [slide 4] There’s a couple of things to notice about the definition. First, if you hold to that, and that is essentially the definition that my co-author and I, Ben Bernanke, provided in a paper about 5 years ago. A consequence of that definition (you might have heard of him), policy does not necessarily run out of ammunition at the zero bound. There are tools, the size and composition of the balance sheet, even if your funds rate is zero. – Vincent Reinhart
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Housing Doom is pleased to be building complete unauthorized annotated transcript VI.C for the American Enterprise Institute’s October 9, 2009 event "No Way Out: Government Response to the Financial Crisis".uuuA The event site has a variety of resources including both an audio and a video of the proceedings. There is as yet no official transcript.
AEI’s Vincent Reinhart has written a 50-odd page prospectusuuuE for a project to examine the (supposedly) recently concluded world financial crisis. This event provided both a kickoff for the "No Way Out" project and an opportunity for a variety of workers to criticize his prospectus.
Table of Contents
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- 0:00:00 – Vincent Reinhart Panel I intro
- 0:03:50 – Reinhart presentation (preview post)
- 0:31:02 – (40 seconds of dead air)
- 0:31:42 – Greg Ip response (preview post)
- 0:49:15 – Chris Whalen response (preview post)
- 1:02:28 – Angel Ubide response (preview post)
- 1:18:11 – Panel I discussion (brief preview post)
- 1:30:39 – Panel I Q&A
- 1:43:17 – adjournment begins
- 2:29:23 – Reinhart Panel II intro
- 2:33:01 – Ethan Ilzetzki presentation (short preview post)
- 3:00:38 – Q&A RE: Ilzetzki
- 3:00:55 – Charles Lane question
- 3:02:28 – Ilzetzki response
- 3:06:01 – Greg Howard[ph] question
- 3:06:14 – Ilzetzki response
- 3:07:08 – Joe Lieber question
- 3:07:41 – Ilzetzki response
- 3:08:44 – Carmen Reinhart question
- 3:10:11 – Ilzetzki response
- 3:12:11 – Chow Chen question
- 3:12:53 – Ilzetzki response
- 3:00:55 – Charles Lane question
- 3:15:51 – Reinhart Fed Panel introductory presentation
- 3:48:04 – Q&A RE: Reinhart (short preview post)
- 3:55:14 – Ricardo Reis presentation
- 4:21:52 – Q&A RE: Reis
- 4:27:23 – Michael Bordo presentation
- 4:47:40 – Q&A RE: Bordo
- 4:59:03 – Frederic Mishkin presentation
- 5:26:50 – Q&A RE: Mishkin
- 5:28:45 (end)
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Vincent Reinhart: [0:00:00] Good Morning, we’d like to start, if you can. My name is Vincent Reinhart, I’m a Resident Scholar here at the American Enterprise Institute. We are joined, not just by everyone in this room, but also by C-SPAN, so I’m going to try to keep everything on time.
As part of the response to the ongoing financial crisis, the US government has significantly expanded its role in the economy. Treasury’s invested in banks, the two mortgage lending giants Fannie Mae and Freddie Mac are in government conservatorship, the Federal Reserve has ownership stakes in some firms, has signficantly increased the variety of its facilities and has a balance sheet north of $2 trillion.
How and when should those equity interests be sold? What strings should be attached to the government’s role in the financial system? And what’s the future of the model of public interest in private ownership implied by "Too Big to Fail". We’re going to address these issues as part of a project sponsored by the Smith Richardson Foundation that will ultimately wind up as a volume, but we wanted feedback while in the process of producing that volume, rather than after the fact, so I’ve drafted a review of events that I’ll talk about briefly; then we’ve talked with numerous market participants on a private basis, and we’ve arranged two panels for today.
The first panel involves the views of market observers, and the second of academics.
Let me introduce the panel this morning briefly. We’ll go by alphabetical order, and each of the three will have about 15 or 20 minutes to talk.
Greg Ip, on my right, is the US economics editor of The Economist, he covers the economy, financial markets, monetary, fiscal and regulatory policy. He contributes to the Economist blog Free Exchange, and comments frequently on television and the radio. Before his current position, Greg was a reporter for the Wall Street Journal and therefore meant that anytime you saw his name come up on your phone log, you knew you were in trouble.
To Greg’s right is Christopher Whalen, the co-founder and Managing Director of Institutional Risk Analytics, where he’s responsible for sales, business development and editorial activities. He’s worked as an investment banker, research analyst and journalist for more than two decades, and covers a variety of industry sectors, including tech and financial institutions. He edits the newsletter The Institutional Risk Analyst, and contributes regularly to such publications as Barron’s, the International Economy and The American Banker.
To Chris’ right is Angel Ubide, a director of global economics at Tudor Investment Corporation, a leading global funds management company. He is a visiting fellow at the Peterson Institute for International Economics and an active member of several international economic policy organizations. He writes a biweekly column on international economics for the leading newspaper in Spain and contributes regularly to a variety of sources.
So I’d like to set the stage [slide 1uuuB] for these guys’ conversation about what just happened to us, and what’s the way forward by asking 5 questions relevant to where we go from here. And those are [slide 2] …
- Why are US households so undiversified?
- How should we manage the crisis?
- How should we deal with troubled financial institutions?
- What has been the role of the international sector? and,
- How should the Federal Reserve respond to asset prices?
And I’ll take those in turn.
In some sense, we’ve seen the problem, and it is us. [slide 3] US households are undiversified, in part [slide 4] because the US goverment provides considerable encouragement to home ownership — mortgage interest payments are deductable for tax purposes, the housing-related government sponsored enterprises [GSEs] have created a market for mortgage securitization and hold a large portfolio of whole loans and [0:05:00] securities.
The Federal Reserve grants those two GSEs direct access to the payment system and facilitates the clearing and settling of their securities. Indeed, the securities of the GSEs are government securities, because the Federal Reserve says it.
Regulatory guidance over time has encouraged housing activity, especially in under-served areas. This encouragement was formalized in the Consumer Reinvestment Act, reporting requirements under HMDA, and affordable housing guidelines to the GSEs.
The American public has responded to those incentives in the sense that, if you look at debt secured by primary residence, as mortgages, they go throughout the income distribution. [slide 5] That chart reports from the Survey of Consumer Finances the share of households that have a mortgage. Starting at the top, the high income, those in the top decile, going down after that by quintile.
Lots of people have mortgages, and notice that it is across the income distribution. That’s even more striking if you look at family holdings of financial assets in the last reading we have, 2007. [slide 6] The left columns look at the share of families holding stock, that is direct ownership of equity. And the plain fact is, equity ownership doesn’t penetrate too far down the income distibution. Households in the top 80 to 100 percent hold … about 40 percent of them hold equities. But once you get below that in the income distribution, direct ownership isn’t that common. That’s not so for houses.
If you look at the column marked "Primary Residence," you see that households hold a lot of their wealth in the form of their homes. Indeed, the last column looks at house values as a share of assets. And for low income people, that’s at least a half.
The housing bubble, the financial crisis and the policy response have been shaped by the fact that the government encourages levered bets on housing and that avenues for wealth creation are limited for lower income households. [slide 7] What’s that mean? It means that for the lower income households, there aren’t many opportunities for capital gains. One, encouraged by the government in allowing leverage, is homeownership.
As a consequence, households are underdiversified, with much of their wealth in homes. The consequences of that, of this focus on housing, means it created retail encouragement to the housing bubble. It also erected a political barrier protecting the institutions facilitating the bubble, and raised the importance of protecting those same institutions when in distress.
The second question I’d like to ask is how should we manage a crisis? [slide 8] And I have 4 simple rules for bailouts.
First, don’t do ‘em. [slide 9] Economists have a pretty easy explanation for that, the possibility of government intervention has consequences for the private sector, the government and the political process. The private sector has less discipline on them to raise capital and address the underlying problems. Why? Because there’s less counterparty discipline. The counterparties see the government as the ultimate backstop.
The government has the problem of opening its agencies to political pressure — once they own an auto company, once they have a particular equity intrest in financial firms. It also confuses the public about policy intent. For the political process, it tilts the political playing field toward intervention generally.
Now my second rule is, if you break rule 1, be consistent. [slide 10] And the problem in 2008 was that policy interventions by the Federal Reserve and the Treasury were ambiguous as to the scale and scope of the protections offered. Depending on which weekend, some firms were helped, and others not, depending on which firms on a given weekend, some creditors were made whole, and some faced haircuts. This created incentives for creditors and short-sellers to test the limits of intervention, and indeed, perhaps fostered speculative attacks.
Rule 3 is if you break rule 2, that is, [0:10:00] you’ve intervened and you’re not consistent, be prepared to spend a lot. [slide 11]
The bars at the right panel give a chart from a book my wife Carmen has just published with Ken Rogoff from Harvard, called This Time Is Different: Eight Centuries of Financial Folly,uuuC and what it lists is public debt 3 years after a financial crisis for 15 financial crises in the post-War period. And the bottom line message is, 3 years after a crisis, on average, the level of public debt is 86 percent higher. Governments have to spend a lot after a financial crisis because: the economy is weak, they don’t get tax revenues, they do fiscal stimulus, and there’s probably some form of assuming the losses on national champions’ balance sheets.
When you spend a lot, the possibility of intervention leads investors to delay capital investments, deepening the capital hole. And if private investors don’t do it, the government has to.
Rule 4, whatever you do, don’t add to uncertainty and worsen confidence. [slide 12] I think you can argue that the statements in the fall associated with facilitating or encouraging the Congress to pass the TARP legislation, and then justifying the interventions with regard to AIG added to uncertainty and damaged confidence. High frequency indicators like The Institute of Supply Management’s Purchasing Manager Index or Spending on Durable Goods essentially fell off the cliff that September and October. That’s a problem inherent in the brinksmanship of bailouts. Political salesmanship doesn’t align well with economic stewardship.
As a consequence, policymakers amplified the shock. They weren’t the victims of the perfect storm, or the hundred year flood. The better for it is to see our financial officials as the Army Corps of Engineers, making decisions on dikes and levees upstream, which has consequences for the floodplain. [slide 13] The government, as a consequence, has a considerable ownership stake in financial organizations, and has widened the perimeter of its safety net.
How should the government deal with troubled financial institutions? [slide 14]
There are three core issues … [slide 15]
- When do you recognize the loss?
- Who assumes that loss? and,
- What protections are given to investors?
Taking those in turn, the government’s response has varied over time. [slide 16] I’ve given you a couple of examples in the rows of this table, and asked those same three questions again: who recognizes the loss? who assumes the loss? and what protections are offered?
In the first row, I give what is our stylized description of the Hoover days of the Great Depression. When was the loss recognized? Pretty quickly, because it was financial institutions that were facing deposit runs. Who assumed them? Well, the private sector. And what protections were offered? None. The consequences for that in terms of contagion and fostering deposit runs led to, in part worsened the economic crisis and led to the backlash associated with President Roosevelt, in which the losses were assumed part by the private sector, but part by the government, and government guarantees were offered to protect depositors.
The range of government responses have varied over the years, but generally, you’ll see in the last column, all governments about all the time offer deposit protection. Sometimes that safety net is porous, sometimes it is cast very wide and quite dense. But most governments do that, because deposit runs are seen as something that should be avoided.
And generally, since the Great Depression, losses have been assumed by a mix … shared between the private sector and the government. Unfortunately, in the last 30 years, the recognition of loss has also been delayed. When it’s the government that has to foot the bill, politicians don’t like to accept that there are losses associated with their [0:15:00] protections offered to the financial sector.
Now, this is another chart from my wife’s book, [slide 17] the blue line gives the incidence of banking crises in all countries since 1800. It gives the share of the total sample in which there’s banking crises. And banking crises are infrequently very common, but they occur pretty often, except in one stretch of time. And that’s toward the right of the panel, you see in the ’40s, ’50s, ’60s and even into the ’70s. There was about 4 decades in which significant post-Depression restrictions on finance slashed the incidence of banking crises.
So one question, one answer to the question how do you deal with financial institutions in crises is, regulate them a lot, restrict their range of activities so they don’t have crises.
We think there’s probably economic costs associated with that, but that’s a question we have to address, and the experience post-1980 has to be looked at rigorously compared to the pre-1980 experience.
Policymakers often, post-1980 policymakers have often opted to allow institutions to delay recognition of losses. That’s called forebearance. [slide 18] And forebearance, the argument runs, allows banks to repair their balance sheets and lessens their need to tap markets when they are currently in disfavor. Forebearance, however, may indeed change the perception of markets about the health of banks. If they don’t have to admit their losses, maybe they’re not as much in disfavor in markets.
But it doesn’t change the understanding bank managers have about their losses, and their need to fill a capital hole. So even during periods of forebearance, bank managers still are reluctant to lend and support market activity, because they understand they need more capital.
It also freezes the market for the asset class you’re forebearing. Why? Because the regulators tell a bank, that asset is worth more on the books — its own books, than it is in the market. And there becomes an overhang of the market. And that leads to a growth cost. [slide 19]
There are a couple of episodes, again going back to the initial table, where forebearance was pretty important. The first was in the United States in 1981 and 1982. A lot of Latin American countries defaulted, and money center banks, many of them, were insolvent. But rather than force the recognition of that insolvency, regulators allowed them to muddle through. They were a drag on spending, they didn’t support markets, they didn’t make many new loans available. But the rest of the economy was in the midst of a powerful recovery, and could get by, past that.
And so, ultimately there was clean-up, clean-up in the form of the Brady Plan in 1988.
But that policy of forebearance, not significant for the US recovery, was significant for the Latin American countries in the Western Hem [Hemisphere]. Why? Because there was no effective market for their sovereign debt for a decade.
And the first reference to "the lost decade" came back in those years. In those years, Latin American countries grew 1 3/4 percent slower on average than the rest of the world, for a cummulative output loss of 17 percent.
Another big example of forebearance is the Japanese economy, in which real estate was driving a large hole through their large banks. Rather than immediately recognize the losses, those banks were able to carry them. But for 13 years, property prices declined as the overhang of those assets on bank balance sheets froze the market. And the Japanese economy, for those almost 15 years — rather for the — yeah, almost … grew 2 1/4 percent slower than the rest of the world, for a cummulative output gap of … loss of 30 percent. Forebearance can be expensive.
Let me go to the … in the interests of time … the Nordics, in the last two columns, are an alternative model, in which their [0:20:00] — rather than delaying recognition, there’s a relatively forceful movement by the government to accept the losses on bank balance sheets. There was a cost associated with that, 3 percent loss in output in Norway, 2 1/2 loss in output in Sweden, but it was short and protracted … it was short rather than protracted.
In this crisis, [slide 20] the government has assumed some of the loss by injecting capital and purchasing underwater assets. And it’s widened the perimeter of the safety net, effectively enshining too-big-to-fail, which is really too-complicated-to-fail, and the Treasury reform would indeed codify too-complicated-to-fail. As a practical consequence of this complexity, [slide 21] large complex financial institutions are hard to supervise, because it’s very hard to understand what goes on inside.
It’s hard for the market to discipline, because potential counterparties can’t really see into that black box, and it’s hard for management to supervise, creating incentive misalignments and suitability problems. So there are consequences for how you deal with the crisis.
Next I’d like to talk about — what’s the role of the international sector? [slide 22] And especially since the Asian crisis in 1997 and 1998, emerging market economies have been accumulating foreign exchange reserves at a rapid clip. [slide 23] Part of this is to build up a buffer for emergencies; the Asian Crisis told them they needed a bigger reserve. But part is to offset upward pressures on the exchange rate to foster a development strategy of export-led growth; and part is to diversify, given that many of the countries have a population with a high saving rate and very rapid growth in income.
As a consequence, the reserves of the emerging market economies have been moving up pretty rapidly, but those capital flows represent a fund … represent a mechanism to fund demands in the United States. [slide 24] About 2/3rds of those increased reserve demands have fallen on US government securities, effectively meaning the global investor funded the US current account deficit. The blue lines give that same reserve accumulation, now inverted, and the red line gives the current account. In many of the years, reserve accumulation was sufficient to fund the entire US current account. This altered the composition of finance, and kept the level of long-term interest rates lower than it would be otherwise.
If you look [slide 25] at the net creation of US Treasury securities — that’s just our deficit — and plot it as the red bars, compared to estimates of the net accumulations of reserves, there are several years in which foreign official accounts wanted more Treasury securities than the Treasury was creating.
What did that mean? [slide 26] It meant that the foreign private sector, if it wanted exposure to the US market, had to get private credit, and indeed foreign exposure to US private credit, the solid line there, moved up sharply as foreign official entities loaded up on treasuries and US financial engineers constructed triple-A exposure to the US for foreign institutions.
Global savings kept US long term interest rates low, [slide 27] and disconnected from the policy rate. [slide 28] If you just look at that left column, it gives the simple correlation between the monthly change in the Federal Funds Rate and the 10-year Treasury yield. In the 1980s, the 1st row, that correlation was about point 4. Into the middle part of the ’80s, the correlation was still point 3. But from ‘96 onward, that correlation was effectively zero.
That is, the Federal Funds Rate was unrelated to the changes in the 10-year Treasury in the sample since 1996.
So if you want to ask the question, the Federal Reserve missed an opportunity to fight the asset bubble. You have to address how, or why this correlation would change. [0:25:00]
That leads to Federal Reserve policy and how it should respond to asset prices. [slide 29] First I’d just like to outline the traditional view, and then talk about why it might have gone wrong.
US monetary policymakers follow a basic syllogism, [slide 30] favorite word for awhile, with regard to asset prices, whether those asset prices were the foreign exchange value of the dollar, equity prices, or home values. Works the same, that’s the … you can just fill it in whenever I say an asset price.
Monetary policy should act to offset potential slack or pressures on economy-wide resources. Such preemptive policymaking requires making a forecast. Monetary policy works with a lag, you make a forecast, and you try to offset unwelcome pressures in that forecast.
Asset prices may be important in making that forcast, because they may be important determinants of current and future spending and pressures on inflation. Therefore, asset prices do matter for monetary policy, but they don’t loom larger than their direct contribution to spending and inflation.
So for the last 2 decades, if you asked a monetary policymaker, don’t they care about asset prices? … aren’t they worried about a bubble? … they’d say, "Of course we’re worried about asset prices, only to the extent they matter for good economic performance in terms of spending and inflation."
This does not say a central bank should be indifferent to asset prices, it doesn’t say you shouldn’t use other tools if you have them, like margin requirements. And it doesn’t say you shouldn’t respond to the consequences of an asset bubble if it bursts. But this was the driving syllogism.
Why? [slide 31] Because, if think, policymakers were much impressed with the idea that the private sector was supposed to have a comparative advantage over the public sector in pricing and managing assets. Financial market participants devote a lot of resources to it, more than at central banks. And once you’ve got the asset, do you really want the government to run it? Indeed, the experience in many emerging market economies is, value quickly erodes when the government tries to run what was formerly in the private sector.
And also, once those assets are there, held by the government, there’s political pressure.
Why also might you follow the syllogism and not do anything more than that? Because asset prices are complicated, and markets were supposed to be rational. [slide 32] Asset prices have many moving parts — expected earnings, expected future earnings, a risk premia, risk-free discount rate, uncertainty matters. Asset pricing is supposed to be complicated. It was delegated to the market. And indeed, because asset pricing was complicated, it really wasn’t even clear how a change in policy would be associated with a change in an asset price.
That scatter plot, those dots at the upper right are just the monthly correlations between the policy rate and the change in the S&P 500. They fill out all 4 quadrants. It isn’t obvious that you have an obvious and predictable lever where you change a policy rate and the stock market moves, or house prices move, or the foreign exchange value of the dollar moves.
Indeed, the little table at the bottom shows how the … how equity prices changed in the week that the Federal Funds target was changed since 1987. And you see in this yellow shaded part 30 percent of the time, the Federal Reserve changed the policy rate, that is, equity prices moved the wrong way. 30 percent of the time the Fed Funds Rate was increased, equity prices increased.
So it wasn’t clear that policymakers knew how to use the lever they had.
And then lastly, [slide 33] acting in specific markets might undermine the legitimacy of a central bank. How so? The Federal Reserve act tells policymakers to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. It doesn’t say anything about keeping homes affordable, or equity prices high, or the foreign exchange value of the dollar around a given range. So there’s no obvious rationale for a preemptive stike on asset prices.
But what have we learned since the period in which the syllogism was [0:30:00] dominant? [slide 34] Well, markets don’t always get it right. How come? The complexity of financial institutions lessens the effectiveness of supervision, market discipline and internal controls.
Foreign funding can facilitate excesses. And cleaning up after the fact can be expensive, particularly when crisis management is not done well and authorities are slow to acknowledge solvency problems.
The political impediment to preemptive action with regard to asset prices remains. I still find it hard to believe that Alan Greenspan couldn’t have gone to Congress in 2005 and said, "House prices are going up too much." And those … that political impediment could get severe … more severe over time through the extent that the Federal Reserve’s independence is eroded.
But, I think I’ve talked too much, and I’d now like to turn it to Greg.
Greg Ip: … and thank-you Chris, [slide 1uuuD] for turning on my microphone. [laughter]
Vincent’s paper that he asked me to comment on covers an amazing amount of ground, and so I can’t possibly comment with any intelligence on all of it. I’m not sure I can comment intelligently on any of it, but I’m going to try and tackle point number 4 in Vincent’s original list of factors, which was the role of international linkages in this crisis. [slide 2] Because, as he says in his own paper, most of the research so far has been narrow and focused inward to the United States, whereas one of the central mysteries or puzzles of this whole affair is how an initiating economic shock, which was essentially a decline in values of particular mortgages and real estate in the United States could wreak so much havoc around the world.
And this implicitly calls for a global explanation, and Vincent does, I think, a superb job of drawing out some of these factors in his paper. But in the process, he implicitly deemphasizes the role of domestic factors and explanations, so while I do find the global explanation compelling, I think that it leaves some mysteries, and I’m going to touch on a few of these.
Mystery #1 is — why did some countries have housing bubbles but not banking crises? [slide 3] As you can see from my list here, there are countries like Australia and Spain whose housing bubbles were, if anything, even bigger and more extreme than that of the United States, but those countries have so far escaped banking crises. In Canada the case was that the bubble was not as large as the United States, but it was a bubble nonetheless, and the economy has performed quite badly, and yet still no banking crisis.
Conversely, look at Germany and Switzerland. You have a situation there where they did not have housing bubbles, and yet they had banking crises. And by banking crises, I mean essentially a situation where one or more large, important institutions needed public assistance to avoid severe distress.
Mystery #2 — why did some countries have current account deficits but not have crises? [slide 4] If you read this bookuuuC by Carmen Reinhart and Ken Rogoff that Vincent, an unbiased observer, recently promoted. [laughs] You’ll get … part of the topology of crises there is that one of the strongest leading indcators of a banking crisis is a large inflow of foreign capital. In that respect, the United Kingdom, the United States are posterchilds for the … the march toward crisis. They had large current account deficits, large inflows of foreign capital, excessive credit growth. This produced asset bubbles and, eventually, crises.
But the exceptions, again, are interesting. Australia and Spain. Large current account deficits, no banking crisis. Germany and Switzerland. Large current account surpluses — they had crises.
Mystery #3 — why did some countries avoid crises, but they still ended up in recession? [slide 5] As I mentioned, the recession of Canada is almost as severe as that of the United States. Interestingly, in the Great Depression, Canada had no bank failures, but its recession was the 2nd worst, I think, around the world. Michael Bordo [on panel II] can correct me on that.
Japan — a recession … one of the worst recessions, if not the worst in the G7 now. No banking crisis, at least no new banking crisis. [laughs] Spain — again no banking crisis, yet a very severe recession.
So what are the answers to these mysteries?
I think, actually, Reinhart … Vincent does a very good job in his paper of solving [0:35:00] mystery #3. [slide 6] He basically says that linkages, both trade and financial linkages around the world have turned out to be very important.
In the case of Canada and Japan, they are very export-dependent economies, in fact you could argue that in the case of Japan and of Germany, their fall into recession is the real-side facet of the global imbalances, which is having exported so much of their excess savings to the United States and the United Kingdom and other deficit countries, their economies became excessively dependent on foreign consumption instead of domestic consumption, and when recession hit their major customers, they had very few shock absorbers. Spain, the explanation is a little bit more straightforward. They had an enormous contribution to growth in the boom years from residential investment, and the collapse of that was essentially a guaranteed recipe for a severe recession.
And more generally, it’s well established that financial contagion goes global, and you don’t need to actually prove that every country became infatuated with subprime collateralized debt obligations. Essentially animal spirits are very … they cross borders very quickly. And if you looked at, for example, withdrawal of funding liquidity in the interbank markets that followed the initial stages of the crisis, this happened in markets like Australia and Japan where funding was extremely ample and the banks were not thought to have any funding problems, and it happened in the countries like the United States and the United Kingdom where those problems were more apparent.
So what about the contribution of domestic factors. Let’s start with US monetary policy. [slide 7] Vincent essentially exonerates the Fed. He points out with some fairly convincing statistical evidence that the global saving glut, a term that was coined by Ben Bernanke and then picked up and adopted by quite a few other people, including Alan Greenspan, broke the link between US short and long term rates. And I have found this the single most compelling explanation for why the global story is … why we got housing bubbles. Because we had housing bubbles around the world.
And as most people who’ve looked at this know, the US housing bubble is not particularly striking in its magnitude. Many countries had bigger housing bubbles, and so the best explanation for this is a global interest rate story. But I don’t think that completely exonerates policy. It may exonerate idiosyncratic US policy, but we should remember that all major central banks pursued the same approach to the deflationary risks at that time. The European Central Bank, the Bank of England, kept policy rates extremely low. No, not as low as the United States, but much lower than historically was the case.
So with hindsight, of course, did we have a synchronized global policy error? And I think this is a fertile area for future research.
But the bottom line is that, whether you buy the story that it was a global savings glut or a synchronized global story, this is a convincing explanation for why housing bubbles appeared around the world, and they reduce, if not eliminate, the culpability of US monetary policy.
What about US regulatory policy? [slide 8] Vincent touches on two areas where US regulatory policy probably contributed to the crisis. During the crisis itself, he says, the Treasury and the Fed’s form of intervention was both chaotic, ad hoc, and it had a tendency to discourage private sector actors from coming in, infusing these weakened institutions with capital, and therefore aggravating the crisis, and increasing the need for public intervention.
Before the crisis, he touches on several areas of policy that aggravated the initial conditions of the bust. He specifically cites the Community Reinvestment Act, which required depositories to extend additional … to essentially have their lending activities essentially in line with their deposit-taking activities in particular communities, and the GSEs. Now I’m walking into the lion’s den here, because I know that I’m surrounded by people who’ve studied this issue much more thoroughly than I have and have found pretty convincing evidence that both CRA and the GSEs were prime suspects in the crisis. But I consider myself unconvinced.
Number 1 — CRA was passed in 1977, and it was tightened in the early 1990s, but this does not help explain why the true excesses in subprime occurred only in the 2000s. And more important, CRA only covered depositories, and yet there is a fair bit of evidence now that loans that were originated by depositories, or more specifically by banks (I’m excluding thrifts here), performed significantly better than those originated by non-banks. And so, I think the explanation — I’m not saying CRA had no role here, but to suggest that it was a prime suspect I think goes against the grain of this important disparity in loan performance by type of originator.
How about the GSEs? Ed Pinto’s sitting in the audience, and so I contest the role of the GSEs at my peril, yet … yes, GSEs did increase their subprime exposure, and yes they did have a strong public policy pressure to do so, but an equally convincing story can be told that as the private label subprime market expanded rapidly in the 2000s, the GSEs faced the potential loss of market share [0:40:00] in their prime business. And so they would have done this even without the prod of public policy; because of their profit-maximizing structure, they would have done this anyway, and doing so in the pursuit of some publicly stated mandate to improve homeownership among low income people was handy camouflage for what was a good profit-maximizing strategy.
And I would point out that exactly the same language was used by Angelo Mozilo of CountryWide, who did not face any of the same public policy pressure to increase homeownership. Yet he repeatedly portrayed what he was doing in terms of expanding loans to people who couldn’t make traditional down payments, as essentially doing the work of the angels. This was what you did to increase homeownership. But I strongly suspect, that while I cannot look into his soul, that if he had to choose between profit maximization and improving homeownership, I don’t doubt what was the more persuasive motivation.
So what were the real regulatory failures? [slide 9] Again I don’t expect to get much buy-in from this crowd on some of my own diagnoses, but I think that, if you look at the specific structure of the domestic financial systems around the world, including the regulatory environment, it helps explain mysteries #1 and #2, i.e. why did countries that had current account deficits and housing bubbles not have crises? and vice versa.
As Vincent points out in his paper, the United States exported some of its innovations in housing finance. We know, for example, that German banks were heavily exposed to US CDOs, that UBS, which required a bailout from the Swiss government, was heavily exposed to the warehousing of US MBS on its balance sheet. Although it’s important to point out that in neither Germany or Switzerland, the problem occurred because of the introduction of subprime mortgages into German and Swiss householders. In fact, it was a consequence of the international activities of their banks.
British banks, a slightly different story here. If anybody went to the UK, you know in the final years of the boom you would have seen, like, ads on the buses promising 125 percent down loans and so forth. That wasn’t an innovation imported from the United States, the Brits came up with that all by themselves. And the other thing that brought down the British banks was excessive dependence on wholesale funding, which exposed those that were the weaker ones to a wholesale loss of confidence in requiring the government’s bailout, a situation that was actually more analogous to the American investment banks, not the commercial banks.
But as to the actual role of innovation being exported, and therefore inculcating vulnerability to crises, I’d point out that after the United States, Australia and Canada have the most well developed Mortgage Backed Securities markets. But neither of them, as I have pointed out, had a banking crisis.
In fact, I think what you need to do to get an answer to this question, you need to more specifically look into subprime … look inside specifically what originators of mortgages were doing with these innovations. If you look at this chart, which I got from the Reserve Bank of Australia, [slide 10] it’s quite striking that notwithstanding the very large Australia MBS market, very few of those mortgages were backed by what they would call nonconforming, unconventional loans. The contrast with the United States is quite a bit larger.
So for whatever cultural, regulatory or idiosyncratic reasons, the United States had a bigger market to what we colloquially call subprime or unconventional loans.
And the other fact that stands out in any comparison of the US to some of these other countries is the size of its Shadow Banking System. Depositories in the United States tend to have a very small share of the provision of credit to households and businesses. If you look at this chart, [slide 11] which comes from the International Monetary Fund, in 2006 you’ll see it’s the lowest of the major countries, at only about a quarter. And by extension, the difference, the 75 percent, is what we’d call the Shadow Banking System.
Remember in the old days, we used to call the Shadow Banking System Non-Banks, and that term never really caught on, [laughs] and I … our hats are off to PIMCO for coining the term "Shadow Banking System," which is so much more of an evocative term for dealing with a rather dry concept.
Now we’ve tended to sort of kick the Shadow Banking System while it’s down, and that’s a little bit too hasty, because it definitely had positive contributions. [slide 12] The fact that this system thrived outside the much tighter regulatory straightjacket that depositories did meant that they were laboratories of innovation, and they produced products such as Adjustable Rate Mortgages, and I’m talking about good ARMs, not the bad ARMs, which then were adopted by the industry as a whole, including the banks.
They made credit increasingly available to segments of the population that were previously shut out. They did make higher homeownership possible, and I have my problems with that as a policy goal, but most of the United States thinks it’s a good thing. And they reduced the dependence of the financial system on taxpayer guarantees, be it deposit insurance (or so we thought). It turns out that that was an illusory benefit.
But the Shadow Banking System had a couple of important minuses.
Number 1, they … because the Shadow Banking System had [0:45:00] much thinner capital cushions, as a rule, than the banking system, it created a more leveraged financial system and introduced fragility that made the US economy much more vulnerable to crisis.
Another minus was that it introduced an unlevel playing field between banks and bank holding companies and the Shadow Banks. And so banks did the natural thing. They tried to find ways to level the playing field. One of the ways they did this was to try and reduce the capital burdens.
For example that was one of the reasons securitization became so important. It’s one reason the off-balance-sheet vehicles became more important, and I would point out that the regulators like the Federal Reserve were generally supportive of these trends. And it also meant that they went out and the purchased non-bank originators; most famously HSBC purchased Household Finance in 2002, and it was a very high degree of delinquencies in the loans that they acquired through Household that caused them in early 2007 to shock the market by announcing they were absorbing large losses. And smart people attribute the beginning of the crisis to the HSBC announcement.uuuF And the other important transaction in this space was Citigroup and their purchase of Associates. Again, purchases that were blessed, and sometimes encouraged by the banking regulators.
Now we routinely call this a banking crisis, but it’s important to note that at first it was not a banking crisis, it was a shadow banking crisis. [slide 13] And in fact, if you plot the sequence of distress and failure against the degree of capital and regulation of the various institutions you will find a pretty good inverse correlation where the companies that had the least capital and the least regulation failed first.
In 2007, it was companies like New Century, at the time one of the fastest growing and largest stand-alone finance companies. We move into the later part of 2007 and the first half of 2008, and the investment banks get into trouble, led by Bear Stearns, and then the GSEs.
And finally, it was the banks and the bank holding companies that started to collapse.
So one of the priors of the regulatory community, which was that whatever happened out there, our banks were well capitalized, and relatively strong, actually turned out to be true. It just turned out that they weren’t strong enough, compared to the tsunami that was about to hit.
What are the policy implications of all the things I’ve touched upon here? [slide 14] I find myself very sympathetic to Vincent’s defense of the original priors of the central banking community, that it is difficult and unwise to target asset price bubbles. I have not yet seen an obvious and compelling solution to the problem of the global savings glut, and the recurrence of bubbles. And therefore, I make this unheroic prediction — that the next time will not be different.
Increasing bank capital requirements is now the most probably uncontroversial policy advice that has come out of this crisis. All countries are moving in that direction. But I would point out that that will simply aggrevate the original incentive to arbitrage away from the banking system towards the Shadow Banking System, which will one day return.
The Geithner Plan on regulatory reform tries to tackle this problem by essentially saying that regardless of whether you have a bank charter or a bank holding charter, you will have to adhere to the various prudential obligations that banks do, and he does this by introducing the concept of Tier I financial holding companies. Although as far as I can tell, only one existing company would actually fall under that new oversight, and that’s General Electric Capital.
And I think inevitably it’s going to miss some, I mean, when Long Term Capital almost brought down the financial system in 1998, the magnitude of the banking system’s exposure to them came as a complete shock to the Federal Reserve and the other banking regulators.
And number 2, I don’t think the Geithner Plan sufficiently addresses the absence, the almost total absence of effective on-site enforcement at the State level. And I don’t know how you solve this problem, because it’s a problem of the Constitution. So absent a constitutional ammendment, we’re stuck with that problem.
And the final problem is, I think, that it relies too heavily on the wisdom and the foresight and the judgment of the Federal Reserve to get everything right, and there’s a variety of issues related to mission conflict and so forth that I think raise important questions about whether the Fed’s the right body to do this job.
Vincent Reinhart: Thanks, Greg. Is it seating order, or the tyranny of the alphabet? Chris is going to … his microphone so I guess, … Chris Whalen’s next.
Chris Whalen: It looks like I am in the middle, but actually you’re right, I am still last, but you’re very kind.
Alex is going to go in reverse order in a couple of weeks, so I feel encouraged.
And I want to thank Vince for asking me to be with him today and to comment on his fine work. We were out in Chicago a couple of weeks ago, and one of the retired senior Fed officials who was there later remarked that I was one of the more reasonable attendees. And I think this is because the economists were still arguing over causation.
If you know anything about my writing or my history, that came as a surprise to me, but I’ll take the compliment.
What I would say to all of you today is I’d like to step back a little bit from this discussion, because … and I’ve seen Taleb’s first book, [0:50:00] The Black Swan. He talks about how people take complex situations and turn them into narratives in order to understand them. And they refine these narratives by speaking and writing and discussing their ideas amongst one another, and they eventually come up with a story that starts to look remarkably consistent no matter who you talk to. This is human nature.
I think the same thing is happening with this crisis. We, especially in the United States, have this wonderful tendency to look at everything from a vertical perspective, in silos. So we could somehow isolate monetary policy and bank supervision and fiscal policy into neat little boxes that are not at all disturbed by one another.
And in particular, when we hear people talking about foreign capital inflows, I want to scream, because those are our pieces of paper, we printed them, and they have come home looking for at least a nominal return. That’s why we have this problem, and I agree with the other speakers, I’m not sure how we deal with it, as long as the rest of the world is silly enough to allow us to have a monopoly on the means of exchange.
But I guess the way I look at this crisis is from a political perspective, because I think if you don’t understand the evolution of the United States and the change that is occurring in our society as we migrate from a democracy focused on individuals and individual liberty to a society which is growing more and more corporatist every day; more and more European every day. And I think this is reflected in the quiet but very intense debate going on in the regulatory community between Sheila Bair & the folks at the FDIC on the one hand, who represent a somewhat legalistic but traditional American view of banks and insolvency and resolution, and what I like to call the internationalist component, which is the Treasury & the Fed, who seem to know nothing about traditional American values, and who are aligning themselves with foreign nations, which are predominately socialist and authoritarian in nature.
I think you can tell whose side I’m on.
You know, it’s fascinating to me to see this, because I think a lot of the people at the Fed, who I love and respect, and I’ve worked with in the past, will recite this mantra about how certain banks are too big to resolve, too complex, plugged into too many clearing systems, etc. etc. … And then I point them at Lehman Brothers and I say, "Well, Harvey Miller did a fine job; the folks at SIPC did a fine job; and the folks in the Southern District of New York did an extremely good job on a very complex insolvency. What was wrong with that?"
And they say, "Oh, well, it was so damaging to the system. It damaged confidence." And we heard Vince mention sacred confidence in his comments. We must avoid damaging confidence, right?
Well if we have that as our rule, then we will never have a market system, because markets have to go from exuberance to terror in order to function. And if we do not have both, then we do not have a free market society. And if we’re going to allow our government to make those rules, then I would suggest that we are not going to be a democracy for much longer.
Just look at Europe. Do you really want to live in a society where the government excludes bad acts, excludes entrepreneurial activity in most industries and basically gives the populace a little bit of freedom now and then, right before elections usually, and then goes back to business soon thereafter.
Now Fed policy, I think, is really very much illustrative of one of the problems that we’re facing. I worked in the bank supervisionary of the Fed, and I don’t know how an agency can be both a monetary authority and a bank supervisor. Why? Well, because of the corporatist construction I just mentioned. We have three groups that are essentially running the show right now. We have a central bank that manages a fiat dollar system, which is totally inconvertable into anything. We have a Congress that equates the revenues from taxes with the proceeds of debt. They’re all one and the same to the Congress, and they’re allowed to do this because the central bank enables this.
Since the 1980s, really the late ’80s, when I was working on a trading desk at Bear Stearns, the central bank has never said "no" to the market, either with respect to collateral or liquidity. It’s only been a matter of price.
When was the last time we had a Fed Chairman stand up and say, "No." I would suggest it has been far too long.
So while the folks at the Fed can go on about how Chairman Greenspan couldn’t go up to the Hill and start saying mean things to members of Congress about housing policy, I think that’s precisely what we need.
If the heads of independent agencies aren’t ready to lose their job every day, when they come in the office, then they don’t belong there. And I would hold up Sheila Bair as somebody who’s willing to do that. The others are not, in my opinion.
And then finally we had the dealers. The dealer community, who are the recipients of the latest largess, sell the government’s debt. And they are [0:55:00] also the mechanisms through which the Fed executes monetary policy.
I would submit to you that the government, our elected political class, and the primary dealers are a tri-partite — I won’t say conspiracy, let’s call them an alliance of convenience — and they fit so beautifully in the now-corporatist mold that is America in the 21st Century, don’t they?
Now, let’s talk a little bit about the Fed’s role, because I think we spend far too much time talking about monetary policy, and not nearly enough about bank supervision, and particularly market structure.
You know, it’s very difficult to predict what’s going to happen when you have over-the-counter [OTC] markets, which are completely opaque. My clients trade Credit Default Swaps [CDSs] and they still can’t see the entire market every day; they’ve got to get on the phone and call around to various dealers for on-the-run instruments just to get an indicative price. Does that strike anybody in this room as strange? We’ve had public exchanges in this country for almost a century, and yet the Fed and the other regulators allowed our banking industry to install this hideous retrograde phenomenon called over-the-counter, both with respect to derivatives and structured assets.
So big surprise that we couldn’t see what was going on in these markets, and we couldn’t predict what would happen when the liquidity ebbed. There’s no suprise here, is there?
The reason we have open outcry markets, and I said this in Chicago, is that they are an analog to something we all know very well, I hope, which is called checks and balances. The whole point of people standing in a room where they can see one another, and they can see who’s bidding on an asset, and then at the end of the day they can see the prices on every trade that occurred on that exchange, is the exact same reason why we have checks and balances in our political life, or we should.
When we go away from that model, we invite instability, we invite chaos, and we invite exactly what Vince was talking about before, which is the dimunition of confidence, and also the dimunition of credibility, which I value, frankly, much more than confidence.
Now we could talk about political capture. The only thing I’ll say about this is, look at the UK. In the UK, the gentleman who was put in charge of the cleanup cannot be approached by a bank. They may not speak to him. He is only answerable to the Prime Minister. All of the nationalized institutions in the UK are at his beck and call; they do what he tells them to do. End of story.
I got into a bit of a row with one of the attendees at Chicago when the issue of the President’s Working Group came up, and their role in helping to ameliorate the crisis, and I said, "You know, I can’t talk to the heads of bank regulatory agencies about policy matters, why should members of the President’s Working Group be able to go out and talk to the CEOs and minions of large financial institutions and evade those legal restrictions?" I have a big problem with the President’s Working Group, and I wish it would be put out of existence. It is totally inconsistent with our system to allow big corporations to circumvent the democratic limits that are placed on individuals.
And again I invite you to consider the difference between the democratic model that somebody like the FDIC has in mind when they are out regulating little banks, putting bondholders and shareholders to the sword, every day, or at least every Friday, and yet the big companies get a pass. And let’s be very specific. What are we talking about here? For the last year we have been subsidizing the bondholders of the biggest financial institutions by putting more public equity in front of them. There’s nothing fair about that.
So what should we do? Well, I have two very simple solutions. We should always be concerned and cautious about people offering simple solutions, but I think … you know, I’m not a fan of regulation, I don’t want to see any more regulatory layers put on our system, we don’t need them. We’ve already got plenty, and they’re completely useless.
I have two basic suggestions, and I’ve said them here at AEI in the past. First, anything that’s sold to a bank or pension fund has to be registered with the SEC, and I mean really registered; no more private placements. What that does, in a very simple sense, and I say this speaking as someone who’s worked in the securities industry for 25 years, is that it’s available to retail, and the lawyers and the banks won’t let them go beyond a certain degree of complexity because they’ll get sued.
We don’t need more regulation, the trial lawyers will do it very nicely, thank you. You just force Wall Street into that same registered template with everything they sell to what I call the least risk oriented, which are obviously public sector investors and banks, and we have no problems, because the hedge funds, the corporations, all the private players can do what they want. And frankly, I don’t want to regulate them. The idea of putting them [1:00:00] under the Fed is crazy.
The second issue, and I think this goes to all the talk about living wills and wind-ups and everything else. Look, we don’t want a wind-up Citibank, we don’t want to wind-up a money center institution and we shouldn’t even consider it.
What we have to do instead, I believe, is figure out a way to fund them when they get into trouble, and right now we don’t have a mechanism. Why?
Well, before the ’30s we had something called double liability stock. If you owned equity in a bank, you had to be ready to put a dollar in for every dollar you invested. So that if the bank got into trouble, they put out a call, you gave them more money, they doubled their capital. I think the debt of every bank holding company, at least in the United States, should be convertible into equity. We have baked-in resolution authority and we don’t even need more legal authority. If the bank becomes undercapitalized, the Fed can issue a cease-and-desist order, the institution turns to their investors who, maybe in 10 percent increments, you convert it into equity.
If we did that with Citibank earlier in the year, not only would our regulators have more credibility but I think we’d have much more confidence in the markets today. Convert a third of their debt into equity? You charge off $300 billion, which is more or less Citi’s holdings, and you’re left with the most solvent, liquid money center bank in the country.
It also has lower interest expense, by the way. And that’s one of the neat mechanisms of debt conversion.
Again, we don’t need legislation for this, and yet, frankly, if we had had different people in place over the last year we could have done something like that now, with no additional legislative authority. The Fed and the FDIC have the teeth.
And then finally, the last point I’ll make. You know we’ve been having hearings up on the Hill about OTC derivatives, and you can see the way this is going. I think we’d be better off with no legislation, frankly, given what I’m seeing from the Frank Committee.
I don’t know what to do in our system, I don’t know how we can insulate regulatory issues from our political process, but if you want to see the damage that’s being done by corporate interests in this very important public policy discussion, just look at the witness list from the Frank Committee. There are only 2 or 3 witnesses on that entire list that you could call critical spokesmen and intellectuals, people like Henry Hu, for example. The rest of them are just flacks for the dealer community.
So with that I will stop and I look forward to my colleagues’ comments.
Vincent Reinhart: Now I’d like to turn to a European statest, … [laughter]
Angel Ubide: Yes, in fact I was once [undeciferable] that I have a Spanish passport. And we are very happy there, by the way, so … [laughs] Thank-you Vince, and thank-you to the AEI for this invitation.
I think Vincent forgot to mention at the beginning of his presentation of something he says in his introduction. That is, the narrative of this crisis will be the most permanent impact over the global economy, above and beyond the very sharp recession we have suffered, and the increasing unemployment, and everything else. Because it is those narratives that then will define the policy reaction to it and the way the markets and the economies will operate over the next — probably decades.
So I’ll try to give some views related to what Vince said about the genesis of this crisis, the crisis itself and the implications for the future. And I’m going to try to be as global and abstract as possible, and avoid mentioning countries, unless I need to. Because I think that we are basically missing the forest by looking at the trees, and when I am in the US I only hear issues about US supervision and regulation; idiosyncracies about Wall Street.
And when I am in Europe or in Asia, I hear completely different stories about what happened, and either they are all right at the same time, or they are all wrong. And so I will try to see if I can basically cut across some of these issues and try to come with some more general conclusions.
First: I would like to reframe this crisis as a credit crisis, not a housing crisis or a banking crisis, but a credit crisis. And a credit crisis in the sense that there was too much leverage in the global economy, and that we could see in a global economy that was growing way above potential growth rates for several years.
And then we can go down to where this leverage was, and we find it everywhere. We find it in households, because households, as Vincent was saying, they focused on housing, and housing is where you find the leverage in households. You find it in banks via the system of originate-to-distribute, because banks were using this as a risk management tool, and not necessarily as a liquidity management tool. So they were finding ways [1:05:00] of increasing leverage there.
We find the leverage in the extension of the structure of credit to mortgage markets, which was an extension that wasn’t straightforward and that generated also an increasing leverage of many of these instruments.
And that was facilitated by the excess demand for triple-A assets, as Vince was saying, as a result of the accumulation of excess reserves in many emerging markets.
So essentially, I think this is a simple way of defining the crisis, as a leverage problem. And then we can go down and try to understand how this problem manifested itself in different countries, as Greg, … I think Greg said [undecipherable] were very, very good in trying to show that we cannot just pin down in the specifics of different … of what would be, for example, early warning systems.
Now I think the narrative of the crisis, … I think what we can summarize it in this: There were three shocks. And each of the three shocks basically changed the paradigm that we were used to until then.
One was a shock to a key macro hypothesis that house prices cannot go negative. That was embedded in risk management systems, in forecast systems, in basically every system we have in our global economy. And that led to a major change.
The second one was a key shock to our key financial market product that was securitization. As Gary Gorton from Yale says, it went from being informationally insensitive to being informationally sensitive.
Now imagine that every dollar you have in your wallet that you suspect is a counterfeit. How are you going to behave? That’s exactly what happened with securitization. All of a sudden we all suspected from every single securitized asset out there.
And the third shock was a shock to the key liquidity assumption that the repo and money markets and ABCP and all that were not going to be there tomorrow morning, is like realizing that there is no water coming from the tap.
So that also changed. It was a fundamental change in the way we had to understand the global ecomony.
So each of these shocks in itself may not have been too bad. You combine all three, and we land ourselves in a hole of night and uncertainty. We don’t know anymore how the world operates.
And I think this is the best way then we can then understand the global confidence shock that Vince was alluding to, the sharp decline in trade that we saw in the 2nd half of 2008, which in my view at least was essentially all the corporates of the planet basically saying, "I don’t know what’s going on, I’m putting every single project I have on hold until I can get some clarity on what’s going on."
Now if these are the three shocks, I think the authorities reacted to each of them. There was a house price deflation; that’s a macro shock, so we have a reaction with macro policies — fiscal and monetary policies. We have a securitization shock, then we need to improve the information problem. We issue guarantees and central banks provide funding for those assets. And finally, the liquidity shock implies that central banks have to become the banks of the global financial system, because there is no more inter-bank market, and there is no more intermediation.
The corollary is, which we have, questionable the solvency of the global banking system, and we need to put in place rescue package. And we need to deal with the night and uncertainty and policymakers tell us they will do whatever it takes.
I think the G7 has not changed yet a language that they used a year ago at the G7 saying no bank will fail. Or no systemic bank will fail, depending who was speaking. And I think that was an important element of this crisis and the way it was handled. They were trying to tell all of us, "Don’t worry, we know you lost faith in our ability to deal with the problem." For the first time in many decades, I think, I’ve seen a great moderation at the end of the way, was a lot view to the faith in the global central banks to deal with recessions.
And all of a sudden, we’ve had to change that paradigm.
So, I don’t know if we can call it Paradigm Lost, [allusion to Milton's epic] or something like that, but we need to find a good title for this … [laughter] … for this narrative.
So let me now make 4 comments about what I think we learned about … from this, which I’m not completely sure I’m convinced in any of the 4, so I’ll put it in more of ask a question rather than answers.
The first one is, until now, when you learn about policymaking in graduate school, or you go to an academic seminar, so you talk to central bankers, they talk about stabilizing the price, … well, inflation, right? Is prices stability what matters. And that’s a dimension that includes growth and prices. But it doesn’t include risk-aversion.
And I think we need to move into a concept — a policy concept — there is a concept of overall stabilization of risk. And that implies on the one hand [1:10:00] we stabilize growth and inflation, but on the other hand we also want to stabilize risk attitudes in some ranges.
And I guess this is the kind of thing that Alan Greenspan basically disagrees with when he was always talking about animal spirits and bouts of risk.
If you think about the dynamics of Value at Risk. Value at Risk is basically the war-horse of risk management in the global financial institutions.
What is Value at Risk? It tells you that you can take a position size, and depending on the volatility of the asset that size can be bigger or smaller.
Now imagine a world where policymakers are so predictable that volatility collapses and is very low. What happens? You can take a bigger position. That’s exactly what happened in the last 15 years. Uncertainty about the future diminished inter alia because policymakers moved (especially monetary policy) into a policy framework of being very predictable and very transparent. And that led to an increase, essentially, in leverage — a procyclical increase in leverage.
So question #1: Is there an optimal amount of risk in the economy, and how is that related to the optimal amount of transparency that policies, especially the monetary policies, can have?
And I don’t know the answer, frankly.
Point #2: We’ve been blaming financial sector participants and banks about their overreliance on wholesale markets and their lack of liquidity planning, but I just like to turn that upside down and basically say that the world policymakers have been fostering the opening up of capital accounts and going for global financial markets and integrated systems, but they have not adapted their liquidity facilities at the same pace.
We had central banks that were providing liquidity at the very short term, on a narrow set of counterparties, a narrow set of collateral, and in domestic currency. That’s like developing Ferarris for all of us, and still riding in rural roads. It doesn’t work. We need to move both things together.
I think that the issue of, for example, the FX swaps and central bank is a major development in the global financial system that should be maintained — should be maintained because that’s the way that a global financial system operates. You may need liquidity in a different currency than the one the central bank is ready to give you.
If that means central banks are going to be taking more risk, then maybe they should think of a way of charging for that risk ex ante. But I don’t think they should refrain from taking the risk, because otherwise, we have an infrastructure that is not matching the system that we have.
Point #3: On monetary policy, I think it’s very interesting that we have — I think if I’m counting right — five central banks at the zero-bound, with 5 different policy instruments, or policy strategies at the zero-bound, right?
We have the Fed doing credit easing on purchases of MBSs, and it wasn’t started before they hit zero.
We have the Bank of England, first hit zero and then buys the government bonds.
We have the ECB that never made it to zero, but decided to go to a full allotment provision of liquidity.
We have the Bank of Canada that hit zero and then commits it to rates at the level for a very extended period of time, giving a date.
And then, we have the Swiss National Bank, that just has to do foreign exchange intervention.
I thought we knew how to deal with this zero bound, but I’m not so sure anymore. And this might be something that the professional has to deal with.
I think in addition we have the zero-bound twice in a decade. It’s not clear to me that 2 percent inflation is the right target anymore, given how costly, or how unclear, I guess, the policies of the zero bound are.
So maybe once we go back to some sort of normal we need to rethink this issue.
The 2nd point about monetary policy is that I think we’ve seen that leaning against the wind has not worked. We just saw a very powerful negative bubble the last 3 years. And monetary policy was powerless against it. And we said we need more instruments. So we went into credit ease, we went into fiscal policy action. We went into tax cuts, we went into targeted assistance to some sectors. I don’t see how that kind of bid[ph] on the way up.
If we are seeing a bubble, and in a specific sector, I don’t see why cannot be pricing something there, be it taxes, be it margin requirements, be it whatever the right instrument is.
And I think we have seen a counterfactual very clearly in the case of Spain that was mentioned before. I mean, Spain had negative real rates for more than a decade. House prices were basically the biggest bubble, if we want … I don’t like the word "bubble," but let’s say they showed the highest appreciation of The Economist’s back page, which is the best source of information for that.
And yet only one small savings bank has failed. Why is that? [1:15:00] Well, because the supervisory and regulatory system had dynamic prohibiting, had a very tight loan-to-value ratios. They didn’t allow SIVs off-balance-sheet. They didn’t allow the use of CDSs for capital mitigation purposes. And they were using covered bonds and not Asset Backed Securities.
And there is a big difference in there, because it implies less leverage in the banking system.
So Spanish banks hid the recession, or hid the crisis with prohibition that was worth 200 percent of the risks they were running. The average in the US and the Euro area was about 50.
I guess that buys you a year or two, and then you can count on the economy helping you to fill the balance sheet rather than the economy taking down the balance sheet.
So there is much more, and that goes to the point of my macroprudential policy, and why it’s so necessary in order to deal with this, because otherwise we have too much faith on interest rates. And interest rates cannot do everything, as Vince was saying, you break interest rates, asset prices go up many times.
A word on macroprudential. I don’t know what it means, frankly. I was a big fan of it, and I continue to be, but I still don’t know what it means. I think one important element is horizontal assessments. I think that’s very important, because then we’ll understand where the crowded positions in the banking sector are, so maybe we would have known the big amount of CDS that were sitting in the banks’ balance sheets, if we had that horizontal assessments.
I think dynamic provisioning is the way to go, it goes to the P&L, and that hurts the banks, so they do it right.
And this rules-based — for those of you who have ever followed the saga of The Stability and Growth Pact, you will see that it’s very difficult to implement something where there is discretion given to the policymakers as to when to activate a lever. It’s very important, when people talk about cyclically adjusted capital ratios, I get very worried, because I don’t know who’s going to say, "Now is the time to increase the capital ratios."
And the final point is, we don’t know how to calibrate monetary policy when we have so many different instruments dealing with this.
So final … I have one minute? … Final point on how to deal with the banking crisis. If you look at the IMF publications, the manual of how to deal with it is very simple, right? You close down the bad banks, you recapitalize the good ones or those too big to fail, and you remove the bad assets from the balance sheets. It’s as simple as that.
Now what we have seen is that unless there is an IMF package on top of that pro- … on top of that country, it does not happen. Because the political economy requires that for as you to need some casualties before you can start doing the right things.
So my question to the future systemic authority is, should the systemic authority, be that the central bank or equivalent, internalize this delay that will always happen, and jump at the very beginning and say, "Since I know the fiscal authority is not going to do the right thing, I might as well do it myself."
And so we need any investor of last resort, … [undecipherable] … And I’ll again, I put the question mark, and I’ll leave it there.
Vincent Reinhart: What I would like to do is turn to the people up here to see if they have any reactions to what they’ve heard. But let me just ask a few questions first, and then we’ll go to the three of you in the order in which you presented.
Greg Ip fell for Ben Bernanke’s reframing of the issue of the global savings glut, so as to mostly absolve US monetary policy. I think he did a good job on that.
There’s another phrase that could explain the same set of phenomena, and that’s fear of floating. And a lot of countries are reluctant to let their exchange rate move either at all, or fully. And so that effectively means their central bank has to shadow US monetary policy.
So we could invert your observation and say, in fact, the fact that so many other central banks shadow US monetary policy means that the Federal Reserve footprint is much larger than just the US domestic economy. Therefore, does that mean if those countries worked that way, the Federal Reserve has a bigger set of responsibilities?
So that’s a question maybe Greg, as we go around, you can address.
With regard to the importance of CRA, I think it’s just one in a list, actually, that in fact, as a nation we provide so many different forms of encouragement to homeownership we are part of the problem. And we shouldn’t be surprised at that.
Also, I think the American Dream is not homeownership, it’s getting rich quick. [laughter] And if you can make levered bets on an asset class, [1:20:00] government will encourage you to do so, you’ll do it, when you think that you’ll get double digit returns.
That’s related to Angel’s observation about the rating agencies’ risk model. My colleague Alex Pollock always notes that some of those models had a term called "HPA." That is, "House Price Appreciation." So if that’s what’s in your formal model, you really haven’t even thought for a minute what happens if house prices start declining.
Greg also noted the sequence of distress — that is: unregulated investment banks; commercial banks; in terms of failure. Another way of explaining that same sequence, rather than the capital standards put on each of them is, in fact, their ability to push off the accurate marking-to-market. And so in fact, they were able to delay what was effectively a large real shock that the financial system had to absorb.
To me, Chris, my favorite example is when supervisors and the Fed talk about how important the clearing banks are, and how they’re way too complicated to fail. Well, they’re actually using the services and backbone provided by the Federal Reserve. They’re the customer for the book entry system, and they’re the customer for the Fed Wire. And if the Federal Reserve has chosen to let its customer use its services in a way that poses a systemic risk, exactly who are we supposed to blame? And wouldn’t there be an opportunity for pricing, in a graduated scale, to enforce better behavior.
Another question I put to Chris is — Are we in the right political path that will ultimately; the sense of unfairness of having the big guys protected, and the little guys subject to the FDIC’s action? That we may, in fact, be jeopardizing our committment to markets, and pose some risks for, among other things, for demagoging the situation going forward?
With regard to Angel, my favorite example — is there an optimal degree of transparency? — relates to a very narrow issue of the Federal Open Market Committee [FOMC]. Once the Federal Open Market Committee started releasing a statement rather than signaling policy through its type of Open Market operation, the story went from the "C" section of the Wall Street Journal to the "A" section. That the statement wrote the first couple — provided the first couple sentences in Greg’s 1st paragraph of that article, and drew more attention. And therefore affected the discussion at the meeting and the interactions with markets. And so that does raise the question: Is there an optimal degree of transparency?
And also related to Angel’s comments, which is also a plug for you to stay to the afternoon session, we’re going to have academics talking, among other things, about historical exits; but also which part of what the Federal Reserve has done in new facilities is durable. And I’ll talk about quantitative easing, and what I find also confusing about the 5 different brands of it is there has been active rebranding of qualtitative easing, of using the balance sheet but calling it something different, and it’s not obvious that that’s helpful.
And lastly, I think Angel identified a very serious philisophical question here in terms of also what a bureaucrat is supposed to do. The first best solution to our problems would have been the Congress of the United States dealing, in an intelligent way, to the solvency problem caused by building too many homes.
If you know you’re not going to get the first best, and maybe can’t even do the second or third best because of political interference, how quickly do you cut over to that? And that raises some very hard questions. So now, Greg?
Greg Ip: Let me respond to, just I think, a couple of things you’ve mentioned here Vincent.
First, you pointed out that the low interest rate environment that prevailed around the world earlier this decade — it wasn’t just the floating markets like the Eurozone and Great Britain, but also all the countries like, most importantly, China, which had de facto [1:25:00] pegged their exchange rates to the dollar. And, you know, that is absolutely a huge issue.
Now … so you raised the question: Does the Fed have to take global implications into account when it sets its monetary policy? And this is not a new question, and it’s one that we’re all grappling with, because you essentially say, "Does the [US] dollar lose its reserve status?" Because the burden on any central bank that controls the creation of the reserve currency, almost by definition, must synthesize both domestic and global issues. And that has been the starting point of crises in the past. And I don’t know what the answer is, except to remove the dollar from its reserve status, and that could cause more trouble than it solves.
The Fed has … I don’t think that if we proposed changing the Federal Reserve Act to add "… and global stability" to its set of goals, I think that would not be an uncontroversial proposal, [laughter] even under this administration. And I would point out that when the Fed has, in the past, explicitly taken those considerations into its policy, it got into trouble. In the late 1980s, the tightening round that began under Volcker and then continued under Greenspan was in part aimed at shoring up the dollar, to sort of maintain US global obligations. And of course the stock market crash was one of the consequences.
In 1998, the Federal Reserve had originally embarked on a policy of tightening, and it decided to leave that path because of the distress that was at that point breaking out in East Asia, and Greenspan gave his famous speech where he said the United States cannot remain an oasis of calm. And so one of the reasons the Fed pursued an easy policy in ‘98 was precisely for those global … because it was taking global considerations into account.
And yet that probably had a non-trivial contribution to the stock market bubble that then developed.
Specifically to the … I draw one large and rather depressing lesson from a lot of what I’ve heard about today. Over time in this crisis where a lot of the steps that we take both in the private sector and the public sector that we think at the time have the effect of reducing or diffusing risk actually, in the end, do the opposite.
We’ve probably forgotten this now, but one of the great attractions of subprime mortgage-backed securities in the early days was that they had very different trading and risk/reward properties than traditional MBS. Traditional prime MBS were mostly sensitive to interest rates. Subprime MBS were mostly sensitive to credit, and so an investor who held both in their portfolio was achieving diversification, and that was supposed to be a good thing that reduced risk.
And similarly in the policy area, the whole move toward transparency and the introduction of the [FOMC] Statement in 1994 was very much consistent with the central banking philosophy that — If you make your policy reaction function more transparent and obvious, you can get the markets working with you, and that produces a more stable world.
But perhaps in some ways, as Angel earlier referred to, it had the opposite effect of increasing risk-taking and leverage, and the only thing I can conclude from all this is, boy, I wish I’d spent a lot more time reading Hyman Minsky, you know, [laughter] in my days as a Fed reporter.
Vince Reinhart: … Chris, any comments?
Chris Whalen: Just quickly. Let’s not start jumping up and down for joy about loss rates on non-bank originations. I think by the time we get through the cycle you’re going to see GSE exposures, bank exposures and even non-bank exposures converge on very similar loss rates.
And this goes to the 2nd point, Shadow vs banks? No. The Shadow Banking System was an extension of the liability structure of the banks. I mean, even Countrywide was considered a non-bank by many people on the origination panel. Because remember all this was happening at the parent level, it wasn’t happening in the bank.
And then the 3rd point — is inflation low? Of course not. One of the ways you lose money through inflation is asset bubbles. That’s what’s going on now. I think it’s ridiculous for our monetary authorities to go talking about low inflation at this stage of the game, given the losses people have taken on financial assets. I think that is one of the costs of inflation.
Vince Reinhart: … Angel?
Angel Ubide: I think your point about the rebranding of q.e. [quantitative easing] is very good. I think we are understanding. There was, I think, a statement by Vice Chairman Kohn. I don’t know … it was at Brookings, where he was basically commenting on an academic paper about whether central bankers at the zero bound should try to generate high inflation expectations for a while, so you upset the disinflationary impact. And basically, I think his comment in his speech was, "That’s a great idea in theory, but I don’t think it’s a good idea in practice, because inflation credibility is just too important to put at risk."uuuG
A point on the problem of the bureaucrat. Let me give you what we have done in Europe about that; that is, to outsource [1:30:00] that bureaucrat to a superstructure that is completely independent from the political influence.
The competition authority in the European Union is the biggest enforcer of market discipline you can imagine. For example, take the bank bailouts in the last 2 years. The government could go and say, "I’m going to bail you out," for example, "… take your money and give you this kind of assistance." But then every 6 months there was a report from the competition authority watching that that bank was not benefiting from undue public assistance that was going to jeopardize competition.
So I think the answer to you question is: Make your bureaucrats more independent, so they can do the right thing at the right time.
Vince Reinhart: We have some time for questions, a limited amount. What we’re going to do is ask you to be … First, identify yourself, be brief, and wait for the microphone. …
Robert Sherretta: Robert Sherretta with International Investor. Mr. Whalen, I thought your point about the derivative markets and the attempts to regulate them were right on. I think you’d argee none of us expect much to come of it right now.
So let me really drive you crazy and ask you to comment on the possibility of more international regulation — cooperation if you like. But something with some real teeth in it in the future that can help to rein in what’s obviously a global market for these instruments.
Chris Whalen: Well the funny thing is I think the Europeans are going to take the lead on this.
I distinguish between two types of derivatives. You have things like currency swaps and energy and interest rate swaps, which are basically fine, because you have a visible-basis market, as I was saying before about the benefits of an open outcry system. Everyone can see the basis for the derivative.
But when we allow our markets to trade derivatives for which there is no basis, then what are we doing? This is absolute madness. You know, risk management implies that you are identifying risks, and you are proactively taking measures to avoid them. And what we have done is the opposite, we let our markets do whatever they want, and then we clean up the mess after.
I think we have to put some basic limits on the derivative, if you will. And if it doesn’t meet a certain test, then we should say, "No." And maybe the Europeans will go first. I don’t know.
Vince Reinhart: How about one right here? …
Gary Kopff: Yes. My name is Gary Kopff. I’m an expert witness on various litigation matters involving subprime and CDOs.
One of the reasons that I come to these conferences, and occasionally speak at them, is I think it’s so intriguing to see the pendulum swing, first from the jailing of the original suspects — we’ve jailed the CRA, jailed the subprime mortgages, [tape skip -- this mic appears to be wonky] … securitization. More recently capital standards and value-at-risk. And as the pendulum swings we have the capital markets "Guantanamo" releasing some of these prisoners as not in fact explanatory causes.
One of the prisoners hasn’t yet been put in jail, because it’s so hard to understand, is CDOs, and there were a couple of references today. One thing that was [tape-skip] … 2002 to 2009 is we generated — we, actually it’s less than a 100, it’s really less that 10 institutions, generated $1.3 trillion dollars of CDOs. And within that $1.3 trillion, the so-called toxic assets, which have now been cleaned up to be called legacy assets[ph - tape-skip] were synthetic CDOs.
The real source of [tape-skip] … series in the Washing– … hurt virtually nobody, talk about the causation of– … $5 billion or so of synthetic … bridging the worst of securitization / CDOs with the derivative markets to create an instrument that burns up on the balance sheets of large banks.
And the interesting slide Greg comparing Germany and Switzerland. I mean Germany and Switzerland, the banking crises are because Deutsche Bank and UBS bought US banks and their FICCs [ph "Fixed Income, Currency and Commodities trading units"], were based in Manhattan and Stamford [CT], not in Germany and Switzerland.
And those institutions, and a few others, Merrill [etc.], created these $400 or $500 billion of synthetic CDOs, and they were so good they weren’t even going to be offered, much less to retail, where God knows [laughs] they couldn’t pass the test[ph] of direct retail disclosures.
They were put on the balance sheet of many of the originators, because unfunded super-senior CDOs, synthetic, was a sure thing. But it brought down banks.
And that prisoner has not yet been put in "Guantanamo," and I wonder why. [1:35:00]
Vince Reinhart: Chris or Noddin[ph], do you want to? …
Chris Whalen: At a certain point, and this was after Lehman and Bear Stearns had gotten into retail mortgage origination, OK? Which was a bad sign (these are normally people who would never go near retail markets), the Street started creating securities out of thin air. And that’s the best explanation that I can give you.
And again, going back to my point about visible-basis markets, if you want to launch a CDO that’s fine, but I want it registered. Because every month the issuer’s going to have to drop an 8-K with the servicer data, and I don’t have to buy the data. And that means the entire cottage industry can do their analysis and support investor valuation.
That’s the biggest problem. If you have to go back to the issuer and say, "Heh, what does your model say about this security?" you have a problem, and that goes to the point that was made earlier. I think Angel was saying we went from no risk and no information to, you know, terror, and that’s why. It was the lack of transparency in that security.
[crosstalk & some dead air] …
Chow Chen: Chow Chen, freelance correspondent. Vincent, you have quite a comprehensive paper. I have several observations and comments, but I just relate to reduce to two very important.
First is [undecipherable] all the regulator and the banking relationship. You see people go once through the revolving door between these two. So my thing is you really need to make the regulator is the real regulator. And second is you talk about[ph] the LCFI [Large Complex Financial Institutions]. And the important is to make this XCRI[ph -- that's the standards people for XML, I likely don't have that one quite right] be transparent and responsible. And to great [undecipherable]. Is there the same country have housing bubble but not have a banking crisis? But in the US, basic is this subprime mortgage, and later you talk about the subprime mortgage is the too-big, and so this proved my point. Thank-you.
Vincent Reinhart: I think this relates to the question I posed to Chris at the end: "Is it possible if we … some large institutions are seen [as] protected and medium and small are not. Will there be a perception of fairness?
Doesn’t help, particularly if we have a succession of Secretaries of the Treasury from a large complex financial institution, or a Secretary of the Treasury who mostly talks to the CEOs of large, complex financial institutions.
I don’t believe that there’s any impropriety associated with any of this, but the perception is damaging to the populace’s acceptance of markets and financial innovation.
As regards to the structure of the LC– Large Complex Financial Institutions, I testified a month or so ago arguing that they should be made modular, and therefore each individual part made more transparent and be able to be taken apart.
Greg Ip: Yeah, a couple of people have commented, including yourself, on the importance of the quality of the regulators and the bureaucracy, and Angel, I think, once smartly noted that one of the things we can do better is to have more independent regulators.
And it is actually one of the few things that we could actually spend more time studying, because one of the reasons why so many different types of regulatory and monetory financial systems failed for different reason is … I should say one of the consequences is that you cannot look to any one particular model around the world and say that’s the model we should all run towards.
So one of the reasons Canada didn’t have a banking crisis had nothing to do with its regulatory framework, but just the culture of the country which, having been burned badly with real estate lending in the early 1990s, is that the people there, neither the regulators nor the bankers, want to repeat that, and they were willing to forego profits in order to sort of avoid that sort of risk.
And the regulatory system, I think, there is something to be said for, number one, paying them better. I think proposals that they cannot go work for a bank for 5 years are actually counterproductive if you also make it, you know, a terrible way to make a living for those 5 years. So if you’re going to make them more independent, give the job more prestige and more money.
I think it’s scadalous, almost, that the same individuals who were at the Office of Thrift Supervision overseeing large west coast entities like Washington Mutual and IndyMac were, in many cases, there at the precessor of OTS [1:40:00] early in the 1990s overseeing the Savings and Loans.
So a little more attention to the quality, training, compensation, prestige of the actual front-line regulators might be helpful.
[crosstalk, Chen off-mic & inaudible] …
Chris Whalen: This came up actually in Chicago. Someone started criticizing Gerry Corrigan for going off to work for Goldman, and I work for Gerry.
I have no problem with regulators going to work for banks, but they can’t come back, OK? [laughter] Once they have gone off into the private sector, they have to stay there, and if we pick Treasury Secretaries who don’t have obvious conflicts, then I think we’d be better off. [scattered applause]
Andrea Psoras: Thank-you. My name is Andrea Psoras. I’m a bank analyst from New York. Thank-you, Chris for drawing some attention to the recolonialization and Europeanization of America, that you could argue is at risk with IFRS, which is the International Financial Reporting Standards that we’re expected to adopt, and that’s a debate right now with the SEC.
So why don’t– Let me ask some questions about where we can address perhaps how we can get back to a better stasis, one of which is … Should we remain with US GAAP? Should we remain with US regulatory framework rather than go into Basel (especially with regard to the capital requirements)?
Should we withdraw from the G20 agreements, which are collapsing the US economy? OK, because that, over the last 15 years, has been obscurred by these bubbles, and I see Free Trade as being one of the ways that this collapsing by way of offshoring production into foreign jurisdictions, which are the former colonies of our allies …
So, and when even if Gerald Corrigan went to Goldman, which I don’t oppose either, should we reinstitute what he had eliminated from the Fed, which was aggressive dealer surveillance and oversight?
Rather than making our banks more like the European banks, which are the too-big-to-fails, why don’t we repair it to former US models that had functioned? (… so can we answer some of these questions? …)
Vincent Reinhart: … think you can cover that in 30 seconds, Chris?
Chris Whalen: You know, the fact is, despite all the international talk and the talk of globalization, we still have national treatment. If you look at the implementation of Basel country by country, they’re all different. We don’t have harmonized regulation in Europe, much less in the world, so I think we have a long way to go before we’re going to have anything practical upon which we can rely on for safety and soundness other than national regimes.
So I think that’s what we’re stuck with, despite the hope.
Vincent Reinhart: OK, does anyone want the last word? … OK. If not, then we are going to adjourn for the next 45 minutes and reconvene for the second panel at 1:30 on the dot.
[Lunch-time adjournment -- 46 minutes]
… [1:45:00] … [1:50:00] … [1:55:00] … [2:00:00] … [2:05:00] … [2:10:00] … [2:15:00] … [2:20:00] … [2:25:00] …
Vincent Reinhart: … We’re going to start up again, Thank-you. … For those newcomers, my name is Vincent Reinhart. I’m a Resident Scholar here at the American Enterprise Institute. I’m doing both … introducing myself for the newcomers, and then giving the opportunity for people who are now speaking to gracefully quiet down.
This is the second panel of a project funded by the Smith Richardson Foundation to learn some lessons from what’s happened to us over the last [2:30:00] two years and to think about how the government can extricate itself from its current entanglements with the private sector.
There are larger issues at … other issues at stake as well, including …
- What should monetary policymakers do in the future with regard to asset bubbles?
- How should the Federal Reserve shrink its balance sheet (which is now more that $2 trillion)?
- What is the role for fiscal policy going forward?
- Is the experience of the last year or so evidence that a discretionary fiscal policy could reliably have an influence on the economy?
We’ll also ask questions with regard to the role of the Government Sponsored Enterprises and the nation’s ongoing support of homeownership.
That middle question I asked, "What’s the role of fiscal policy going forward?" depends importantly, obviously, on what you think the effectiveness of fiscal policy is. And so our first speaker today is someone who has brought forth agreement between Paul Krugman and Greg Mankiw, which is an accomplishment when you think about it.
What Krugman and Mankiw agreed was that the paper by Ethan Ilzetzki, Enrique Mendoza and Carlos Vegh on multiply– … fiscal multipliers around the world was a very successful examination of that issue, and added to our knowledge by bringing in a range of experience of more that just what we know about the US over the last 50 years.
Ethan is here to present that paper. He is a lecturer in economics, which is Britsky for Assistant Professor, at the London School of Economics, and an Associate at the Centre of Economic Performance. His research focuses on macro and fiscal policy with a particular interest in developing countries. He’s held positions at the IMF, the US Department of the Treasury and the Millenium Challenge Corporation.
I have to admit at this point that this is in fact an elaborate sting operation. Ethan worked with my wife at the University of Maryland, and they have six books overdue. [laughter] … And she’s blamed him.
Ethan, would you talk for the next 20 minutes or so about about how big, or small, are fiscal multipliers.
… [a few seconds of dead air] …
Ethan Ilzetzki: OK, thanks. Thanks, Vincent, we’ll try to get those library books back in time. [slideuuuH 1]
So I have the … My talk is going to be based on, as Vincent mentioned, joint research with Enrique Mendoza and Carlos Vegh. I have the misfortune of speaking right after lunch, so I hope I can keep you awake. I also have the misfortune of speaking before some very illustrious academics that will follow, who, moreover, are speaking about the more established science of monetary policy. And unforturately I feel in the past few decades we have somewhat ignored fiscal policy in the profession, and its implications as a countercyclical policy tool.
So we’re trying to fill– … to contribute to filling in that gap with this paper.
So the basic question we try to answer, and has become a very heated debate over the past couple of years is, "What is the impact on GDP of a $1 increase in government expenditure, …" that’s going to be our focus, "… or a decrease in tax revenues."
So in mathematical terms, [slide 2] the fiscal multiplier is simply the change of GDP caused by the change in G, where that G is a percentage of GDP. And the cumulative multiplier is just summing over the effects, over a period of time, of a fiscal stimulus on output in the long run.
Now, again, if we talk about monetary policy, [2:35:00] despite the fact that there are debates about the appropriate monetary policy in certain circumstances, I think there would be a broader consensus in the profession as to, "What does a 1/2 percentage point change in the Fed Fund Rates do to mon– … to GDP in the United States?"
When asked the question what a 1 percent change in government spending would cause in terms of output in the context of the fiscal stimulus package that is now being gradually implemented by the Obama administation, Romer and Bernstein, writing within the administation say, "Well, a 1 percent increase of government spending as a percentage of GDP would cause a 1.6 percent increase in output," so that we get a free lunch plus … and then some when we try to use the fiscal stimulus in a recession of the type we are experiencing.
At the other extreme we have Robert Barro and others who … Robert Barro says basically his benchmark on what he would say the fiscal stimulus would do is a very round number.
So those two examples are not just specific outliers or just special cases. If we look at the existing economics literature, we see that there is a broad range of estimates on what a government … what the government expenditure multiplier is going to be. [slide 3] And even if you look at that second paper there by Roberto Perotti, he finds in his … in the exact same sample he finds, depending on the country and the time period, the multiplier can range from -2.3 to 3.7. So he doesn’t even agree with himself on the exact value of the fiscal multiplier.
Well we’re going to try to contribute to this discussion, and actually we want to try to pull back from this "my multiplier is better than yours" debate, and try to shed more light on … or more subtlety on the empirical evidence.
Now the limitations of studies that have been conducted so far is that there’s really only been a small subset of countries, actually only about 4 or 5, for which data was available to conduct long-time-series investigations into the effectiveness of fiscal policy. And therefore there’s also very little cross-sectional evidence so, as Vincent was mentioning, a lot of the evidence is from the US or UK or another few countries for which we have good data, and it’s become almost … These studies have almost become of the nature of biblical interpretation. We have this one data set, and we’ll try to squeeze that out as much information as we can from this one series of the United States’ expenditure and GDP experience.
What we’ve done in our case is assembled the database for 45 different countries and attempted to get broader evidence (cross-sectional evidence, comparisons across countries) on the effectiveness of fiscal policy.
There’s also been very little attention in studies so far on which types of stimulus spending. There’s been studies on taxes vs spending, but very little on the composition of government spending, and what effects different components of government spending would have.
So (yeah, that doesn’t add up) it’s supposed to be 45 countries, 19 of them are high income, and 26 developring. [slide 4] We’ve assembled a new data set in which we look at real GDP, which was available earlier, but the real novelty here is that we have, at quarterly frequency, real government (central government) consumption for 45 countries. So this the first data set, as far as I know the first data set of this sort.
The sources [slide 5] are very varied. We … I was on the phone a lot with statistical agencies and even fiscal ombudsmen of different countries to ensure that the data is of appropriate quality to conduct a high-frequency analysis of fiscal policy, [2:40:00] and also to ensure (this may sound maybe trivial, but it’s not so simple) to really ensure that the data was really collected at quarterly frequency.
Sometimes they themselves aren’t certain whether the data was collected at quarterly frequency, or the reporting agencies are actually kind of guesstimating based on certain benchmarks.
So we were very careful to make sure that this data is of appropriate quality and frequency.
Because we have a large subsam– … because we have a large sample of countries, we can look at various subsamples. So we can compare high income countries to developing countries. This is the first study of– … or comprehensive study of fiscal multipliers in developing countries. We can look at how exchange rate regimes affect the fiscal multiplier. We can see whether open economies and closed economies differ in the fiscal multiplier. And, specifically focusing on developing countries, whether highly indebted countries behave differently than low-debt countries.
OK, so, to the evidence itself. This first figure [slide 6] shows you the impulse response: the response of GDP. The numbers are probably too small for you to actually see, but it’s … I’ll try to fill in the … I can’t see them from here, [laughs] so I’ll try fill in the blanks from memory.
On the left hand side we see high income countries, and on the right hand side we see developing countries.
First of all, before we even get into the multiplier, you can just see by the impulse response that the effect of fiscal policy is much larger in high income countries than in developing countries, and we’ll go into more detail on that. Actually, at some point it looks almost like in developing countries the effect becomes negative after a while.
We also see that the output response is much shorter lived in developing countries. There’s something about what’s happening in developing countries that makes the output response to fiscal policy not sustained.
So from this we are going to … we estimate the fiscal multiplier (this is the cumulative fiscal multiplier that I mentioned earlier) at various time horizons. [slide 7] So this goes from zero quarters to 24 quarters, that’s 6 years. And we see that in high income countries overall, in the long run, we see a fiscal multiplier of almost 1.
Actually the impact response is pretty small. It’s about 0.3, so that a 1 percent increase in government spending as a percent of GDP increases output only by 0.3 percent, so there is some evidence here of crowding out of government’s– of private consumption, or investment from a government spending stimulus.
But we do see that in the long run output does seem to catch up, and at the end the output response is almost 1-to-1 with the cumulative government spending response.
In developing countries we see that the response is a little smaller. Actually the impact response is pretty much zero, and in the long run the response is smaller.
We divided our sample into countries, actually, episodes of countries, that had fixed exchange rates, and episodes where countries had flexible exchange rates. [slide 8] And here the difference is even more striking. It appears that exchange rate regime is very, very critical in determining the effectiveness of fiscal policy. The blue line over there shows countries with fixed exchange rates, and the red line countries with flexible exchange rates. We see that while the multiplier is rather large in countries with fixed exchange rates (actually exceeding 1, about 1.5 if I recall correctly, I can’t see it there) and in contrast, in countries with flexible exchange rates, the effect is almost zero. So fiscal policy appears to be very ineffective in countries with flexible exchange rates.
Now this is in principle consistent with a standard macro model that says that fiscal policy should be more effective in countries with fixed exchange rates, because monetary policy is forced to accomodate through the fixed exchange rate to the fiscal stimulus.
What is a little surprising, what surprised even us, is that we found that the crowding out of … [2:45:00] through net exports of GDP is a full crowding out, so that government spending does nothing in countries with flexible exchange rates.
Looking at open vs closed in a similar vein, [slide 9] fiscal policy is very effective in closed economies, defined here as economies with exports plus imports of 60 percent of GDP or larger. So closed, smaller, and open larger than 60 percent of trade to GDP.
And we see that in open economies, fiscal policy is washed out, while in closed economies, fiscal policy appears to be rather effective.
Turning, homing in on developing countries, what turns out to be interesting is that if we separate our sample into developing countries with high levels of debt to GDP, to countries with low debt to GDP — given the current US experience, maybe a debt to GDP of 50 percent doesn’t sound all that much, but for developing countries, as Carmen Reinhart has pointed out, the situation is much different, and a burden of debt of 50 percent of GDP is rather large for developing countries.
What we see [slide 10] is that, in some sense there’s a double whammy here. Might not be entirely entirely apparent from a first look. But first looking at countries that don’t have … that aren’t highly indebted, the impact of fiscal policy appears to be rather small. So if you’re not highly indebted, you’re not getting a lot of bang for the buck for your fiscal stimulus.
But then if you are highly indebted, if you’re able to push that fiscal stimulus out the door, it might be effective for a short while, but then actually, perhaps not surprisingly, output is act– becomes negative … the effect becomes negative as perhaps, we hypothesize, there’s some market discipline of highly indebted developing countries.
Now looking at that right panel, this might be a little misleading. Actually I consider showing that exact impulse response inverted, because developing countries tend to conduct pro-cyclical fiscal policies. So it’s not that this is the stimulus pattern that you would observe in a developing country during a recession, you would see the exact opposite. You would see a 1 percent decline, say, in government spending to GDP, which would cause a very large contraction in output, based on that impulse response, but will eventually pay off as that country reduces its debt burden.
So this actually might look like, "Oh, fiscal policy is great in these highly indebted countries, at least in the short run," but remember that they’re not really conducting counter-cyclical policies, so what we learn from this is that these pro-cyclical policies are very costly in the short run, but do, perhaps, pay off later on.
I’ll briefly … How much time do I have? … [crosstalk] … OK, …
So obviously we’re here at the American Enterprise Institute, so I should say something about the United States experience. [slide 11] And what we’ve done here is (and this is again rehashing the same data set that many have explored before, and our results are rather consistent with others who have used similar methodologies to ours). What we see is that in the United States, over the entire sample period from 1960 to today, we see that fiscal policy has a multiplier on impact of about 0.6 which, in the long run, gives a multiplier of over 1.
We argue that looking at the entire sample period is a little misleading, given the cross-sectional evidence we’ve shown, and we think that, for that very reason, the cross-sectional evidence sheds some light also on the US experience.
So in the bottom panel here we look at the periods before and after 1980. 1980 is rather arbitrary, but 1980 is about the time where monetary policy stopped accomodating to fiscal policy in almost automatic way. Before, in the ’60s and until the early ’70s, of course, the US had the dollar fixed to gold, so it did not have a flexible exchange rates. But even in the period between [2:50:00] the … in the ’70s one could argue that there was some accomodation on the Fed to fiscal policy.
After 1980 we feel like the US really had a flexible exchange rates and some form of monetary policy that was independent of fiscal policy. And what we see is that the blue line, the top line, most of that action that we have in the above panel is coming from the pre-1980 period.
Fiscal policy was, historically, effective in the United States. But once the United States moved to flexible exchange rates, as the United States has been opening up to international … or as trade has become a larger component of US GDP, fiscal policy has become less and less effective. So it’s possible that the red line there is the better benchmark to where we’re standing now than the top panel.
However, in practice, [slide 12] a lot of the (and this is coming to my … returning from my earlier discussion of new evidence on composition of government spending) in practice at least parts of the stimulus package in the US right now are in the form of government investments. Some of the spending is in the form of government investment, some of the spending is in the form of transfers to States, and part of that is going to turn into government investment. And so we were interested in seeing, what is the multiplier on government investment, and we found that the multiplier on government investment is much larger than that on … actually this is highly statistically significant. The red error band … the red bands give error bounds, and so we can actually even reject that the multiplier on government investment is lower than 1.
So we can … basically we have confirmation of government investment being a force that crowds in private– … or stimulates private spending or investment, and rather than crowding it out.
So this points to the fact that we have to think carefully about the composition of government spending, not only on the magnitude of the fiscal package that is put forth.
We’re still exploring some of these questions. We actually have data on government investment for several countries. We’re going to get some cross-sectional evidence on government investment. There are theoretical aspects that we’re going to be looking at. I’d be happy to talk about the state of ecomonic theory on fiscal policy in the Q&A if that comes up.
But I will conclude with policy rather than academic lessons from what we have just seen.
So I will start with policy lessons for high income countries. [slide 13]
We see that fiscal policy is less effective in countries that are open to international trade, and there is a move to larger globalization, larger openness to trade. We can expect that OECD countries will have larger shares of trade in their GDP looking forward. And given that, it’s not clear that traditional counter-cyclical fiscal policy will be as relevant looking forward.
Or, alternatively, it points to the fact that there might be a need for international fiscal coordination so that these fiscal leakages don’t occur. The question is whether such fiscal coordination across countries is politically feasible.
As I’ve already noted, the composition of the stimulus package of attempts to use … insofar as fiscal stimulus is used, the composition of stimulus is important. It’s not a trivial question to ask– … to decide what to spend that money on.
And turning to developing countries, [slide 14] we have seen that debt intolerance is an important … is important in assessing the desirability of counter-cyclical fiscal policies.
We have seen that as there’s been a push towards greater exchange rate flexibility in developing countries, as we’ve seen that fiscal policy is less effective in countries with flexible exchange rates, counter-cyclical fiscal policy may become less relevant for that reason as well.
But insofar as countries continue to, … many countries continue to have experience fear-of-floating, and to, at least de facto, have a peg to the US dollar, [2:55:00], the euro, or some other currency, then it is rather important that pro-cyclical fiscal policies that are observed in developing countries be reversed.
We’ve also seen in the context of highly indebted developing countries that pro-cyclical fiscal policies may be extremely costly.
So I’ll end on that note, and we can …
Vincent Reinhart: So actually, let me take the perogative of being Chair to ask you a couple of questions, and the first relates to the discussion of, "Is it the red line or the blue line for the United States?"
Your argument is: In the first part of the sample the US has a fixed exchange rate, in the second it’s got a flexible. You have the result that it’s … the multiplier is smaller for flexible than fixed.
Paul Krugman, given a sample range of all the potential multipliers you’ve come up with, attaches to the high number, that associated with fixed exchange rates, because monetary policy is at the zero lower bound, and just as in a fixed exchange rate regime, the Federal Reserve has to be perfectly accomodative to fiscal policy. I was wondering if you could comment on the size of– … what you think the size of the multiplier is in the current conjunction.
Second. Any time academics get together and talk about the multiplier, there’s a whole long discussion on the endogeneity of the fiscal policy response, and I was wondering how you deal with it, what you think about it, and whether the differences in multipliers, say between countries that are counter-cyclical versus pro-cyclical, are in part influenced by endogeneity?
Ethan Ilzetzki: So, on the first question obviously, for obvious reasons various people have chosen to concentrate on the bigger multipliers, we’ve found, and others have chosen to focus on the smaller multipliers based on what their opinion on the topic is. We’re trying a little to get beyond that and really to refine the answer to that question rather than give … than get into that argument.
Having said that, I mean I do argue here that we do think that the post-1980 period is more relevant for contemporary times, given that the United States does have larger shares of trade-to-GDP, and a more independent monetary policy that is not targeting any exchange rate.
Having said that, there’s a lot of theoretical work being done now on fiscal policy when a country is in a … at the zero interest rate bound. And one can think of having … when all countries have the interest rate at zero you are basically, at least, accommodating as fully as you can to fiscal policy.
So I think it is … there is some … I think there is some validity to look at the … to not only look at the flexible exchange rate estimates that we get in the current context, and maybe the reality right now is somewhere in the middle. But all econometric work is economic history, so we can tell you what [laughs] happened, but we can’t tell you what is happening right now.
And as for the endogeneity, we, so far in this, in what we’re showing you here, we use a standard identifying assumption, identifying assumptions that have become standard in the econ– … in the literature on this topic, which is we’re cleaning the data from what would normally be seen as automatic stabilisers. So we’re only looking at discretionary fiscal policy, and then we’re assuming that the lags to implementation of fiscal policy require at least one quarter, which I think is a reasonable assumption. And so that’s how we get around that issue.
You know, actually, on the multiplier itself, it’s surprising that a lot of the estimates in the literature aren’t really dependent on whether you use that sort of assumption or, say, the assumption [3:00:00] that Ramey and Shapiro have done with military or, Robert Barro has done on using military spending. You know the debate there tends to be more of an inter-economic battle about whether fiscal policy is crowding out consumption, or whether it’s stimulating consumption.
But the estimates, actually, on the multiplier itself, don’t seem to be all that off. They’re, of course, going at each other because they have these debates they’re discussing. But we’re looking at other items, defining assumptions too.
Vincent Reinhart: OK, so I think no we turn to questions, and the same rules apply. Please wait for the microphone to come to you, identify yourself and make it a question.
Charles Lane: Hi. I’m Charles Lane. I write editorials for the Washington Post, and I’m not going to let you off the hook from Vince’s question, but follow up.
We’re … Right now … There’s a discussion going on right now about whether a second stimulus of some fashion, some size, is warranted given the very bad jobs picture in this country. And, you know, you’re the oracle on multiplier effects. America wants to know, so you have to tell us now what the likely consequences of a substantial second stimulus would be. And I, just to add to the point I would like you to address, the way this fiscal stimulus package was designed was not to come in all at once, but to spend out over a couple of years, and I wonder how that affects the analysis, number one.
And number two, the fact that it is occuring in the context of this sort of flat-out quantitative easing from the Fed, does that change the kind of long-run calculus about the cost, or the economy’s ability to grow over the long run given that, for example, when Reagan ran a 6 percent of GDP deficit in 1983 it was coming on the heels of deliberate Fed tightening.
Vincent Reinhart: … and you’re doing it on live TV.
Ethan Ilzetzki: Yeah, OK, let me see how I elegantly evade your question. So, I think, looking specifically at the stimulus package that is in the process of being implemented, so it’s not clear what a second package would entail if it occurred.
But the stimulus package that was … that is being implemented included, I think, around 1/4 or 1/3 of it is in the form of tax … of temporary tax cuts. Now on temporary tax I provide no evidence and I have in some sense nothing to say about that. But the general consensus in the profession is that tax cuts (and this is true on both kind of the old Keynesian view of fiscal policy and the more modern macroeconomic approach) that tax … that temporary tax cuts are not particularly effective as a stimulus tool. And I think there has been some nice evidence that a lot of the tax rebates were not spent.
And so, … Then turning to the spending side, it’s actually, it’s not that easy (coming back to my discussion on composition) to assess, in real time, how effective this fiscal stimulus currently is, or is expected to be. A lot of the stimulus is transfers to States. I think the States are cash-constrained and I think there’s some moral hazard in bailing out the States in the long run, but we do think they are liquidity-constained and that this … that assistance could help, but we don’t know what the States are going to spend, or what spending they’re not cutting, you know. It’s kind of a counter-factual, which spending would have been cut if a State were not assisted.
And then we are a little disapointed, given our results here, that there is not as much … there could have been more investment, I guess, in the stimulus.
As for a second one, you know, you have to [3:05:00] … you were saying about how the Administration planned the stimulus not to come all at once. If that’s true then, you know, that perhaps could turn out to be wise, given that the job situation doesn’t look all that rosy, but at the same time, that just indicates how, when you are implementing a fiscal plan, you somehow have to think about what’s going to be the situation when the money is actually rolled out, and I don’t know who can project how 2011 is going to look at this point. So …
Vincent Reinhart: And the genius of the Delphic Oracle was to say things that allow multiple interpretations. Anybody have …
Ethan Ilzetzki: I hope I gave you at least one sound bite there, so … [laughs] … No, OK, sorry.
Vincent Reinhart: May I ask a followup of Charles, … Do you want one later? …
Greg Howard[ph]: Hi. Greg Howard[ph]. I was wondering if you estimated a multiplier on non-investment government spending, and what that meant for the current stimulus package.
Ethan Ilzetzki: So the … All the figures that I presented, until the very last one on government investment, was for government consumption. And so that all was non-investment.
One category that we don’t have evidence on, and actually for econometric reasons is actually really difficult to assess, is what is the role of automatic stabilizers. So how much do those stimulate. And so I think that’s going to be an interesting research topic for the profession looking forward is to understand the role of discretionary versus automatic stabilizers.
Vincent Reinhart: Why don’t we go to the other side? …
Joe Lieber: Hi. Joe Lieber, Washington Analysis. I’m wondering if you looked at any studies of how consumers relate to a stimulus package. I’m thinking of a Dr. Curtin in the University of Michigan’s studies that we’ve seen; surveys have shown that given the size of the stimulus package, the $787 billion package, some consumers have felt it was way too big, and would be detrimental to the economy in the long run and actually pulled back on spending. I think someone at the University of Michigan survey showed that pulled back on spending. And could that have had a counter-effect to the stimulus package? What’s your studies may have shown on that?
Ethan Ilzetzki: So, as I mentioned, … I mean that’s pretty consistent to what I answered to Charles’ question before, that both the macroeconomic theory, the macroeconomic evidence, and some microeconomic evidence seems to point that people are more sophisticated than just spending a tax cut the following day. So I think that is … And there have been even studies on the stimulus in 2008, microeconomic studies looking at what happened to that tax cut, and I think there is a case to be made that … Whether your psychological ana– … interpretation of why they’re not spending it is correct or not, I can’t talk to that, but I think there’s something to that.
Vincent Reinhart: … and please identify yourself and ask the question …
Carmen Reinhart: Like you don’t know who I am? I’m Carmen Reinhart, and he’s been deliberately ignoring me (I’ve been raising my hand). Ethan, two questions. One is — Have you and your coauthors thought of the issue of spending fatigue. That is, if after a certain … which is very pertinent to the questions here that have been raised regarding a second round of stimulus. I mean, you know, if your multiplier, as the years progress … Japan would be an interesting case to look at that; whether the multipliers are significantly impacted. That’s question number one.
Question number two is — I like very much the idea of the way you have approached cutting between fixed and flex. I was also wondering whether it might not be useful to cut between high-inflation / low-inflation groupings. Since you do have some emerging markets here that have been more chronic inflation, high inflation countries and that, you know, I think that that really impacts the government’s [3:10:00] ability to finance itself and raises a lot of crowding out issues.
I was wondering whether you guys have looked at either of those issues.
Ethan Ilzetzki: OK, that’s great questions, of course. Carmen was my … I’m a student of Carmen’s so she’s putting me on the spot here.
On the 2nd round of … the multiplier on 2nd rounds of stimulus packages, that’s actually, from an econometric perspective, very difficult to do because you have to try to isolate how … because the … even the first multiplier is going to have lagged effects. It’s very hard to isolate. We should think about ways to try to find clever ways to isolate the effect of the two, but it’s not an easy task. It’s not a straightforward task for sure. But I think there is something to that.
In terms of the spending fatigue, one thing that we do see in developing countries is that stimulus packages are very short-lived. Now whether that’s because … we still can’t say whether that’s because the market is disciplining them and not letting them spend for more than, say, 4 quarters, or whether that’s because there’s no political appetite, or other, or the public is not going to respond to that.
And in high inflation / low inflation, that’s something we are looking at. The main difficulty in that is that we … It’s the reliability of our data. In countries with high inflation it is a little spotty in the high frequencies that we’re looking at. So we have to think of ways to make sure that we’re not getting an incorrect answer because of that.
Vincent Reinhart: Any other questions? …
Chow Chen: Yeah, Chow Chen, freelance correspondent. Is this possible that the number would be negative for the developed countries? And also, is possible that the number were bigger than 1? And for simple[ph] question, since now, inject another factor, now you are getting maybe should include the possible expenditure. So now you are [undecipherable] expenditure, and the private spending. Thank-you.
Ethan Ilzetzki: So I’m not sure I understood the last part of that, maybe I’ll have you repeat it afterwards but, you know, whether a negative … I mean we do get some zero multipliers here for some countries. When we try to look … I’m a little skeptical of our analysis of individual countries. We do get some analysis of individual countries with negative multipliers. But other than the 4 or 5 countries … [inaudible crosstalk] … for developing countries.
Well, I mean the charts I showed on, say, fixed exchange rates and flexible exchange rates are for the sample as a whole, so they include developing countries and developed countries and high-income countries. And actually you get a pretty similar result when you look only at high-income countries.
And so I do have a sense that there might be some high-income countries where fiscal policy is not effective at all.
[inaudible crosstalk]
Well, you know, the high-income is the high-income countries as a– … So the first slide I showed you was looking at high-income countries as a whole. So in panel analysis of this type, I’m not really telling you what’s happening to individual countries, I’m telling you what the evidence of … When I pool the data across a large group of countries, what we can say about that group collectively.
And so in high-income countries, that multiplier we get of about 0.3 on impact, about 1 in the long run, could be hiding within it some countries with a multiplier of zero, and some countries with multiplier of ever more than 1.
So we … But part of the idea of this panel study is that we can’t really tell you on any given country, but we can tell you with more confidence about a group of countries together.
[inaudible crosstalk -- several seconds] … [3:15:00] …
Vincent Reinhart: … but the multipliers you do are for a total GDP, aggregating across … [crosstalk] … right. [crosstalk]
Ethan Ilzetzki: … Right. I … Yeah, I mean I … We don’t have evidence at this point. I think that’s something we could look at at some point, as to the components of GDP, yes.
Vincent Reinhart: Any last comments Ethan? OK, thank-you.
Now the next three presenters will discuss the role of the Federal Reserve, both in terms of its use of its balance sheet, historical episodes of trying to head for the exit and the Federal Reserve’s role more broadly in the fincial system.
So to actually set up that discussion, I will now give a presentation, [slideuuuI 1] given the little delays here [with the slide-show], talking about the Federal Reserve’s exit, more principles to understand exit strategy for monetary policy.
… Thank-you. And what … To give you a roadmap [slide 2] for what I’m going to be talking about, I first talk about quantitative easing described, or Q.E., Q.E.D. Understanding the entrance is essential to understanding the exit. It also helps appreciate the departure from the standard models that policymakers usually work with.
And I think it’s also important to hold policymakers accountable, that when they fashion the exit, they provide the same rationale and arguments for that exit that they provided at the entrance. You don’t want them to give one set of arguments to describe why it’s important to go into quantitative easing and another set of arguments why to exit quantitative easing.
Next I’ll talk about, "Why talk about the exit before you’re going to do it?" And in fact, there are benefits and costs of explaining the endgame before you enter it.
Then we’ll do a couple of case studies of just recent vintages. Mike Bordo, later on, will talk about the US experience in exits and wrong turns.
The last two topics will be the tools and transmission — basically "Does the Federal Reserve currently have the ability to exit from its unusual policy accomodation?" Is it a question of ability or willingness?
And then lastly, "Are we at the end of the beginning, or the beginning of the end?" That is, is it time to just continue to talk about the exit, or is it time to begin to actually exit.
Now first I’d just review the channels of quantitative easing. [slide 3] For some of the reasons that we talked about in the first session that I’ll bring up.
And I think the classic definition of quantitative easing is that the size and composition of a central bank’s balance sheet influences financial markets and the economy over and beyond the level of the policy rate. [slide 4] There’s a couple of things to notice about the definition. First, if you hold to that, and that is essentially the definition that my co-author and I, Ben Bernanke, provided in a paper about 5 years ago. A consequence of that definition (you might have heard of him), policy does not necessarily run out of ammunition at the zero bound. There are tools, the size and composition of the balance sheet, even if your funds rate is zero.
And so therefore, it’s not necessary to keep your policy powder dry (that is avoid getting to zero), because [while] being stuck at the zero bound has some numeric significance, it doesn’t necessarily mark the end of policy acco– … ability to provide more policy accomodation.
Another thing to note about this definition is quantitative easing is not just about the level of reserves [3:20:00] in the banking system.
People who narrowly discuss quantitative easing in terms of the amount of reserves outstanding are basically giving away the game. When I talk about the effects of quantitative easing, the level of reserves is just one potential channel.
It also means that quantitative easing can be undertaken at a non-zero policy interest rate. Why? Depending on the tools you have available, you can have a positive policy rate and change the size and composition of the central bank’s balance sheet.
Indeed, as Angel Ubide mentioned in the first panel, the ECB asserts it is taking … it is undertaking quantitative easing. it is taking credit policy decisions. Why? It is changing the composition of its balance sheet even though its policy rate is still positive.
Recognizing that quantitative easing can be undertaken at a non-zero policy interest rate is also relevant for the unwinding of the policy stimulus. As we’ll talk about, it is possible that the Federal Reserve could still have a very large balance sheet, could still be easing quantitatively. It will just so happen that the funds rate may no longer be zero.
Now quantitative easing potentially works through both sides of the central bank’s balance sheet. [slide 5] What do you do in monetary policy? You buy stuff. Because of double-entry bookkeeping, that affects both sides of your balance sheet.
The large provision of reserves (that is, let’s look first at the liability side of the central bank’s balance sheet) could make (this would be commercial banks) make use of idle balances. That’s a money-multiplier effect — the traditional narrow channel of quantitative easing is if you put a lot of reserves into the banking system, they will get used because banks don’t want those balances to sit idly.
The large provision of reserves, effectively providing more reserves than you need just to keep your policy rate at zero, also may convince market participants that the policy interest rate will be low for a long period of time. That’s called the policy duration effect.
Now again, how did you get the reserves into the banking system? You bought some stuff. So if we look at the asset side of central banks’ balance sheet, the accumulation of assets could influence spreads in markets — basically asset substitution. If the Federal Reserve buys more mortgage-backed securities, it can push down the spread of mortgage-backed securities relative to other market interest rates. If the Federal Reserve were to buy more mortgage-backed securities and sell its treasury securities, an equal amount, no change in the overall size of the balance sheet, that compositional effect could still potentially affect spreads.
And then lastly, by making its balance sheet big, the central bank is probably generating additional income, and that could provide a fiscal space to encourage additional fiscal policy action.
So four channels of influence related to:
- What’s the effect of reserves going up?
- What’s the effect of the large level of reserves on expectations of how long the policy rate will be low?
- What did you buy with those reserves? and,
- What did you do with the income you earned on those reserves?
The logic of quantitative easing effectively is to massively oversupply reserves. [slide 6] What’s that mean? It means that you put more reserves into the banking system than are strictly necessary to set the policy rate at zero. That’s on the right-hand panel, I’m talking about reserve demand goes down, banks are willing to hold more reserves as the policy rate goes down. At some point, when you hit zero, their demand for reserves (because they’re effectively free) is flat.
In quantitative easing you put more reserves into the banking system than you need to keep the policy rate at zero. And that may have some direct benefit: it could lend confidence that rates will be low for long; it allows the purchase of assets in volume; and, it generates fiscal revenue, revenue for the fiscal authorities.
As an aside, [slide 7] there are five central banks are now bounded, … are embarked on quantitative easing. All five central banks call it different names. [3:25:00]
There’s been a rebranding of quantitative easing. Indeed, the Federal Reserve started quantitative easing in October 2008, before embracing it for macro reasons. That is, it created a lot of facilities to handle credit problems in the market, the amount of reserves outstanding (that’s the top panel) increased sharply, the Federal Funds Rate dipped down to zero. At that point, the Federal Reserve was easing quantitatively.
However, the Federal Open Market Committee, for a month and a half after that, had a policy target of 1 percent. It had a policy target that was above the rate actually trading in markets. They were easing quantitatively but they weren’t admitting it. And then, as they embarked on QE they’ve given it different names like "credit policy," or "enhanced credit support," as in the ECB case.
Why? I think basically no one wants to be compared to the Japanese. That the last major central bank to embark on a policy of quantitative ease was the Bank of Japan, was a policy of zero interest rate, which they affectionately refer to as "ZIRP," the zero interest rate policy. And interpreted mostly and narrowly through the reserve provision they were doing, and there is … and the other major central banks don’t want to join that club, so they rebrand.
Another aside [slide 8] is that this is not just a crisis in global financial markets and economies. It’s also a crisis in economics and finance, because the macro models used to evaluate policy are not particularly helpful at this stage. Why? In those macro models they enforce a lot of netting across agents and talk about the representative agent. So it isn’t gross flows that matter, it’s net flows. It isn’t the overall size of a balance sheet that matters, it’s the net worth of that household, or that bank, or that financial institution.
So they do a lot of netting across entities. And they also assume arbitrage across markets, so that interest rates across many markets are linked to a single rate, the policy rate. And that reduces the policy problem to an issue of the control over the short-term interest rate.
What does that mean? It means that gloss flows don’t matter, so concerns about what we heard about this morning (overall risk exposure, cascades of failures, large gross positions, becoming large, exposures in the event of a failure) aren’t captured in those models.
The fact that they’re assuming arbitrage across markets implies that they are not good descriptions of what happens in markets when spreads blow up across markets. And, if you’re easing quantitatively you’re using the size and composition of your balance sheet, the short rate no longer describes everything you’re doing.
As a consequence, policymarkers do not have a good way of quantifying what they’ve already done, and they’ll not have a good way to judge when they are done. And they may not agree amongst themselves about the way quantitative easing affects the economy.
And one thing to understand about central bank communications with the public — if they can’t agree amongst themselves, they’re not going tell a coherent message to the public.
And so given the lack of standard analysis of quantitative easing in the multiple channels of central bank influence, it’s not surprising that major central banks are having trouble communicating their actions.
It’s easy to describe policy to the basis point when the only thing about policy is the level of the Federal Funds Rate. Much harder when it’s about your facilities, the size of your balance sheet and the composition of your balance sheet.
With that as background, why would you want to talk about the exit? [slide 9]
And to an important extent, people’s intuition about the advantages of temporary stimulus comes from fiscal policy. [slide 10] That is, in the standard analysis of the Reagan deficits in the 1980s economists noted that capital markets priced long-lived assets (like equity, like the long-term interest rates, like the foreign exchange value [3:30:00] of the dollar). And those prices influenced current spending decisions. Your wealth influences today’s spending. But you wealth depends on your expectation of developments well into the future.
In that environment, concerns about the longer term prospects for government spending can influence your decisions today, through what is known a expectational crowding-out. A government that spends a lot today and is anticipated to continue spending in the future might prompt concerns among the public that interest rates will be higher in the future, and they’ll bring forward that force of higher interest rates by raising long-term interest rates, lowering equities, and having influences throughout the whole spectrum of asset prices.
In that environment, the largest Keynesian multiplier in a dynamic standpoint comes from government spending when current resource use is slack (that is, you’re spending and you’re not competing with other demands for those goods) and the ratio of permanent change to … rather, temporary change to permanent change is high.
What does that mean? You’re likely to have a bigger multiplier if the public sees your action to be temporary. Why? Because you’ll have the immediate effect on spending, and none of that expectational crowding-out of interest rates higher in the future.
So in that regard, fiscal virtue is more than its own reward. It makes temporary policy more effective.
And I think that does influence our thinking about, "Stimulus policy should be temporary."
There’s a problem, [slide 11] and that problem is — In some analyses of unconventional monetary policy, longer term rectitude is counterproductive.
What do I mean by that? If monetary policy is pinned at the zero bound, that’s to nominal interest rates. If you can generate inflation expectations, you can lower interest rates in real terms. So the more inflation expectations you generate, the more effective you will be in reducing real interest rates, the more stimulus will be provided.
In that sense, the more the central banks is viewed as irresponsible, the more it can lower real interest rates. So virtue, in that regard, is not helpful.
Indeed, conventional thinking might hinder unconventional policy. And people who’ve talked about the virtues of irresponsibility also argue for the need for a Rooseveltian moment. That is, a new Administration coming in, changing expectations about the likely course of policy going forward, prompting a shift in expectations from continued declines in prices, deflation, toward inflation.
That Rooseveltian moment may spur increases in inflation expectations, declines in real interest rates.
[crosstalk]
Now the thing about that, what you want to view is the real long-term interest rate, depends on the whole term structure of inflation expectations. [slide 12] The real long-term interest rate equals the nominal long-term interest rate minus your expectations of inflation in the near term and expectations in the long term.
So central banks actually have a whole profile of inflation expectations to influence. The real long term rate, presumably the rate that matters for spending decisions, can go down because longer term expectations of inflation go up, or near term expectations of inflation go up.
As a consequence, in the next slide, [slide 13] this arithmetic reveals some ironic bedfellows.
Both the critics of unconventional policy and those who call for constructive irresponsibility talk as if the central bank can only shift the entire term structure of inflation expectations in a parallel fashion. That is, the only way you can generate inflation expectations is if you’re seen to be generating [3:35:00] inflation now and into the future forever.
So, for the former, the critics of unconventional policy, such as Alan Meltzer, my colleague here at the American Enterprise Institute, that’s just too big a long-run cost. That there is a cost of having inflation, and if we have to bear that for a very long time, it’s just too big in terms of output, it will add to volatility, it will offset policy effectiveness.
Those arguing for constructive irresponsibility, for wanting the central bank to generate inflation expectations, view that property, "the only way you can increase inflation expectations is if you permanently increase inflation expectations," like Paul Krugman, worry that that property will make central bankers less aggressive than they should be. That is, the central bankers’ concern about longer term inflation expectations will make them unwilling to generate the inflation necessary in the near term.
What’s wrong with that? It actually doesn’t give central banking enough credit, because unconventional policy can work in the near term within a longer term framework. [slide 14] And indeed the aim of unconventional policy should be to invert, or prevent from steepening, the term structure of inflation expectations. That is, to raise near-term inflation expectations while keeping fixed longer term inflation expectations. Why? Because the increase in near-term inflation expectations will lower real interest rates, but not give, but not– … the economy will not have to bear the costs of permanently higher inflation.
So virtue can be rewarding, in monetary policy too, as long as the central bank is seen as only being temporarily unvirtuous. That is, it’s OK to anchor … If you can anchor long-term inflations in principle, generating near-term inflation can be helpful.
The communications challenge to that is, of course, considerable. [slide 15] Why? Because you’re talking about what policy will do in the future, not what it’s going to do quite yet now. That is, you want to convince the public that you’re willing to tolerate some inflation, but only temporarily, and only some.
So what do you do? What you do is you be very stimulative while talking about the exit in the future.
So the reason to under– … To understand why so many Federal Reserve officials are out in the hustings talking about the exit is that they believe that buys them the space now to be more aggressive than they would be otherwise. Because if they can convince people that they will exit when the time comes, and longer-term inflation expectations will not rise, then they’ve got more scope to provide policy accommodation now. They have more scope to raise inflation expectations in the near-term.
Now the risk is that the A-students can understand the central bankers’ concern about expectational crowding out, but the C-students may not. What’s that mean? It means that if you go out there and talk all the time about the need to exit, so as to anchor long-term inflation expectations, you may perversely lead people to believe you must be exiting very soon. Why else would you be talking about it?
And if you think that is just a hypothetical case, I think the Summer of 2003 is exactly when that happened. Federal Reserve officials spent a long time talking about the remote possibility of unwelcome disinflation. But fear not, there are many policy tools to deal with that. The problem is the repetition of Federal Reserve officials talking about unwelcome disinflation led people to believe, "It must be much more likely than I previously thought," and those remote possibilities of unusual actions were actually quite likely.
So the communications challenge is, "How do you talk about a future contingency without changing prevailing expectations about that contingency?"
All right, [slide 16] now I’ll briefly [3:40:00] talk about exits and wrong terms, because the record of just the last 10 years has been relative– … but the longer term record has been relatively spotty with regard to the ability of central banks to stick the dismount. But I’ll only do it briefly, because Mike will also talk about it.
Federal Reserve policy in the 1930s [slide 17] showed that unconventional policy can work. There was a Rooseveltian moment in 1933, Roosevelt took office. The devaluation of gold allowed everybody to change relative to the price of gold, effectively increased the balance sheet of monetary authorities, even as the short-term interest rate in the bottom panel was effectively at zero and it would stay there for the next decade.
Notice what happens, the balance sheet of the central bank, high-powered money, rose markedly even as the short-term rate was pinned at zero. That’s quantitative easing. The size and composition of the balance sheet matters, even as the policy rate is unchanged.
The problem, as Christina Romer noted in a recent Economist piece is the Federal Reserve exited prematurely from that unusual policy accomodation in 1937, raising reserve performance, offsetting some gold inflows. And as a consequence, the economy went into a second recession in the same decade, a very sharp decline in industrial production after 1937.
The premature heading-for-the-exit can be very costly. [slide 18]
Japanese officials in the 1990s made several false exits [slide 19] in both the monetary and fiscal policy stance. For monetary policymakers, they continued to characterize their policy interest rates as "unusual and abnormal." If you, as an official, describe something you’re doing as unusual and abnormal, it probably means you won’t do it for that much longer. So there were several reversals in the structural deficit, and there was an unwillingness to embrace the zero-bound when they were providing policy accommodation.
In the 2000s, however, the Bank of Japan did show it was able to unwind its balance sheet very quickly. [slide 20] There were 5 months in 2005 where they shrunk their overall asset holdings by a fifth (that yellow area) by running off more than a third of the bills they owned. Bank of Japan, at that time, had the advantage of having a very simple balance sheet. It held lots of government securities, it held lots of government securities of short maturities. And so by just letting those securities roll off, their balance sheet shrunk.
So the exit can be done, but there’s also evidence that central banks head for the exits too soon sometimes.
What lessons do I take from this experience? [slide 21] Unconventional monetary policy can work, but talking about the exit is a challenge, and timing the exit is even harder. And it’s not about the ability, it’s about the willingness to unwind your balance sheet.
Central Banks have tools at their disposal to unwind the balance sheet. [slide 22] What are those tools? [slide 23] To return to a positive policy rate, the Federal Reserve is going to have to shrink reserves. It could do it outright by selling off some of the assets it holds. It could allow its loan facilities to run off. It could also shrink those reserves temporarily by doing temporary transactions.
Alternatively it could substitute reserves for other liabilities. What do I mean by that? It could have the Treasury start building up its deposits at the Federal Reserve, increasing the liability of the Federal Reserve, allowing the Federal Reserve to shrink another of its liabilities … reserves. The Federal Reserve in principle could issue its own debt, but that would require amending the Federal Reserve Act, and I don’t think they have any appetite for that. Or it could raise the corridor on policy interest rates. Right now there are 3 rates that matter, there’s the discount window … the discount rate, [3:45:00] the policy rate target and the deposit floor. By raising the deposit floor, in principle it could pull up all the remaining interest rates.
Now to repeat, part of the logic of quantitative easing is to massively oversupply reserves. [slide 24] That means reversing that reserve accommodation could require large actions, and it could take some time.
In principle, [slide 25] the tools that allow the expansion of a central bank’s balance sheet aren’t inherently asymmetric, but there’s one regula– … but again, it’s about the willingness to be aggressive, not the ability.
There’s one regularity to note about policy interest rates over the last 30 years across major central banks. They’re asymmetric. Policy interest rates tend to go up very slowly, and go down very quickly. That’s going up by the escalator and down by the elevator.
Yet that must reflect some constraints on policy action. If they’re there for movements in the interest rate, then they’re probably also there for movements in the quantities on the balance sheet.
What kind of contraints are there? [slide 26] Why might the Federal Reserve be asymmetric in its aggressiveness to shrink its balance sheet? Well four main ones …
You’ve got to be cautious. Policymakers might be unwilling to test the resilience of markets. Again, policy rates move asymmetrically, and so too, probably will be the size of the balance sheet.
Some of the long-lived assets the Federal Reserve holds may not have any markets anymore. I’m thinking in particular for its Maiden Lane, the securities it holds in the Maiden Lane portfolio, and those associated with any potential purchase of legacy assets.
Third, some of the programs have been funded with a first-loss tranche by the Treasury as a way of sharing risk, as a way of controlling the risk to the Federal Reserve. If the Treasury was present at its creation, does it have to be amenable to its destruction? That is, will the Federal Reserve have to consult with the Treasury in unwinding some of its facilities.
And then lastly, political pressures might be intense in an environment in which the unemployment rate is high and only going down slowly.
How about talking and walking? [slide 27] There are risks of quantitative easing, [slide 28] but the biggest risk to the legitimacy of a central bank is to fail to use all its tools at a time of evident economic threat. Major specific risks can be addressed. That is, the Federal Reserve could try to embrace a longer term inflation goal, and such precommittment can strengthen the effectiveness of its temporary policies.
And that’s it for me, [slide 28] so how about time for some questions? … and the same rules apply, wait for the microphone, identify yourself and ask a question.
Bob Feinberg: Bob Feinberg and I consult on the financial crisis. And you referred to the A-students and the C-students, and I just like to throw out a couple of ideas on how the honor students out there would respond to some of these initiatives and actions.
The late Bob Weintraub used to say that when the Fed takes upon itself to try to deal with some of these problems, it gets off-course with respect to monetary policy, and that creates confusion as to expectations.
Then when the authorities say that "We’re going to buy toxic assets," the honor students say, "Well that’s what they want to buy, let’s give them some. We’ll even create some new ones so they can buy them," in the case of Maiden Lane you referred to.
Chairman Bernanke gave assurances there’s nothing to worry about as to those evaluations, because they’re rated triple-A. These were by the same agencies that helped create the problem.
A yield curve is a policy instrument, just in case that touches a nerve. The industry believes that this is something that should be used to recapitalize by the back door.
There are also assurances given that as long as the banks don’t lend, then it doesn’t … we don’t have to worry about an inflation risk.
And then, as to expectations, two programs are supposed to expire shortly, the TARP / TALF, and the Housing Tax Credit. But on the Hill the engine is already running [3:50:00] to try to get those extended.
So hopefully you can have reactions to some of those ideas.
Vincent Reinhart: So I was talking very generally about the Federal Reserve’s balance sheet as if the composition of the facilities and the structure of the individual facilities didn’t matter. There are very strong incentive problems associated with some of the Federal Reserve actions, including lending to investment banks, lending to an insurance company, its willingness to be a buyer of last resort.
So I agree completely, and to me the best example of the ability of rocket scientists to fill a gap created by financial action is that the week after Bear stearns– … the Fed lent to Bear Stearns and created the Primary Dealer Credit Facility, Lehman Brothers rolled together the bits and pieces of individual securitizations into a single note whose only economic purpose was to serve as collateral for the Discount Window. And as a note of irony, those were called "Freedom Notes."
… Charles in the back? …
Charles [last name not given]: Thank-you, Vince. I suppose you could say every country has its own characteristic form of chronic uneconomic resource utilization? Japan has these little rice farms that they prop up. We have our housing policy.
What is the relationship between the ability to exit and structural reform of the economy? It seems that that … One of the missing links in Japan’s quantitative easing was those kinds of structural reforms to reduce the uneconomic use of resources in the country.
Does the Fed kind of, or does the central bank get kind of stuck with this policy because the rest … the structural reforms are not forthcoming?
Vincent Reinhart: … Two main points. I think exactly right. The structural problems are problems, they also create this opportunity. Japan is working so far within its efficient productive possibilites set that there is scope for reform to generate lots of extra output and lots of income. The fact that you need to be bowed three times to get into the store and then have your package wrapped by three different people tells you that maybe there’s scope for productivity improvements in retailing, for instance.
And so, that’s basically outside the purview of the central bank. It takes as given the level of potential output and the prospects thereafter.
Structural reform is important because, however, for a central bank, because it’s easy to imagine getting trapped in a facility when the facility is seen as helping a legacy industry. For instance, however what we do with the housing related GSEs, my bet is the Federal Reserve will not be the first mover in deciding to shed its … those assets from its balance sheet. It’s going to wait for cues about what’s going to happen to the GSEs.
What would happen if the Fed owned commercial paper of the auto industries? Would it be the first mover there? No. So I think central banks easily can get trapped in dead ends when there’s a failure for structural reform, and indeed, then you get the political economy of the situation.
Is it more likely to be a dead end because there is a buyer of last resort? Are we going to not get meaningful reforms as long as the Federal Reserve has a facility there willing to continue to buy this class of commercial paper, these kinds of structured products? And I think that’s a very serious and open question.
We have other speakers to talk about monetary policy, and we can ask questions again, but I do want to take advantage of our speaker who has quite graciously come from another conference, 15 blocks south of us, to talk about the Federal Reserve’s balance sheet, and that speaker is Professor Ricardo Reis, who is at Columbia University. He’s also a Research Associate of the NBER and a Reseach Affiliate of the Centre for Economic Policy Research in Europe.
Before Columbia he taught at Princeton University, and he served on the Board of [3:55:00] Editors of the American Economic Review, and is an Associate Editor of the JME and the JMCB. And so, thank-you, Ricardo, and you too can have the clicker.
Ricardo Reis: Thank-you, and thank you for having me in. [slideuuuJ 1] Let me start by thanking you for inviting me as well. It was for … well, since I’ve done so in private, let me do so in public. I want to apologize for having to walk in and then I’m going to leave as soon as I’ve finish, because I’ve committed 6 months ago to this other conference, whereas, this conference only came up 2 weeks ago.
But I really want to be here, and so Vince was gracious enough to allow me this walking-in-and-out. But I still wish you want to discuss some of the issues that I will raise, please feel free to e-mail me or contact me in some way. I would very much like to stay here, but I can’t, due to the prior commitment.
So I was asked to talk here about exit strategy of the Federal Reserve, thinking very much about the nuts and bolts of what the Federal Reserve has been doing in terms of its monetary policy.
And so, I can’t really do that without starting by telling you, giving you a sense of how extraordinary the last 2 years have been.
Now, for many of you this is probably I don’t need to make that point, that times have been extraordinary, but I have to give them insofar as from the perspective of the Federal Reserve, and from the perspective of what determines monetary policy and its tradeoffs.
And so, I just brought a few pictures to look at. [slide 2] And so this is interest rates, the interest rates are essentially as monitored by the Federal Reserve. The red one is the Federal Funds Rate. This is an interest rate in a market where the central bank actually isn’t, but a series of banks are, and they lend funds to each other overnight.
But the Fed, because, … and the banks do this because they are trying to get financing overnight, and because the Fed can then buy what’s called Open Market Operations by selling and buying bonds from these banks, and therefore crediting their reserves, or giving them money, can effectively control the demand and supply in this market, and therefore can announce a target for the interest rate in this market.
And so I have it here since 1989 in red. In blue I have the Discount Rate. There’s been some changes in how it gets computed and works since 2002, but you can pretty much extrapolate it back, because it’s been a few basis points above the Federal Funds Rate. And then in green I have the interest rate on reserves.
First point to make, even though I only started the picture in 1989, since 1954 at least (that’s at least since I have reliable data) interest rates have never been at zero for such a prolonged time as they have been, in terms of the Federal Funds Rate. The Federal Funds Rate has now been at zero for almost a year. It had never happened in 50 years.
Second, the interest on reserves (it’s not a coincidence that it’s on the horizontal axis, because by law, you can’t pay interest on reserves until about a year ago). Now, of course, as soon as you authorize to do it, there was a little spike up, but since then we’ve chosen to pay zero, but one of the extraordinary changes is that something the Fed had not done since it was created almost a century ago, is that it could not pay interest on the reserves that banks hold in its vaults, and now it can. And that’s been a big change, even if you don’t see it insofar as we’re not actually choosing to pay these reserves.
Second in terms of reserves, [slide 3] precisely this money that banks choose to hold, or are forced to insofar as they are required in part, at the vault of the central bank. And so in red what I’ve plotted in there is starting in 1930, simply these reserves (and to scale things I divided by annual GDP). So the total amount of money the banks are … having sit at the vault in the Fed, divided by just GDP so that I would get the trend.
And so what you see there is, it’s very clear the big upward blip over the past year, and to realize how extraordinary it is, note how big it is. And too that, with the exception of 16 months during World War II, at the beginning of World War II, reserves have never been this high.
So banks are just holding a tremendous amount of reserves at the vault of the central bank, they’re not lending this money out, they’re just keeping it in there on deposits, deposited at the central bank. That’s pretty extraordinary, as you see from the picture, since … Even in the Great Depression that hadn’t happened.
Fourth, [slide 4] and very related, the two basic concepts in trying to study monetary, … money supply are what’s called the "monetary base," and one, or a measure of money, the monetary base is the amount of currency out there that we’re holding in our pockets, plus the reserves of the banks, or holding at the central bank, as that’s money, because … sorry, … because that’s what the … Why is it called the monetary base? Because that’s what the central bank controls.
The central bank can either print money, or actually can just simply credit the account of the banks that they’re holding in their vault, OK?
So that’s "B" and that’s the green line, … that’s, I guess, the yellowish line.
"M", the money supply, if you measure it as M1, is the, again, the amount of currency in circulation, plus the checking deposits that people hold in banks. Normally, M and B are very closely linked, and the ratio between them is called the money multiplier, and the reason why they’re linked is because when I credit reserves on a bank, it wants to go and lend them out in the economy, but as it lends this out in the economy, people go and deposit them in other banks; then those banks [4:00:00] lend it back, and that multiplies from a given base into a given M, OK?
So that plot over there is the growth rate. And you see that indeed those growth rates tend to be very close to each other (I did it for the last 10 years).
What happens over the last 12 months is that the growth rate of the monetary base (what the Fed controls, effectively) and the growth of the money supply (the actual money that’s out there in our pockets) have become essentially divorced, OK? And in particular the money supply’s grown a lot less than the base. Why? Purely mechanically, because these banks are choosing to hold all these reserves in the vaults instead of lending them out. And that’s where the gap comes from.
Third fact, Fed’s credit. [slide 5] Traditionally the Fed intervenes in a very minimal way in markets, or at least minimal [laughs] relative to what it’s doing now. It’s not an absolute, but a relative statement. And so what the Fed pretty much almost exclusively do is go and buy and sell Treasury securities, government bonds, whether they’re bills or bonds or notes, OK? And it does this in exchange for bank reserves.
That is, what the Fed does is it goes out there and says, "Let me go and buy some Treasury securities from the banks. I’m going to pay you in exchange for those …," the way I pay it is to put credit in your reserves in my account, and you can come and withdraw them if you want, "… and the reverse," OK? And that’s the way in which it controls the amount of reserves.
What is it doing now, … So for instance, even though the Fed is a central bank, the Fed doesn’t actually lend money, for the most part, directly to the banks (although it doesn’t simply buy stuff from them, being credit to reserves that they have on the central bank).
Nowadays there’s just a soup of facilities (they all end in "F" and they all have different names that someone creative came up with) and so you have this through the TAF, now the bank, the central bank actually started lending money to banks directly instead of buying something from them to give them reserves in return it actually lends to them the reserves (at 28 and 84 days). Through other programs started lending to primary dealers — not just banks, but also primary dealers. It started lending against collateral provided by asset-backed securities (those asset-backed securities on students, auto, credit card and small business enterprise loans. It started giving, … I started lending money to Money Market Funds, started giving credit to firms directly, by buying commercial paper as a backstop provider as this was being issued, OK?
So it started all of a sudden lending money to all these different people, which it … Before it wasn’t lending money to anyone, really.
And moreover it started purchasing this series of assets. Started purchasig mortgage-backed securities at a very large scale. The Fed, by some estimates, accounts now for something like 10 percent of this market.
And, of course, infamously through the Maiden Lane, it took on assets form Bear Stearns and AIG, OK?
So you go from a Fed (and just looking at its assets, [slide 6] January ‘07, before there was ever even any inkling of a crisis) where the Fed was holding at a balance of total assets of around $900 billion ($878 billion), and most of them were being held as US securities, a lot of it short-term bills ($277 billion, $500 billion notes and bonds) and this is January ‘07, but if I look 20 years before, it looks very similar. And then marginal amounts of gold and other things.
And the situation now is where 1) the Fed holds very few short-term government bonds, but it’s holding mostly long-term notes and bonds; 2) it’s now holding this very large amount of direct credit to banks through the TAF which you see there, $220 billion. It’s holding commercial paper, it has the Maiden Lane money, it holds this huge amount of mortgage-backed securities, $600 billion, it’s engaged in some liquidity stops[ph] to external[ph] banks, and so as a result, its assets have ballooned from $878 billion to $2,063 billion as of the end of August, OK?
So this is again completely extraordinary, not just in terms of the size and scope, but also even the things that the Fed is doing. It is doing a lot of things that it never did before, OK?
So this is the sense in which it’s very extraordinary times for a central banker. And this is even, as I said, independent of the extraordinary things that are happening in the economy, just in terms of what looks extraordinary if you’re just looking at the accounts of the Fed and the actions of the Fed.
So I was asked to think about exit strategies for this conference, and the way I put this was in terms of 3 questions. So let me tell you my 3 questions.
First question. [slide 7] What are the dangers of the current situation of having had all these changes?
So let me start with what many say is the primary task[ph] of the central bank, which is to control inflation.
Now if you’re a naive monetarist, and by naive I really mean (well, this is literally what I teach to my undergraduates at Columbia, I was just teaching this 2 or 3 weeks ago) there are 2 basic principles that you have, which are that 1) by controlling the monetary base, the Fed controls the money supply; and 2) that inflation is always and ever a monetary phenomenon, that is by controlling the monetary supply you control inflation.
And through those 2 principles, you think that, essentially, it’s by controlling the monetary base that the Fed is accounting for inflation. You look at the current situation and you have a total [4:05:00] nightmare.
Why? Because the link between the monetary base and the money supply is gone, so all of a sudden the Fed doesn’t seem to be able to control the money supply, and too, the money supply itself is now … the monetary base is grown by 100 percent, the money supply has grown 70 percent per year already for a few months, and the money supply itself has grown by something like 30 or 40 percent. So you’re expecting huge amounts of inflation over the next year, OK?
So if you’re a very naive monetarist and this is just, two basic principles, then you really … Things can get worse. You stop controlling money and there’s so much money out there that you think there’s going to be a whole lot of inflation.
Is this correct? Turns out that it isn’t quite correct. And so that’s why a sophisticated monetarist, if you are, or even a non-monetarist, realizes that this is actually not as much of a fear as may seem.
First, pure data observation, if you look at the inflation today, we’re not seeing 20 percent inflation, in fact we’re seeing negative inflation — deflation.
Two, you look at expectations, either measured by the market or surveys, they’re incredibly low and anchored. If anything they’re lower than they were before this explosion in the money supply. So the data itself, at least at this prima fascie, very first look just doesn’t seem to be showing that influence.
Second, what this ignores, of course, is that even a monetarist would say that this causes inflation insofar as the increase in the money supply has been permanent. However, insofar as the Fed, as soon as thing get better, or as soon as it wants to reverse things, starts raising interest rates, OK? Then there’s no reason why that wouldn’t control inflation. In particular, if we’re expecting that interest rates are going to be rising in the future, even if they’re very low today and there’s a lot of money out there, that in itself will control inflation today, OK? Insofar as people want to … they don’t want to be changing their prices all the time, realizing that there’s going to be reasons not to be raising their prices in a year, controls their desire to raise their prices today.
Third and though more importantly, and this is where the naive monetarist comes in, is that the first change that I pointed to you, which is that our paying interest on reserves means that the naive monetarist’s suppositions are wrong, even by … and even Milton Friedman, of course, a friend of monetarists realizes this.
The thing is that once you pay interest on reserves, the end you’re paying interest on reserves by the same amount that you’re paying on the Federal Funds Market, now when you’re increasing the monetary base and crediting reserves to the banks in exchange for securities, say, then the banks no longer have an incentive to re-lend this out. They can be keeping it in their vaults, or they could be letting it out. They’re earning the same return de facto, in fact, since both interest rates are the same.
So the reason that the monetary base and the money supply are divorced is actually exactly predicted by theory, by monetary theory, and is simply a result of the fact that now those two interest rates are the same, whereas usually we have the Federal Funds Rate being positive, and the interest on reserves being pegged at zero, which is why banks, whenever they got reserves, were dying to get rid of them, and would only keep the minimum amounts to keep the legal requirements, and that would make its way into the economy and the money supply in a predictable way, OK?
Once you pay interest on reserves too, the first proposition of this naive monetarism was out of the window. You don’t control money supply, but that’s to be expected.
Second, as soon as interest rates are zero, as they are right now, then it means for households or firms or private agents, holding money, holding money in their pocket or even as deposits at the bank is costing them nothing in terms of opportunity cost. Because if they went and invested and bought bonds, they would earn zero as well.
That means that even as the money supply may be growing by 20 percent, that doesn’t lead people necessarily to go and start spending all of this money (because they want to get rid of it so as not to earn the zero interest) and therefore it doesn’t necessarily go and spur demand and spur inflation.
So from the moment you have this interest on reserves, and when this interest rate now is zero, [for] the conventional naive monetarist these two steps essentially have been broken. So there’s actually no reason for the monetarist to have a nightmare, as soon as he realizes that the naive monetarist was predicated on the view that the Federal Funds Rate would be positive and above the interest on reserves, OK?
So there’s actually not … There may be inflation, but it’s not those money statistics that should be convincing you of that.
Moving to employment, second objective of the central bank. Should we be worried about employment? Well, certainly we shouldn’t, we are having a pretty big recession, but from the view of the central bank, can it do something more than what it is doing about it?
So the concern here is what is called "the zero lower bound," on nominal interest rates. Nominal interest rates cannot go below zero, or approximately can’t go below zero, because if you can just stuff the money under the matress and it’s still worth the same amount of money in 6 months, assuming the matress doesn’t burn, or something. Because of that, remember that the real interest rate, the amount that you get on real investment, is equal to the nominal interest rate minus the inflation rate. If the nominal interest rate hits zero and inflation expectations are anchored at 2 percent, that means the real interest rate can only be as low as minus 2 percent.
Well it is a very bad recession, even like the one that we’re seeing now. A bad recession’s the time in which people aren’t willing to spend very much right now. That is, they’d rather save instead of spending. Well, that can always be fought against if you want to discourage it [4:10:00] by lowering the real interest rate. As the real interest rate gets lower and lower, people would want to not save, but instead to start spending, and that may be able to fight the recession.
Insofar as because of this zero lower bound, real interest rates cannot fall below 2 percent, and maybe nowadays in order to boost employment we need negative 5 or 6 percent real interest rates, it may be that we’re having a too inefficiently low amount of employment, and in particular one that is below what … if the Fed could do something about it would be able to do something about it, OK?
That’s certainly true, and this is a big fear that beyond whatever shocks are going on, the Fed can do little about, there’s also the fact that the Fed might not be able to lower interest rates below zero is adding further to the recession. It’s very difficult to see what more can the Fed be doing. If anything, it’s been doing too much because of this fear. A lot of those Fed’s actions of trying to intervene here and there have been predicated on the principle of trying to lower interest rates in other markets beyond the Federal Funds market. So if anything, the danger that the Fed has not been doing enough to boost up employment, I think, is somewhat implausible at this point.
What is there for what I see as the ver– … the true danger. And the danger is really one of political economy. The danger of political economy is that — 1) As the Fed is holding all of these assets on its balance sheet, and therefore incurring in the risks that it can suffer some serious losses, OK? … it may be the case that at some point the Fed may need to turn to Congress for funds.
If the Fed turns to Congress for funds, then essentially the bank’s independence gets jeapordized in that once the Congress has to approve a transfer of so-and-so billions to the Fed, the Congress will naturally want to have a say in what the Fed is doing.
One of the things that we’ve learned in monetary economics in the last 20 years, both through extensive theory as well as a lot of support from the empirics and the data, is that central bank independence from Congress seems to be a good thing, in terms of certainly controlling inflation.
Why? Because once the Congress starts being able to tell the central bank what to do, then it always has an incentive to push for lower interests rates in order to boost employment and to guarantee, say, re-election.
So there’s a serious fear that as the Fed is taking all of this risk in its balance sheet it will have to turn to Congress for funds. It’s still a remote risk, I mean the Fed still has a lot of room for maneuver, but it has certainly opened this possibility. Moreover, once the Fed started intervening in markets in a very direct way, beyond just the buying and selling of government securities as it used to, it raises some very natural questions from Congress, and very understandable questions, of — the Fed is in some ways engaging in a series of forms of what would be called in normal circumstances fiscal policy. And so the Congress should have a say about it.
And so this fine line between separating what the Fed does and what the Congress does has been broken by the Fed, maybe justifiedly so, but it certainly opens the way for it … for the opposite direction. In some ways, perhaps, desirable in that it would be good to have more Congressional oversight of what the central bank is doing, but in some ways a very, very dangerous one, insofar as we know that whenever this barrier gets broken, there’s this very strong temptation for Congress to push for the Fed to … for higher inflation.
Second is, of course, the capturing by financial market participants. What I mean by here is when the Fed was just buying and selling different securities, again it was only perhaps subject to the lobbying of the Treasury, the seller of those securities, or the issuer of those securities. Once the Fed started buying a bit of lots of things, it opened the door for, "If I own a security, if I’m issuer of a security, I can say, ‘Why don’t you buy my stuff?’ If you’re buying the mortgage-backed securities, why don’t you buy my so-and-so security? It’s as important to the US economy," I will argue, of course, and I’ll be very persuasive at it.
"And so once you open the door and they start buying some things, why not start buying mine?" This is particularly serious with the mortgage-backed securities, because once you’re 10 percent of the market (and this is a very politically powerful market, the morgage market, as we know from Fannie Mae and Freddie Mac and all of the problems from there) there’s going to be some serious pressure on the Fed to start intervening this way.
So the Fed, again, by starting to intervene in the markets has really opened this danger that people start trying to use it, or asset markets start trying to use it to pursue whatever private goals they have.
So those are the dangers, as I see them.
Second question: can the Fed get back? [slide 8] Well so if we think these dangers are serious enough, can the Fed in the next 6 months to a year just go back to the old status quo that had prevailed for 90 or so years?
Let’s go subject by subject.
Monetary base, is that easy to lower? … to lower the amount of reserves? Yes, it’s pretty easy. That’s what the Fed … that’s the bread-and-butter of the Fed, just do open market operations in the other direction. Yes, there are some implementation issues about how to get the bonds and whether you have to have a Treasury account or not, but those, I think, are mostly details.
The credit programs. A lot of these 28 to 84 day loans to the money markets and so on. Are these easy to reverse? Yes, because for the most part, they are at most [4:15:00] 90 … they have a duration of about 90 days, so if you really want to reverse them, just don’t renew them and in 3 months we’ll be back.
The fact that the Fed has shifted into longer maturities, that it’s now holding very few T-bills and a lot of T-bonds, a lot of longer term government securities. Again that’s very easy. The Fed can just go and sell its long-term and buy short-term. The Treasury may not like this for some reason. Treasury’s problem. If the Fed thinks that this is an important thing there’s no reason why it can’t do it. And if anything, the Fed … The maturity of the US government debt is a responsibility of the Treasury, not of the Fed.
So these ones are not hard. What are very hard?
The big one, the big elephant in the room right now, which I already alluded to, is the mortgage-backed securities. The Fed is holding some $600 billion of them. It’s very hard, I’ve tried hard to try and get an idea of what’s the average maturity of these. It’s very hard to measure, because there’s a mix of a lot of them, but it’s certainly at least 4, 5, 6 years, if no more.
So letting them expire by themselves is really not an option, so you have to go and sell them.
Now, best case scenario? The market for mortgage-backed securities gets back in action in 6 months once the crisis is over. You go to the market, you sell them, maybe in some gradual way, but it’s not very different from the way in which the Fed got rid, and lots of central banks over the world reduced their gold reserves over the last 20 … after Bretton Woods.
More difficult, what if that doesn’t happen? If the mortgage-backed securities market hasn’t … is not active? Then how is the Fed going to sell these? The political pressure that, as I’ve said, there’s very big stakes here. It’s a lot of money. That isn’t clear, how the Fed is going to be able to do this if the market doesn’t reactivate.
Even worse, of course, although much less important, because it’s only 10 percent of the amount, it’s only about $60 billion, is the Maiden Lane assets. The Fed has bought a lot of things from Fannie Mae, has taken a lot of assets from (not Fannie Mae) … AIG and Bear Stearns. A lot of them are incredibly illiquid, you may lose some money in them. The only comfort is that at most you will lose $60 billion. Hopefully not more than that. Selling these? Who knows?
At least, even as just a student of the Federal Reserve, I’m not sure what is in there in those $60 billion. Consolation, it’s only $60 billion. So I still think the elephant in the room is the mortgage-backed securities.
I think it’s clear, and I think … I’m not sure if people at the Fed would admit it, but it would have been ideal if the Treasury had taken on Maiden Lane. That’s the way it should have been done. For many reasons it was done so that the Fed took it onto its balance sheet. Hopefully this was with a deal with the Treasury that the Treasury will take on the losses, so the $60 billion will come back from the Treasury, since they’re the ones that should have taken the assets. Who knows what’s going on?
Third and final, to conclude my intervention, "Should it go back?" [slide 9]
So I said it’s dangerous. I said, "Can it go back?" Now "should it go back?" Which of these changes should be reversed or not.
One, the credit programs. Should they be reversed? I think there’s an unambiguous answer, "Yes." There’s just no reason why the Fed should be making these loans directly to banks, that it should be making loans to primary dealers, there’s no reason to be making loans to money market funds. They’re a dangerous interference with financial markets, they raise the issue that you’re always going to have to intervene in some but not others.
I think no one, I’ve not seen one good argument for why these credit programs shouldn’t be unwound.
Interest rates. Certainly that, if the Fed just kept them at zero forever, or for a very long time, this would lead to inflation. After all I told you not to worry about inflation because as I was counting on the Fed to raise interest rates as soon as the crisis is over.
It’s important to note, though, that the messages here are a little bit more mixed in that the eagerness to raise them can be dangerous. The Fed has been very keen (I was just — the conference I was in an hour ago was at the Federal Reserve, and I just heard Don Kohn at the lunchtime address saying that they’re very ready to raise interest rates as soon as the crisis seems to be over, and in particular they’re not aiming for an inflation level above the one that they had before, even though we had all this deflation). And history here (and Mike Bordo is a teacher of these things, and a master of these things) tells us that both in coming out of the Great Depression in 1937 / 38 as well as in Japan’s lost decade in the ’90s, the reason why those … or one of the big reasons why those lasted, those two very negative and bad events lasted for so long, was that the central banks were very eager to reverse things, and were not willing to let the interest rate be stuck at zero for a little bit longer, so that we were truly out of the woods.
So there’s a … Whenever I hear the Fed talking about exit strategy I get very nervous, because of what I know from the Great Depression and Japan. You can be too eager here.
Third and finally, and this is the … So first one, you should definitely go back, interest rates, yes, but be careful not to rush it, third one you should not go back, in my view. But I think this is supported by most economic theory.
Monetary [4:20:00] base has grown by a lot. It’s grown from (I’ve forgotten my numbers, but) $80 billion to something like $600 billion.
Is this bad? And as I told you, this is partly because we’re paying interest on reserves. No. This is not bad at all. This goes back to a point that Milton Friedman famously made, and it goes under the name of "the Friedman Rule," that says that creating money, creating reserves, printing little pictures with … pieces of paper with pictures of Presidents in them, former Presidents in them, doesn’t cost anything to society. It has some benefits, it helps us make transactions. If it doesn’t cost anything and has some benefits, we should push those benefits all the way to zero by flooding the economy with liquidity. Meaning we should have enough money to be able to do whatever transactions we have. Of course the value of that money will adjust, but still we should have enough of this money that we can make our transactions conveniently.
It’s all fine[ph] to satiate society with liquidity. Milton Friedman made this point that, given the opportunity costs of holding money, as I told you, is zero, … (I’m sorry …) the opportunity costs of money’s interest rate, then the interest rate should be zero. And so you have probably heard of the Friedman Rule as: "No Interest Rate Should Be Zero."
Actually, the correct statement of the Freidman Rule is that, "the nominal interest rate should be equal to the interest rate on reserves." It was only stated as "zero" because the interest rate on reserves was zero.
For a loan for which you are paying an interest rate on reserves, the optimal Friedman Rule is to keep the interest rate on reserves completely in line with the Federal Funds Market, have the banks and people hold as much money as they want. If they want more money, we’ll just credit the needed reserves. If they can raise to $2 trillion, it can go down to $500 billion, it has absolutely no effect on inflation, because what’s determining inflation is the interest rate, the Federal Funds Rate, it’s not the amount of money out there.
And having all this money out there serves a useful purpose. You’re not losing control over inflation, and you are satisfying demand, just as Milton Freidman had said so. And that’s the end of my intervention.
Vincent Reinhart: Thank-you Ricardo. We’ll take one or two questions? … and the rules apply, wait for the microphone, introduce yourself, and then maybe right here first? … and make it a question.
Paul Horne: Paul Horne, international economist, retired from Citibank when the share price was $52. I’m interested in the underlying motivation of the Fed’s exit policy. Since its quantitative easing, zero interest rate policy has been directed primarily toward the financial sector, and assuring the survivability of the financial sector. Its motivation for the economic recession (we’re dealing with the consequences of the economic recession) has been minimal to date.
But don’t you think the exit strategy is going to have to hinge primarily on the length of the recession, the length and depth of the recession, as opposed to the financial sector’s survival?
Ricardo Reis: Are we doing give-and-take? Good. So there’s two sides. One side is this credit programs. There were many of them in place to prevent the failure of some key markets. As soon as those markets recover, there’s no reason to rely on the credit programs.
Then there’s the side of, if you want a more conventional monetary policy, like setting interest rates. In that regard, those should have an almost exclusive view and eye on what’s going on in the real economy, and indeed, even if financial markets recover, the setting of interest rates, they went[ph] to raise them from zero, should be by keeping an eye on what’s going on in the real economy. And that’s strongly the case.
As for your first … the beginning of your question, which is, "Should the Fed have been intervening directly in the real economy?" The Fed did that partially through the commercial paper market. I think that … I was very nervous, and the Fed was certainly very nervous about the credit programs to all the different massive market participants. I’d be even more nervous about the Fed going in, lending to different sectors where it’s much harder to unwind, because there’s no, very often, liquid markets. And the Fed’s know-how is even much lower.
And so I think that, as the … If you’re going to intervene, that would take us even more in the direction of where I think it’s very, very dangerous. And the Treasury can, of course, do that. It’s better prepared to do so, if it wants to.
Gillian Garcia: Gillian Garcia, formerly IMF. You mentioned three dangers. I’m concerned about a fourth, and it’s one that’s not been mentioned, I think, at all today. And that’s the value of the dollar and the exchange rates. Suppose that the rest of the world, particularly those surplus countries, stopped wanting to buy treasuries securities. What does this do to the policies?
Ricardo Reis: I subscribe entirely to what you’re saying. I mean, I didn’t mention it, but it is one big danger. So there’s one way in which [4:25:00] we can make that danger very present, which is to exactly let inflation go out of hand, and therefore through that scare the international investors who are expecting the inflation and the associated depreciation of the dollar, who may start panicking now.
The Fed is certainly not … The Fed has been very clear it’s still keeping an eye on inflation. What if, because of the events, these international investors just get spooked and take their money out? I think that’s a very … that would be a very big problem.
It’s a problem that’s been discussed for 10, 12, 15 years, since these funds have been coming in. I think it’s a problem that’s even in part orthogonal to the crisis. I mean, we have … That was true 7 years ago when when we were having what was then called these very big global imbalances.
There’s some debate, I mean Carmen Reinhart, who’s sitting there, knows this much better than me. There’s some debate on whether this would be truly dangerous or not, whether we can do something about it or not. But in some way, the reason that I kept it out of my presentation, to justify myself, is that I think that that’s partly orthogonal to the crisis.
There’s another issue, the issue of global imbalances, an issue of foreigners having a lot of their savings here. What if all of a sudden they take them out? The crisis is related to it insofar as it may trigger that event. It doesn’t seem to have done so a year and a half ago. That’s a policy issue that we’ll have to confront if it happens.
Vincent Reinhart: Actually, why don’t we let Ricardo go now, … It’s always good to leave ‘em wanting more. And there are two more speakers up on Federal Reserve policy, and those questions can be asked again. But thank-you.
… Now a number of us have made assertions about, "This is what happened the last time," or "You have to worry about the premature exit." We’re actually now going to have a speaker that you can put faith when he says that.
Our next speaker is Mike Bordo, a professor of economics at Rutgers University. He’s worked at numerous central banks, including the Federal Reserve, the Bank of England and the Bank of Switzerland. He’s currently an editor of the Internation Journal of Central Banking and has written extensively on stock market activity, the Great Depression and central bank policy.
The floor is yours, Mike.
Michael Bordo: There’s a number of people who would say, yeah I’m an economic historian and so I take the long view and I look at events like recessions and crises because we’ve had them for a very long time. [slideuuuK 1] And Carmen Reinhart’s sitting there, and they’ve just written a really nice book which, what’s the book called, Carmen? … "This Time It’s Different."uuuC
Basically she shows, and Ken Rogoff shows that, you know, the crisis problem is old hat.
Now this recession [slide 2] (sorry about the font, it will get bigger in the next few slides) … This recession is familiar in some respects, but it’s novel in others.
It’s familiar in the sense that the recession, although it’s somewhat longer in duration and somewhat deeper than the post-War average, is within the realm of the post-War experience. In other words, it’s bad, and we think it’s terrible, but it’s really not as bad as it was in the 1930s.
It’s novel in the sense that it was precipitated by a financial crisis, which was consequent upon the collapse of a major housing boom. So that’s a very unusual event for the United States. Again, as Carmen shows, this happened a lot in other countries.
And it is the most serious crisis event in the US since the Great Depression. So this is the … These are the novelties about it. And the crisis, as everybody’s been telling us before me, the crisis and the recession were dealt with by vigorous orthodox policy responses and by unorthodox quantitative easing and the creation of credit facilities.
So the Fed has been dealing with this, and the recession, … And I’m not going to talk about some of the mistakes that they made along the way. But the recession is now over, and although the NBER hasn’t pronounced on that yet, but I’m pretty sure it’s over, and the question arises, "How do you return to normal growth and low inflation." In other words the question of the exit strategy.
And the question is, "When should this happen?" And there are really two views on this subject. OK, one view argues that because of the financial crisis, the credit crunch and the large overhang of non-performing loans and toxic assets, that the recovery’s going to be slow and the need to tighten is not going to occur for quite some time. [4:30:00] And this view is backed up by cross-country evidence from the IMF, and also by the evidence that Carmen and Ken have done, which demonstrates that recessions accompanied by financial turmoil tend to be deeper and longer.
But the alternative [slide 3] view is that the recovery’s going to be V-shaped. And this was the case, as was the case in most severe recessions in the US in the 20th Century, and especially from 1933 to 1941. And in that case, expansion would have been even more rapid (it was pretty rapid over the whole of that period) it would have been even more rapid if not for the New Deal cartelization policies like the NRIA and the Fed policy error of doubling reserve requirements in 1936 / ‘37, and I’m going to talk about a bit more in a couple of minutes, which led to the serious recession of 1937 / ‘38.
So the question is, "Which scenario plays out?" That’s going to be crucial to the timing of the Fed’s exit.
Now based on the historical record, we can classify the risks facing monetary policy with respect to the exit strategy as basically two-fold:
- either you tighten too soon, and you create a double-dip recession; or,
- you tighten too late and that leads to a run-up of inflation.
And so what I’m to do is I’m going to consider the lessons from history on the risks of an incorrect exit policy. I’m going to focus on the Fed’s exits from easing policies since 1920, and what I’m … and that’s what I’m going to do in the paper I’m going to … that’s going to be done for this conference volume.
But today I’m just going to talk about a number of de– … just a small number of episodes of both kinds of errors.
So the first error is tightening too soon. [slide 4] And there are two episodes that stand out — 1937 / ‘38 and 1980 to ‘82. The second one is a bit more controversial.
The ‘37 / ‘38 recession, which cut short the rapid recovery from the Great Contraction of 1929 to ‘33 was a consequence of the Fed’s doubling of reserve requirements in 1933 to ‘36 to sop up the banks’ excess reserves. And the banks held excess reserves in reaction to their sad experience in the banking panics from 1930 to ‘33, when the Fed, instead of acting the way it’s supposed to act, as a lender of last resort, basically sat on its hands and the banks failed.
And so the banks were really worried. The banks that survived the Depression were really worried that this could happen again, so they held these large precautionary reserves. Now the Fed officials at the time were concerned that these reserves would lead to an explosion of lending and would foster a recurrence of the asset price speculation of the 1920s.
And in fact, the speculation of the ’20s led the Fed, the stock market on Wall Street, stock market boom, led the Fed to tighten in 1928, which killed the bull market and started the contraction in August 1929 that would become the Great Contraction.
Now the Fed officials also believed that reducing excess reserves would encourage member banks to borrow at the Discount Window. And they followed a policy strategy back then called The Burgess-Riefler Doctrine, which is quite different from today, which argued that the Fed could exert monetary control by using Open Market Operations to affect member bank reserves and hence to alter member bank lending.
And this is discussed in Alan Meltzer’s voluminous Volume 1 of his History of the Federal Reserve. And so they wanted to have the ability to tighten, and they wanted to get the banks to have … increase their borrowing so they could get to the Window, and so they wanted to, in a sense, reduce their excess reserves.
And the consequence of doubling the excess–… the reserve requirements in three steps from August 1936 to August 1937 was that the banks sold off their earning assets, cut back on their lending to restore the desired cushion of precautionary reserves. And according to Friedman and Schwartz in their "Monetary History of the United States," that this greatly reduced the money supply, leading to a serious recession, [4:35:00] and in fact the ‘37 / ‘38 recession, in which output fell by 10 percent.
This recession we just finished experiencing, output will not have fallen in total by 4 percent, OK? So it was 3 times, almost 3 times as bad.
So that was the first mistake. The second one is the 1981 / ‘82 recession. And that one quickly followed the recession of 1979 to ‘80. And the background to both recessions was a long-standing and severe build-up of inflation from about 2 percent in 1964 to double-digit levels by 1979. So that’s called, we refer to that as The Great Inflation. And in August 197– (I’m not going to talk about all the Fed’s … the terrible mistakes the Fed made that got us there) but in August 1979 President Carter appointed a well-know inflation hawk called Volcker as Chairman of the Federal Reserve. And two months after taking office, Volcker announced a major shift in policy aimed at rapidly lowering the inflation rate. He desired that the policy change would be interpreted as a decisive break from past policies that had led to the run-up of inflation.
And the announcement, the announcement was followed by a series of sizable hikes in the Federal Funds Rate. And that the Federal Fund Rate was increased by 7 percentage points between October 1979 and April 1980. And that was the largest increase over a 6 month period in the history of the Federal Reserve System. But what happened was that the tight monetary policy stance was relaxed, temporarily abandoned, in 1980, in mid-1980, as economic activity started to decline.
And what happened then was the FOMC at the Carter Administration’s behest imposed credit controls, but they also let the funds rate decline, and in a sense the Administration was pushing for them to do that.
Now the argument I’m making is that the policy reversal that occurred in 1980, and the acquiescence to political pressure was widely viewed at the time as a signal that the Fed was not committed to achieving a sustained fall in inflation. And having failed to convince wage and price setters that they were … that inflation was going to fall, the GDP deflator rose almost 10 percent in 1980.
So then the Fed came back in the game of tightening. They embarked on a new round of tightening in late 1980. The Federal Funds Rate rose to 20 percent in late December, and that implied an ex post real interest rate of close to 10 percent. And this second and more durable round of tightening succeeded in reducing the inflation rate from about 10 percent in early 1981 to about 4 percent in 1983, but it did this at the cost of a very sharp and very prolonged recession.
So in a sense, the argument that I’ve made in a paper with a couple of guys in the Federal Reserve Board is that had the Fed, in a sense, had a credible commitment, if the markets that believed that the Fed was credible, that the second recession would not have been nearly as nasty as it was.
So the next type of mistake is tightening too late. [slide 5] And the key episodes here are in the 1960s and 1970s. And over its history, the Fed has always tightened monetary policy when inflation threatens, and loosens in the face of recession. And before the mid-1960s they adhered to the nominal anchor of the gold standard.
It was through the Bretton Woods system, but the US was, … the dollar was tied to gold until … officially until 1971, but essentially they started relaxing the anchor in 1965.
Now what this meant was that the price level was mean-reverting, would tend to rise and then fall back around some mean, and see you’d have periods of inflation and deflation which would always be short-lived. And in a sense having a gold standard anchor in a sense really forces the Fed to always react and try to tighten in the face of inflation, and loosen in the face of falling prices.
But with the breakdown of Bretton Woods after 1965, the nominal anchor weakened and inflation became more persistent. [4:40:00]
And after that point, starting in ‘65, when faced with incipient inflation the Fed would tighten, but then when they were faced with falling real output and increases in unemployment it began to cave in to political pressure to cease its tightening.
In addition to political pressure was the belief they had at that time in a permanent Phillips Curve tradeoff whereby lower unemployment, with assumed lower high welfare costs would be traded off for higher inflation with lower assumed welfare costs. So based on political pressure and the Phillips Curve they caved in.
And the first episode was in 1966 when the Fed, under Chairman Martin, tightened to offset the buildup of inflation that had started in ‘65. This was called the Credit Crunch of 1966. And there was political pressure from Congress, which came from the housing industry (see, they’re always involved in something) which suffered under rising rates and credit rationing. And then the Fed backed off. And the same type of events started again in ‘68. They tightened in ‘69, same thing happened. They got pressure, there was rising rates and there was credit rationing and the Fed backed off.
And then, the third incident, which I’m just going to allude to, because there’s been a ton that’s been written about it, and Alan Meltzer is the expert, is what happened with Arthur Burns. And he caved in in 1972 in the face of a policy that tighened inflation, in the face of direct pressure from the Nixon Administration.
And then also there was further episodes in the ’70s of pressure being put on the Fed. And so what happened was that because of these policies, inflation and inflationary expectations racheted up as market agents came to doubt the credibility of the Fed’s commitment to fight inflation.
OK, the last episode I’m going to mention is the recent episode, 2001 to 2004, where the Fed engaged in expansionary policy to head off incipient financial crises. And after Y2K, when no financial crisis occurred, it promptly withdrew the massive infusion of liquidity it had provided.
But by constast, after that point, it foresaw a series of shocks to the economy that might lead to financial crises — for example the Tech bust of 2001, and 9/11, and in each case it injected liquidity, but when no financial crisis occurred, it permitted the additional funds it had provided to remain in the money market. In addition, it overreacted to the threat of deflation in 2003 / 2004, which may have been of the good, productivity-driven variety, although we never actually had it, rather than of the bad, recessionary variety, like Japan, which they were worried about.
So if consequent upon these events, the markets hadn’t been infused with liquidity as much as they were, and for so long, then interest rates would not have been as low before 19– … before 2005 as they were, and the housing boom which burst in 2006 may not have expanded as much as it did.
OK, so those are the episodes that I’m going to discuss. I wanted to just mention some policy lessons that come from this. [slide 6]
The first lesson is, and Ricardo said the same thing basically, is that a repeat of 1937 to ‘38, which people have talked about a lot, that that can be easily avoided because the Fed can separate its tightening policy from the banks’ holding of excess reserves by paying interest on reserves. So they don’t have to worry about it.
A second lesson is that, following a stable, credible, nominal anchor can make the exit strategy easier. The post-War exits before 1965 and after 1982, when the Fed did follow a credible nominal anchor, worked better than those in the 1965 to 1982 period. And moreover, had Volcker’s initial tightening seemed credible, the recession of 1981 to ‘82 would have been less severe.
The third lesson from the Great Inflation–… the Great Inflation period is for the Fed to avoid succumbing to political pressure at all costs. And this is a lesson that’s been given by two preceding speakers. And I think [4:45:00] that this issue may come up again in the near future if the next exit occurs when unemployment is still high. I think this is a very serious worry.
The last thing I want to mention is that, in a sense, I intend to really write a paper (this is an abstract of what I was going to do). I mean some of the others have already talked about what they did.
And what I want to do is I’m going to look at, [slide 7] if I have time, a panel of past recession events in the US since 1920, and then I’m going to look at, sort of, the peak-to-trough … the trough to peak that we get from the NBER, and I’m going to compare the timing of changes in the behavior of several measures of Fed policy around the turning point with various macro indicators that could influence them. And I think that if I can look at these, at sort of the timing of policy and then the indicators like inflation, inflationary expectations, growth, deviations of real GDP from trend, and unemployment, and assets prices and a bunch of other stuff, that I can … And if I can amplify this with the historical narrative, which will be greater than what I gave you today, I can … I think I’ll be able to shed some light, so more systematic light, on the circumstances under which exit policies have occurred in the past.
And if time permits in this project, I may run a regression which you would, in a sense, be a cross-section regression across episodes where the dependent variable would be the time that elapsed from the trough to the change in the policy stance from ease to tightness, and then on the right-hand side, as independent variables, I could include various characteristics of the business cycle like the depth of the recession, indicators of financial turmoil and measures of inflation and inflationary expectations.
And a regression like this could tell us if there’s an ideal timing, or give us some ideas about if there’s an ideal timing for an exit strategy. Thank-you.
Vincent Reinhart: OK, thank-you, Mike. If you thought that Alan Meltzer’s volume I was "voluminous," I can report that volume II clocks in at over 1,200 pages and will actually have to be produced in two parts.
Michael Bordo: Well you know, I wrote a review article of volume I and it took me a whole year to do it, and I’m not going to do volume II. [laughs] I don’t think I have enough time in my life.
Vincent Reinhart: OK, anybody have any questions? And that could also include repressed questions from the previous two sessions, given we have a little bit of time here. … Over here, and please wait for the mic, identify yourself and ask a question.
Fernando Saldanha: I’m Fernando Saldanha from the Rock Creek Group. My question relates to deficits. I mean, all these monetary developments will happen in an environment of very large US budget deficits. This year is something like 12 or 13 percent of GDP. Even optimistic forecasts are still of a very substantial deficits in the next 10 years or so.
So my question is — What’s going to happen to the balance sheet of the Fed in such an environment where foreign countries which have absorbed a lot of government, US government debt in the last few years might be reluctant, and have given signs to be reluctant, to continue absorbing that debt? What’s going to be the role of the Fed in such an environment and will it be able, really, to get out of this situation, or implement this exit strategy in such an environment?
Michael Bordo: OK, that’s a pretty interesting question. I think I’m going to answer in two parts. I’m first going to talk about the connection between large deficits and Federal Reserve policy, and if we look at the history of the 1960s and ’70s, deficits can actually give, to the extent that they’re monetized by the Fed, can be inflationary.
OK, so that’s one issue, that the Fed really has to be careful not to monetize the deficits, and I think it’s been … It knows the lesson, but it’s something that is a worry.
The second thing is about, if foreign countries … are unwilling to absorb treasuries, or divest themselves, what should the Fed do? Well, I’m not sure the Fed should be doing anything. I mean, the question is what will happen to inflation, OK? So if it, if again, if this leads to a … if this leads to a [4:50:00] decline in the dollar, and the decline in the dollar affects inflationary expectations, OK? And that leads to a run-up in inflation, then the Fed will have to tighten, OK? And that could really hamper its exit policy.
Vincent Reinhart: Any other? … Right here?
Chow Chen: Yeah, I have a … Chow Chen, freelance correspondent. I have some comment on the unconventional monetary policy. First is, it’s hard to implement, and second is, as to exit, when to exit, maybe we need to help Michael get the future paper to get an answer.
And also, I mention about political pressure, the and political pressure is unavoidable. And most time, the political pressure is unmanageable. And this policy had to be aggressive, and how aggressive is aggressive? And also, in reality, it mostly failed. All this student-C kid on the top and the student-C is in control. Thank-you.
Michael Bordo: All right. I don’t think that, with conventional policy, it’s hard to exit. I mean, all you have to do is raise interest rates. I mean, Ricardo Reis told us how they would do it. They have the tools. I don’t really see that a problem, and I don’t see it a problem with their quantitative easing.
As he said, the only thing is — how do they sell off their mortgage backed securities? … or the Maiden Lane stuff? But generally, whatever else they’ve got in their portfolios they can just sell.
So I don’t really see that as a problem at all. [crosstalk off mic] … Well? If the … What really matters is that once the economy starts to look like it’s picking up, OK? If the Fed doesn’t tighten then you’re going to get more inflation than if they … If the Fed just caves in because they’re afraid of unemployment, then you’ll get inflationary expectations taking off, and things will get a lot worse, and then you’ll get like the 1970s that I described before.
So if you got this incredible nominal anchor, and supposedly they have one, right? They have sort of an implicit inflation target. They have to get back to it. And that is what they’re supposed to do. That’s what central banks do, and that’s the most important thing. It would be a huge mistake if they didn’t.
Vincent Reinhart: One last question, back here …
Andrea Psoras: Hi, Andrea Psoras, a bank analyst from New York. So you’ve identified what are the concerns about where the Fed needs to obstain from being vulnerable to political pressure, but we’ve got … When you look at the Fed, especially with Greenspan and with — although Bernanke’s far more, he seems to be so much more of a puppet than Greenspan is / was, but –
You’re looking at ad hoc government. I mean, you’re looking at where the Fed and the OCC overrode the CRA component in Gramm-Leach-Bliley, ad hoc, without any public due process in 2003. And they raised the limit where the … a bank would be examined for CRA compliance from $300 billion, … (I’m sorry) $300 million in assets up to $1 billion of assets without any public due process.
So I mean … And that’s a simple way in which it was ad hoc, OK? So there’s just … I mean it would … I can’t even think so quickly of the major … But why … Where is there the effort that Congress needs to find to rein in, or to mitigate mission creep of the Fed, where it can just in effect … And so that the Fed actually can say, "This is our mission, and we don’t really have to play political games, we can just go about our jobs," which is to effectuate what the activity, the Open Market Operations or whatever. And then that would be it.
So it, perhaps where, … And you can speak to this: that one of the reasons why it’s politically vulnerable is because it’s become a political beast.
And it’s operated in a way as the power of the large financial institutions anyway. So they’re really the ones that are running everything.
Maybe that’s what comes with guts, which government acts … Oh, yeah, well … The Creature from Jekyll Island, it’s pretty much served the purposes of the major financial institutions, I mean, anyway.
Michael Bordo: I’m not sure I … I’m not sure I can distill a question from that. But I think what you’re saying is that we’re in very treacherous waters right now, and that it may not be that easy for the Fed to exit and to disentangle itself from the Treasury and also from pressures from Congress.
And that is a real risk, and that’s why I gave you the lesson of the 1970s, when in a sense Chairman Martin caved in. He was actually a pretty good … he was a pretty good Chairman for a long time, and then in ‘65 he just sort of caved in.
There’s a story about LBJ taking him for a ride around the ranch and sort of … Another one says he was thrown against a wall. But whatever happened, when he tightened, he raised interest rates in, I think it was December of 1965, and the Administration was really telling them, pushing really hard no to do it, and he went and did it, and so then Johnson really let him have it and after that, I mean, I don’t know if this is true, it’s an apocryphal story OK? … But after that, is sort of when the Great Inflation started.
There’s a lot of other things going on, but so this is why we have to worry, I think, a lot. And I think this is a very big problem, which will come up, and which is present, and will be with us for quite a while.
Vincent Reinhart: Let me ask the last question then, Mike. If you look at that ’60s experience, politicians are always with us. Some are more pressing than others, LBJ being one of them. But how much was the case for principled opposition (that is, the ability to push back against those pressures) undercut by economists saying there was a stable tradeoff between inflation and unemployment?
Michael Bordo: I think, right. In fact what was going on was … So the Keynesian revolution sort of came into the Fed around … in the early ’60s. So the staffers were now starting to think about the permanent Phillips Curve trade-off and the Council of Economic Advisors, starting with Kennedy, and then most gener– …. most markedly under Johnson, these guys did believe that fiscal policy is the most important policy tool, that monetary policy should be coordinated with fiscal policy, and that the Fed should basically be sort of subservient to what the Administration wanted. And Martin, the Martin Fed began to, in a sense, cooperate (the terms they used), began to cooperate with the Fed, OK? And they held off on a number of important occassions, they held off from tightening when their sense said, "This is bad, we should be tightening." And the Administation was saying, "Listen, we just want to sell some more bonds, we have to finance the War in Vietnam, we have to keep interest rates down," and they held off.
So this is the kind of worry that we have.
Vincent Reinhart: Thank-you, Mike. We talked earlier about fiscal multipliers, spending fatigue. I think panel fatigue is setting in. But the good news is we have one last speaker, and he is Rick Mishkin. Rick is the Alfred Lerner Professor of Banking and Financial Institutions at the Graduate School of Business, Columbia University. Research Associate at NBER, and from 2006 to 2008 he was a Governor of the Board of Governors of the Federal Reserve System, where I had the pleasure of working with him, and explaining him to some of my colleagues. There are several times when I would get a phone call and say, "No, you just don’t understand. That’s Rick being Rick."
And now, Rick is going to be Rick for the next 20 minutes or so.
Frederic Mishkin: … and it’s also easier to be Rick when you’re not a Federal Reserve official, so it’s a great pleasure to be here.
What I want to do is discuss three topics in terms of the whole issue of the Federal Reserve activist crisis, but many of these issues also apply more generally in central banks throughout the world.
So the first issue I want to talk about is the future regulatory role of the Federal Reserve system. The second is the dangers to Fed independence, which I think is clearly been coming up. And the third is the whole issue about what kind of macroeconomic research needs to be done at central banks, and also elsewhere, both by people in central banks in other countries in world, but also in the general economics profession. And what should be our view of the role of macroeconomic research during this recent financial crisis?
So let me first talk about the issue of the future of the regulatory role. And the issue here has come up, come to the fore because the Treasury has proposed that the Federal Reserve become a [5:00:00] systemic regulator of the financial system. And I want to talk about this issue.
The first issue that comes up, which is, "Do we need a systemic regulator?" Some people believe not, that … I testified in Congress with several other people, John Taylor, for example, did not think we needed a systemic regulator.
I very much think we do. I think that the problem that we’ve had is our regulatory system has been based on taking … of making sure that individual institutions are sound. And the view, of course, is that we do need to have individual institutions being sound, so that they don’t help … they don’t blow up the system.
But the interactions that we’ve seen during this recent crisis tells us that we need more. In particular there are two things that are very different about the financial system than existed in the past. One is the huge growth of securitization, so the so-called "Shadow Banking System," that a lot of the action now is not inside the banking institutions, although banks were intimately involved with it. And indeed the real blow-up here, a lot of it occurred, actually started in … outside the banking system in the Shadow Banking System and then fed back into the banking system. So that’s number one.
And number two is that what we’ve seen in a crisis of the type that we’ve had recently that attempts to protect you … for an individual institution to protect itself can spread throughout the rest of the financial system. So protecting yourself can actually mean that you withdraw funds form another institution, which then tries to protect itself, and you get this cascading effect that’s very damaging.
So the spillover effects, I think, also require that we think about regulation from a systemic viewpoint, and not just from an individual institution viewpoint.
And that requires thinking about regulatory reform in a major way.
So the question is, if you think there needs to be a systemic regulator, who should it be? And I would argue quite strongly that the only really logical choice in this context is the Federal Reserve system.
And there’s four major reasons why I take that view, which is that first of all, the Federal Reserve is intimately involved with the markets every day, and if you’re going to be a systemic regulator, you need to have exactly that kind of contact. And the Fed does, and actually through its Open Market Operations, and also through its surveillance activities.
The second issue is that the we know that the lender of last resort role is extremely important. It’s been used big-time during this crisis. It’s great if you write money and banking text books because you can have so many interesting stories to tell. And also I’ve had my course, which was always popular, has now become the second most popular course at my school. And it wasn’t a tribute to me, it was actually the events that occurred.
The key issue here is that if you are going to be the lender of last resort, you have to have the information that tells you whether you need to do it or not, and how to do it. And if you don’t have that information you’re going to be in trouble. And actually supervising a systemic … the important institutions is absolutely key to knowing whether you in fact have to engage in that activity.
And by the way, it’s important to recognize that the Federal Reserve already is in some sense doing some systemic regulation, because it actually deals with all the bank holding companies, which are now actually a wider group because all the large investment banks actually became bank holding companies. So it’s not something they haven’t been doing.
The third is that when you think about the goals of a central bank, and in particular price stability, but also stabilizing the economic activity, that’s actually very, very consistent with the concerns that you have to have about financial stability. So again, very natural to think about them.
And the last is that the Federal Reserve is one of the most independent government agencies, as most central banks are. And systemic regulation is going to require a lot of independence if it’s going to be done right. And so, in that context, the Federal Reserve again is a natural choice.
There are, however, three arguments against, and I think they have to be taken seriously. The first is that by focusing on financial stability, a central bank may lose its focus on price stability. And so that’s a serious concern. The second is that, in terms of resolving, or getting involved in resolution of systemically important institutions that get into trouble, it could cause an overreach for the central bank. And the third is, the very important is, the dangers of politization of the central bank, and in particular the potential loss of independence. And that’s something I’m going to want to talk a lot about later on.
I should mention that there are safeguards against these three arguments– … these three criticisms. One is that the potential for loss of focus on price stability is an issue which can be dealt with by a central bank committing very strongly to focus on price stability. The Federal Reserve has done that to some extent, but we know that there actually are institutional frameworks to do that in a stronger way. That’s what we call "inflation targeting." I don’t want to go on about this, I’ve been a strong advocate of inflation targeting for a long time. I think it would have very much [5:05:00] helped during this crisis. Vince knows that I was pushing for this quite hard when I was at the Federal Reserve, and we got part way there, much closer, but not nearly as close as I would have liked to have gotten, but that’s the life of being a policymaker. You make a difference at the margin, but you actually make much less difference than you frequently hope to.
The second issue is the issue of resolution. Clearly that’s a fiscal action. For resolution you want to have that done by fiscal authorities or people who are sanctioned by the fiscal authorities. That should be the Treasury or the FDIC. That should not be a part of the role of a systemic regulator.
And then there’s the issue of Fed independence, which is very important and needs support. I’m going to go back to that.
So what should the systemic regulator do? There is a bunch of things that it needs to do.
First of all it’s going to need to gather, analyze and report on information that actually provides information on what’s going on systemically in the financial system. There actually is a blueprint for this. Many other central banks have already been doing this with something called "financial stability reports," so this is something that I think is a very good idea for the Federal Reserve to do.
Secondly, it has to be involved in designing financial regulation to deal with systemic risks. And so this takes several dimensions. Clearly one is the whole issue of too-big-to-fail, which is a huge problem right now. The genie is out of the bottle. People say, "Well, you know, if you talk about systemically important firms, you’re going to prop them up, well by golly if you’re going to prop them up anyway, …" because this is what happens in a crisis, there’s no way that a government’s going to stand by when really systemically important firms get into trouble.
And the second issue, … And so clearly you have to think about too-big-to-fail, there’s a lot of things you can do on this. One of the issues, for example, is capital requirements, which needs to be larger for institutions that are seen to be too-big-to-fail. The reality is that the larger, more systemically important you are, the more likely you are to get bailed out. And the more likely you are to get bailed out, the less market discipline. That’s a subsidy to risk taking, and given that there’s a subsidy to risk taking, you want to take it back. And that means that you need to have regulations which actually take away some of that incentive to take excessive risk when in fact you’re so large and so important.
Also this is … You have to think about the amount of liquidity and the way that liquidity is put on the liability side of a balance sheet. The less liquidity that a systemically important firm has, the higher, again, should be the capital charges.
And third (and so this is extremely important) third is a very important issue from a systemic viewpoint, which is the kind of compensation structures you have.
If you think about what went on in this crisis, it was … we refer to it in economics as "agency problems," that every part of the food chain, in terms of the financial system, was engaged in making fees, but were getting large incomes but not getting necessarily large incomes … (excuse me but) not having to worry about whether the ultimate holder of the security would get paid back. And so in a sense there’s a sense in which this whole thing was one big carry trade.
And conmensation structure’s extremely important. I think it’s great that the Federal Reserve has gotten involved in saying that they’re going to focus on compensation structure from a point of view of thinking about risk management. This is far superior to having the government write rules that will be very non-productive. So, for example, people saying that bonuses should only be a certain percentage of salary is just wrong thinking.
The issue is not … bonuses … In fact having large bonuses has … having your salary mostly bonus could actually be an optimal way of paying people. The problem is if bonuses are paid for you to take risk, and the risk eventually either causes the firm to get in trouble, or actually means the taxpayer has to bail it out.
And so that’s the issue, that’s where the focus needs to be, and it should be part of the supervisory process. And in fact we’ve been heading in exactly that direction.
So I’ve talked about what the Fed should do. What shouldn’t it do? Well, one thing I think the Fed should get out of is consumer regulation. I was involved in the Federal Reserve in terms of consumer regulation, as many of you know. The Fed is / was given consumer regulation by the Congress as part of the Truth In Lending Act. I do not think that this is synergistic with other roles that the Federal Reserve is involved in, or should be involved in. It’s not synergistic with monetary policy, and it’s not synergistic with the role as a systemic regulator.
In particular it’s a very different mind-set, being worried about consumer regulation, or business practices, what’s deceptive practices is a very different kind of thinking. It’s much more about legal work and frequently "I gotcha!" and not about thinking about [5:10:00] how do you make the system safe and sound, and how do you get monetary policy that works well.
So there’s no synergy, and in fact when you actually do something that has no synergy, it causes a lack of focus and can actually make you weaker in doing the things that you really need to focus on.
The other issue that’s extremely important is that consumer regulation is super-political. And I experienced this first-hand. One of my great pleasures when I was at the Federal Reserve was testifying to Congress on credit cards. It was great … In the old days, by the way, we used to say that … There was a very funny movie called "The President’s Analyst" [1967] where they talk about the … Somebody trying to take over the world. It was the phone company, and everybody hates the phone company. Well, credit cards have some of those same elements now. Having the Federal Reserve engaged in that activity really does subject it to a lot of political pressure, and again, that can be very dangerous.
So let me go to the topic of the dangers to Federal Reserve independence. This is incredibly important that we know from both theory and evidence that central bank independence has huge payoffs in terms of getting better economic outcomes. Central banks that are not independent are much more likely to produce inflation. Michael was just talking about this issue, so the good news, I can skip that [sound of pages turning] because it was already discussed.
But what is very clear right now with the Federal Reserve is that independence is under severe and incredibly attack right now. This is something that is very, very scary.
Why has this happened? Well, the Federal Reserve went to the … as Paul Volcker said went to the very edge of its lawful powers. I never viewed that as a criticism from Paul Volcker. It was the fact. That’s what we did at the Fed. That there was done in several ways, but the key issue (in terms of manifestation we talk about now) is there was a huge expansion of the Federal Reserve balance sheet. How did that happen? Well, first of all, it has several ramifications. One is that there was a huge … there was a big increase in involvement it private credit markets, so big interventions. That both, either through lending facilities or actually purchases of actual securities that have … that are important in the credit market. I’m going to talk about MBSs, there are some issues of MBSs where the Federal Reserve’s 80 percent of the market. If you don’t talk about that as intervention in private markets I don’t know what is.
And the other issue is that there’s a fiscal element to this because the Fed has put on its balance sheet things that are risky. Now that’s not as bad as a lot of people point out, because Vince was involved in figuring out how to minimize the risks to the Federal Reserve through haircuts and so forth. But on the other hand the perception that this is a huge problem, and the fact that there is actually some risk on the balance sheet, is created a lot of concerns that the Fed is engaged in business it should not be.
So my view is, by the way, the Fed needed to do this, I was supportive of this when I was there. The reason is, as somebody who’s been a student of financial crises, what you see is the faster somebody intervenes when you’re in a financial crisis, the less severe the crisis is; and I actually, believe it or not, the less intervention you eventually have to do.
And the only person who really has the capability of doing this quickly is the central bank, because they can create liquidity out of thin air. So this is extremely important — example of this was the Bear Stearns and the PDCF, where in fact … instantaneously the Fed was able to provide the funds to make sure that Bear Stearns was … did not blow up in a way that would create problems, and then created a facility for broker dealers to backstop the system.
The other issue was that the US government had severe political constraints when this crisis hit. We had a lame duck President who had a very low popularity rating, to say the least, that … One of the things, I think, that is not recognized sufficiently is that everybody talks about Lehman Brothers as being the thing that blew everything up, but to me, Lehman Brothers was what helped trigger things, but actually the AIG blowup, which was saying the rot in the system in terms of everybody generating fees and not worrying about whether things would get paid off, was an indication that it wasn’t just a subprime mortgage crisis, it was a much more inherent crisis.
But also, the fact that it took 4 days for the Congress to pass legislation was actually seriously damaging to the financial system, because everybody said, "Gee, I’m not sure I can trust the government to do the right thing." And indeed, that that actually became a serious problem later on, because, as a result of the very poor execution of TARP under Paulson, which I think really poisoned the waters, that the ability of the Obama [5:15:00] Administration to get more funds to deal with any kind of potential future crisis disappeared.
And I can tell you, when I was sitting in March, and sat there and said, "I know that they can’t get any more money, they’re not willing to ask for it. If there’s a major shoe drops, we are in deep doo-doo."
And luckily, we did not have that happen. And also, credit spreads went sky–… went through the roof, the Fed became very, very active at that time. I think the … that without doing so the probability of a depression was much higher. And thank goodness we escaped this.
I should point out that there was a huge tradeoff here, that Chairman Bernanke had to deal with. I wasn’t there, but I’m sure he was aware of it because there was … it was obvious. The tradeoff was, depression or risk the Fed’s independence by going to do action which in fact are going to leave us very vulnerable.
And I can tell you that I would definitely have taken the choice that he chose. I think that Ben Bernanke showed great courage, and that although there’s been a lot of criticism of both him and the Federal Reserve, that if he had not … if he and his colleagues had not done what they did (I was a little biased, because I was part of that until September 2008) the world could be a much worse place.
What should the Fed do, by the way, in terms–…? Well the other issue is the attacks on the Fed, we’ve seen them big-time. One was that there was a non-binding resolution. This occurred in the fall, which actually said that the Fed should reveal who it lent to and how much and all of the terms right away. So it’s not unreasonable to ask if the Fed to be accountable and to ask them later on to tell what they’re doing, because they’re effectively spending public money. But if you think the stigma problem that has always been talked about in terms of the Discount Window is bad, it would have become much worse.
The other issue here is … the other case which is very recent is the Ron Paul Bill. I would not call Ron Paul a mainstream Congressperson. If, you know, you go on his website, it has … you can buy tee-shirts to say, "End the Fed," stuff like that. So I’m not surprised by his Bill, but what’s shocking is that 250 fellow Congresspeople became co-sponsors. [crosstalk] … Oh, now it’s 299. Well I’ll have to change that in my write-up. It’s 299. That is scary.
What should the Fed do about this? Well, I think that the issue is the Fed has to recognize that as this crisis winds down, one of its highest priorities has to be protecting its independence. And that has to be co-equal with thinking about monetary policy during this period.
And what that means is the Fed has to think very clearly about the exit from this balance sheet. So when you’re talking about exit strategy, I think the monetary policy one is the simple one, by the standards of this thing. The exit strategy from the balance sheet is huge.
Some of it’s not too difficult to do, some of it’s involved with just winding down its lending facilities. That actually has been happening. So you look at some of the PBCF is at zero right now. A lot of these facilities have been winding down naturally, dying a natural death as the financial system improves. But the sort of gorilla in the room is MBSs.
So the Federal Reserve has already actually in a sense started talking about a wind of this down, because it’s indicated that the program is going to end in March. They’ve actually extended it, indicated they’re going to buy a little bit slower. But the key issue is, is going to be, something like 1 1/4 trillion dollars of MBSs on the Fed’s books. And to have that on the Fed’s books in the long run is something that is incredibly dangerous for the central bank.
And in particular, what–… the bottom line here is that the Federal Reserve, if it’s involved in housing finance, which is the most politicized part of the financial system, that could be a disaster in the long run. And in particular we know how political it is. There’s tax deductability of mortgages, there’s government guarantees on mortgages. The GSEs are the poster child for this, that almost all economists who have studied this stuff said the GSEs were going to blow up, that there were incentives for them to take excessive risks. I had that in 5 editions of my textbook going back 15, 20 years.
Then we get to the 1990s, and they expand the role of the GSEs astronomically, and of course, it blew up in a way that’s cost the government a lot of money. It’s telling you that the one thing that you don’t want to be involved as the central bank is housing finance.
So the issue here is that you need to get out of this. How is the Fed going to do this? I think it’s very [5:20:00] tricky, that the … there are several issues here, which is timing and how you do it.
The first issue here is that in terms of timing, you don’t want to disrupt the mortgage markets while the financial markets are still very skittish. Going into the mortgage market in the first place was extremely important in terms of stabilizing the system, because stabilizing housing prices is a way of allowing assets to be valued properly. And that then actually helps the system to recover, and also it affects aggregate demand in terms of helping the housing starts to increase.
So you can understand why they did this. The issue is, when they get out, it’s going to mean that interest rates back up in the mortgage market. My view is that’s a tightening of monetary policy. That’s going to be fine, because at some point you need to tighten the monetary policy, but you also have to be very careful that you don’t disrupt the markets.
So one issue of tightening is you’re going to want to do something when you think the markets are more secure. I don’t think that’s going to be too far in the future, but I hope that’s true, that … sometimes I think that the markets will keep on recovering, and hopefully without any bad surprises, that we’ll in the situation that they’re not skittish. And that’s going to be well before the economy is in good shape, by the way. And that’s a time when the Fed actually has to announce an exit strategy.
On the other hand, in order not to disrupt the markets, they have to actually ease out of it. Announcing, alone, will have an effect on the markets by the way, … will raise rates.
One thing that they’ll need to do is, they can let some of these mortgage-backed securities just mature out, but the problem is a lot of these purchases have been of very long term securities. And they can’t let them mature out, they’re going to have to sell them. So that’s going to take great courage. My view is that this is imperative that the Fed do this. And also, I think the good news is that we have a Federal Reserve Chairman who does have cojones, which is an expression that I was taught by Carmen.
So the last issue is macro research, that … maybe this is something that affects me more. We’ve recently had a lot of media dicussion of how macroeconomics has been irrelevant and is been completely bankrupt. The Economist had a silly article on this.uuuL Paul Krugman had a New York Times piece.uuuM Paul should know better. It’s really a scandal that he wrote the piece that he wrote, that this work is both ill-informed and silly.
That it … First of all, that it says two things which was one thing was that macro research in the last 30 years has been irrelevant? And secondly that it missed out in terms of helping us with thinking about the financial crisis.
That is just plain wrong.
Although I’m going to say that there’s this serious criticism.
So why do I say that? Well macro research on financial frictions has been a very exciting area of research. I have actually participated in that, Michael has participated in that. We’re students of financial crises, which for a scholar is like sex, drugs and rock-and-roll. And in fact, the Chairman of the Federal Reserve, Michael, myself, have all done a lot of work on the Great Depression, and say … said it was a financial crisis, and that actually was incredibly informative during this current crisis.
That that work is mainstream in the macroeconomic literature, it was extremely important in terms of the way the central bank reacted. So you have to remember August 2007, we hit the first phase of this crisis. That at the Federal Reserve we had lots of people who’d done work on this. As I said the Chairman and I had both done a lot of work. Ben Bernanke’s famous paper, that really made him famous in the profession was on financial frictions during the Great Depression.
What did we do? We didn’t sit there and say, "Gee, you know, the economy in August 2007 was doing great." It was a lot of momentum. What the Federal Reserve did was it said, "Wait a second. Financial frictions are really important." The staff did a lot of research, Vince can tell you, a lot of research saying, "Here’s what the financial conditions are bad, it’s going to have a big impact." And then they actually revised their forecasts very dramatically by in fact putting judgment into their models and putting negative add-factors in.
And what did the Federal Reserve do? It started easing monetary policy very aggressively when the economy was on a roll, and when inflation was near 5 percent. So to think that this macro research didn’t help during this crisis is absolutely wacky.
The thing, however, to point out here, is that there is serious criticism of the macro literature, which is that although this work has been done, it’s very partial-equilibrium, it has not been embedded into the general equilibrium macroeconometric models that are used at central banks.
And so everything had to be done on an ad hoc basis. It was, I think it made [5:25:00] a huge difference in terms of the outcomes. I’m proud that I did research on this area. Michael’s proud, Ben Bernanke’s proud. (Well, I can’t speak for him, but Michael’s proud …)
And yes, proud that we did this research and made a huge difference. But the serious criticism is, it wasn’t really in the models that were used for forecasting the policy analysis. That is extremely important. That’s where the lacking is, where criticism should be.
Research needs to be focused in that direction. It already is. I’ve just spent two days at a conference at the Federal Reserve. There was a lot of discussion about exactly these issues.
But one thing I want to point out is that that research is going to have … is going to have a lot of impact, but a lot of the lessons we’ve learned from macro models that do not have financial frictions in them’s still going to hold up:
- how important the role of expectations are;
- the importance of anchoring inflation expectations;
- having a strong nominal anchor;
- inflation targeting;
- the management of expectations as a key element of doing policy.
All of these things are still going to be elements in any model that deals properly with financial frictions.
So when I think about the world right now, for me, there’s bad news and good news. The bad news is that very bad things have happened recently. That we’ve had the most serious recession in the post-War period. There’s a huge loss of wealth. I, unfortunately, am part of that. I actually, unfortunately, I right now have 2 houses. My wife says that one house is the weekend house, but’s it’s only 3 minutes away from my current house. So that’s a problem as a result of what’s happened.
That … this is a big problem, but the good news as a scholar is that the research in macroeconomics is going to become exciting as hell.
And so I think we’re going to go to a new golden era of research in macroeconomics. And for me, maybe that’s more important than a loss of wealth. Thank-you.
Vincent Reinhart: Thank-you, Rick, for getting out of your shell. [laughter] And I also don’t want to know about the particular Spanish lesson you got. We don’t have time for much, many questions. Actually, Ethan has one.
Ethan Ilzetzki: So I had a question about inflation targeting, looking forward. Given our experience of the zero lower bound, have you changed your opinion on what the appropriate level of the inflation target would be? And then on the same issue as … Given the balance sheet of the Fed, is inflation targeting a sufficient statistic for the market to know what the Fed is going to do in terms of interest rates versus other measures?
Frederic Mishkin: So the last … Inflation target gives you some information, but there’s a lot of other information that you need.
In terms of inflation target, it may affect the views at … of the FOMC participants. I was always a 2 percent inflation guy. And there were a lot who were lower than that. And I think 2 percent inflation does provide a cushion, and … but it doesn’t tell you that if you have a once in a 70 year shock to the financial system that you’re not going to have to worry about a deflationary environment.
I don’t think any reasonable number, which would be consistent with the price stability still isn’t going to solve that particular problem.
Vincent Reinhart: Actually, we are on a clock, and that clock has just expired. I want to thank a number of people, including the audience. There was no pre-mature exit here, which is impressive, considering we’re headed for a three day weekend.
I want to thank all the participants, both sitting here on the panel, those who were earlier and in the morning session. There are a number of people at the AEI to thank, so I can’t really start naming them, because if I did I would go over time.
Thank-you everybody. Have a good weekend. [applause] … [5:28:45] (end)
[uuuA]: "No Way Out: Government Response to the Financial Crisis", AEI event homepage, October 9, 2009.
[uuuE]: "The Origin, Propagation, and Magnification of the Financial Crisis: A Prospectus for the No Way Out project" (PDF), by Vincent Reinhart, AEI, October 2009.
[uuuB]: "Five questions relevant to where we go from here" (PDF slide deck), by Vincent Reinhart, AEI, October 9, 2009.
- Title
- The Five Questions
- Q1 – Why are U.S. households so undiversified?
- The U.S. government provides considerable encouragement to home ownership.
- Debt secured by primary residence
- Family holdings of financial assets in 2007
- The housing bubble, the financial crisis, and the policy response
- Q2 – How should we manage a crisis?
- Rule 1: Don’t do them
- Rule 2: If you break rule one, be consistent
- Rule 3: If you break rule two, be prepared to spend a lot
- Rule 4: Whatever you do, don’t add to uncertainty and worsen confidence
- As a consequence of missteps in management of the crisis …
- Q3 – How should we deal with troubled financial institutions?
- There are three core issues in dealing with troubled financial institutions …
- Governmental responses have varied over the years
- Significant post-Depression restrictions on finance did slash the incidence of banking crises
- Policy makers often opt to allow institutions to delay recognition of losses
- The growth cost of delay
- In this crisis, the government …
- A practical consequence of this complexity …
- Q4 – What has been the role of the international sector?
- Emerging market economies have been accumulating foreign exchange reserves at a rapid clip
- International capital flows facilitated funding the housing boom
- Official demand tilted heavily toward government securities
- The foreign private sector increased its exposure to U.S. private credit
- Global saving kept U.S. long-term interest rates low …
- … and disconnected from the policy rate
- Q5 – How should the Federal Reserve respond to asset prices?
- U.S. monetary policy makers followed a basic “syllogism” with regard to asset prices (whether the prices of equity, homes, or foreign currency)
- Why? 1. The private sector was supposed to have a comparative advantage over the public sector in pricing and managing assets
- Why? 2. Asset prices are complicated and were supposed to be rational
- Why? 3. Acting in specific markets might undermine the legitimacy of a central bank.
- What have we learned about asset prices and monetary policy?
- (blank)
[uuuC]: "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises" (PDF — 123 pages), by Carmen M. Reinhart and Kenneth S. Rogoff, Harvard, April 16, 2008. Here’s the Google preview of the 2009 book version, This Time Is Different: Eight Centuries of Financial Folly
[uuuD]: "Comment on Vincent Reinhart: ‘The Origin, Propagation, and Magnification of the Financial Crisis’ (PDF slide deck), by Greg Ip, Economist, October 9, 2009.
- Title
- Intro
- Mystery #1: Why did some countries have housing bubbles but not banking crises?
- Mystery #2: Why did some countries with current account deficits not have crises?
- Mystery #3: Why did some countries avoid crises but not recessions?
- Mystery #3 solved
- What about U.S. monetary policy?
- What about U.S. regulatory policy?
- The real regulatory failures
- US subprime mortgage market unusually large
- US has largest shadow banking system (banks’ share of credit, %)
- Shadow banking
- Not at first a banking crisis
- Policy implications
[uuuF]: Cowabunga! Does that mean I win this round with Doom commenter Old Mike?
[uuuG]: "Speech: Monetary Policy Research and the Financial Crisis: Strengths and Shortcomings", by Vice Chairman Donald L. Kohn, Fed, October 9, 2009. [obviously, from the date, not Ubide's source but repeats the gist of it]
To be sure, we have not followed the theoretical prescription of promising to keep rates low enough for long enough to create a period of above-normal inflation. The arguments in favor of such a policy hinge on a clear understanding on the part of the public that the central bank will tolerate increased inflation only temporarily–say, for a few years once the economy has recovered–before returning to the original inflation target in the long term. In standard theoretical model environments, long-run inflation expectations are perfectly anchored. In reality, however, the anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted. Models are by their nature only a stylized representation of reality, and a policy of achieving "temporarily" higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high.
[uuuH]: "How Big (Small?) are Fiscal Multipliers" (PDF slide deck), by Ethan Ilzetzki, London School of Economics, October 9, 2009.
- Title
- The Multiplier Debate
- Current Estimates
- Data (1)
- Data (2)
- 1. OUTPUT RESPONSE TO 1% SHOCK IN G
- 2. FISCAL MULTIPLIER
- 3. MULTIPLIER: FIXED VS. FLEXIBLE EXCHANGE RATES
- 4. MULTIPLIER: OPEN VS. CLOSED ECONOMIES
- 5. OUTPUT RESPONSE: FINANCIAL FRAGILITY IN DEVELOPING COUNTRIES
- 6. UNITED STATES
- 7. GOVERNMENT INVESTMENT
- Policy Lessons: High-Income Countries
- Policy Lessons: Developing Countries
[uuuI]: "Exit strategies for monetary policy" (PDF slide deck), by Vincent Reinhart, AEI, October 9, 2009.
- Title
- Roadmap
- 1. The channels of quantitative easing
- QE holds that the size and composition of a central bank’s balance sheet influences financial markets and the economy over and beyond the level of the policy rate
- QE potentially works through both sides of a central bank’s balance sheet
- The logic of QE is to massively oversupply reserves
- An aside: Rebranding QE
- Another aside: This is not just a crisis in global financial markets and economies
- 2. Why talk of the exit?
- Intuition about the advantages of temporary stimulus comes from fiscal policy
- In some analyses of unconventional monetary policy, …
- The real long-term interest rate (RL) depends on the term structure of inflation expectations
- This arithmetic reveals ironic bedfellows
- The aim of unconventional policy within a longer-run framework
- The communications challenge is considerable
- 3. Exits and wrong turns
- I. Federal Reserve policy in the 1930s
- Indeed, very costly
- II. Japanese officials in the 1990s
- III. In the 2000s, the BoJ was able to unwind its balance sheet
- Four lessons from this experience
- 4. The tools and transmission of policy
- To return to a positive policy rate, a central bank has to …
- To repeat, part of the logic of QE …
- In principle, …
- Why might the Federal Reserve be asymmetric in its aggressiveness to shrink its balance sheet?
- 5. Talk or walk?
- There are risks to QE
- Title
[uuuJ]: "Exit strategies and the Federal Reserve" (PDF slide deck), by Ricardo Reis, Columbia University / AEI, October 9, 2009.
- Title
- Extraordinary times: interest rates
- Extraordinary times: reserves
- Extraordinary times: money
- Extraordinary times: Fed’s credit
- Extraordinary times: Fed’s assets
- First question: what are the dangers of the current situation?
- Second question: can the Fed get back?
- Third question: should it go back?
[uuuK]: "How to Exit from Monetary Ease: A Historical Perspective", by Michael Bordo, Rutgers University, October 9, 2009.
- Title
- Introduction
- Introduction (continued)
- Tightening too soon
- Tightening Too late
- Policy Lessons
- Empirical Evidence
[uuuL]: "What went wrong with economics: And how the discipline should change to avoid the mistakes of the past", Economist, July 16, 2009.
[uuuM]: "How Did Economists Get It So Wrong?", by Paul Krugman, New York Times, September 2, 2009.
