December 2007, part 2: Mishkin explains how the Fed caused the Great Recession.

If you haven’t read my previous post, read that first.  Here’s Frederic Mishkin in December 2007 on the state of the economy; later we’ll look at his policy analysis:

But I want to talk about why my sunny disposition is much less sunny right now and why I’m actually very, very worried—not to say depressed, but at least a little more that way than usual. It is because I think that the kind of negative scenarios that are pointed out in the Greenbook are very real possibilities. In particular, there are two scenarios that they go into separately—the housing correction scenario and the credit crunch scenario. I think that there’s a very strong possibility those would come together because, if housing prices go down more, that creates a much more serious problem in terms of valuation risk, and a serious problem in valuation risk will mean a further credit market disruption, which then can lead to more macroeconomic risk because it leads to this downward spiral. The real economy gets worse. That means that there is more uncertainty. Credit spreads get worse, and you get a very bad scenario happening. That could lead to the credit crunch scenario. Similarly, a credit crunch scenario, I think, would have a very negative effect on the real economy, which would mean that housing prices would go down, which would then make it much more likely that we have the greater housing correction scenario. So that’s the first part of my depression.

The second issue is that the Greenbook does not go into the issue of what effect that might have overseas. There has been a lot of discussion in the media about decoupling the U.S. economy from foreign economies, and when it’s just trade that’s going on, I think that is usually completely reasonable. But when it’s financial, then there is very good reason to think of recoupling because a financial disruption in the United States is very likely to spread to financial disruption abroad. We, of course, have already seen that. It’s remarkable that what happened in the subprime sector has in some sectors affected European banks maybe even more than American banks. So the possibility that problems develop in the United States and lead to problems in Europe and other advanced countries and then those problems actually spill over back into the United States again means that there’s a third scenario that could be all tied together.

When you look at all of this, I get very nervous. The bottom line is that my modal forecast is certainly down, very much along the lines of what the staff has suggested. But I think there is a significant probability that things will go south. You don’t like to use the R word, but the probability of recession is, I think, nearing 50 percent, and that really worries me very much. I also think that there’s even a possibility that a recession could be reasonably severe, though not a disaster. Luckily all of this has happened with an economy that was pretty strong and with banks having good balance sheets; otherwise it could really be a potential disaster. I don’t see that, but I do see that there is substantial risk that the economy could have a severely negative hit to it that would be very, very problematic.

So Mishkin understood the dangers facing the economy.  But so did lots of other people.  It’s his policy recommendations that presents an absolute a masterpiece of analysis:

So let me just lay out this argument. Would a 50 basis point cut matter? This is a question that President Fisher has asked. I think the answer is very much “yes.” It is not the actual cut itself that matters; it is the managing of expectations that really matters. In fact, whenever we make a 25 basis point cut and you ask, “How big an impact does that have on the economy?” the answer is, “Not a whole lot.” That comes out of our simulations. It is really the path of interest rates implied by our actions that is important. In particular, the idea here of a 50 basis point cut is that, by getting ahead of the curve, we provide a signal to the markets that we would be willing to take steps to react to events in the financial markets that might indicate that we are getting into a vicious-circle type of situation. That is exactly what I felt we did in the September meeting. That move was very successful, and the markets really improved very dramatically afterward. The signal we were sending at that point was that, if things got much worse, we might have to do it again.  (emphasis added.)

Mishkin is warning that the standard view coming out of the simulations is wrong—a 25 basis point difference can be a very big deal if it tells us something about the Fed’s willingness to aggressively prop up NGDP growth.  And of course Mishkin was right, 700 points on the Dow were separated by a mere 25 basis points in the fed funds rate.  It’s all about expected future policy, as Sumner (1993)/Krugman (1998)/Eggertsson/Woodford, etc., keep insisting.

Mishkin continues his policy recommendations:

Now, as I said, we thought in October that things were looking pretty good. I thought we had this great game plan; we were on board for the game plan; and, of course, the game plan is unfortunately out the window. So I think that taking an action like a 50 basis point cut would have an important impact and would provide the signals and the managing of expectations that can have critical implications for how the economy evolves, particularly how the credit markets evolve. It also raises the issue that one thing we do need to do, no matter what, is to indicate to the markets that we understand that our job is to prevent bad shocks from propagating in a very bad way. We can’t prevent the shocks—because things happen—but our job is to make sure that they don’t propagate in a very bad way.  (emphasis added.)

A “very bad way” is of course falling NGDP, as in the early 1930s.  Mishkin understood that “no matter what” that cannot be allowed to happen.  And it’s “our job” to prevent it from happening.  And the Fed needs to “indicate to the markets” that they understand it is their job.  Reading that almost brings tears to my eyes, especially when I think of all the totally unqualified people who serve on the FOMC.  People who are not experts in monetary policy and yet who make decisions costing millions of people their jobs.  Years ago I did a post arguing that only people like Mishkin, Bernanke, Woodford, Krugman, Mankiw, McCallum, Svensson, etc, should even be allowed to serve on the FOMC.  Pay them whatever it takes.  (If you don’t believe me then read a few Richard Fisher speeches.)

Here Mishkin responds to the hawks who were worried about inflation:

I think we are operating in a very proactive, forward-looking way. In that regard, we would have to act similarly in terms of thinking about inflation. There are two cases in which there would be signals that we would have to act very differently. One is that credit conditions could improve very quickly. We are hoping that this would happen, and actually sometimes you do see these things just turn around on a dime. All of a sudden a virtuous circle occurs. If that actually started to happen, it would be imperative if we did a 50 basis point cut that we reverse very quickly on that action. Second, we have information about inflation expectations, and if we saw those numbers starting to go in a bad direction, we should also operate very quickly in a reversing direction. It is extremely important not to be in the Taylor-rule type of framework, where you wait to see actual inflation and output outcomes to drive your policy. It really has to be much more proactive than that. There have been mistakes in the past, at least in my viewpoint, when we could have reacted more quickly. For example, in ’98, it was very appropriate for us to cut rates the way we did. But we were a bit slow to raise them, and I think part of the reason was that we were reacting more to what was going on. I’m not sure—you can correct me in private afterward, Don—but I think that inertia was there, and if we think about doing things differently, it could work out very well. (emphasis added.)

Mishkin understands that what matters is not past inflation, but inflation expectations.  That makes me think of the September 2008 meeting, where the Fed refused to cut rates below 2%, even though Lehman had just failed and the economy was reeling.  Why didn’t they act?  Because they were worried about high inflation.  It’s true that headline inflation was elevated due the the oil price shock in early 2008, but by the time of the Fed meeting 5 year TIPS spreads showed only 1.23% inflation (a prediction that will eventually prove fairly accurate.)

Many of those who favored the 1/4% point cut cited a fear that a 50 basis point cut would frighten the markets, as investors worried that the Fed might know something that they didn’t know.  In retrospect that concern seems almost laughably naive; the markets were actually worried that the Fed didn’t know something that the markets knew—we were in deep trouble.

I can forgive people who made erroneous forecasts—-I didn’t expect a big recession back in December 2007.  What I cannot forgive is policymakers who don’t even know the basics of the EMH.  Who don’t know that their job is not to try to avoid scaring the markets with bad news, as if market were an impressionable child, but rather to give markets confidence by doing the right thing.

So Mishkin got almost everything right.  He understood the danger that NGDP could plunge causing the housing recession to spill over into the broader economy.  He saw that the Fed was not ahead of the curve on policy, but was trailing behind the rapidly deteriorating financial conditions.  He understood that it was essential that the Fed not allow NGDP to plunge, and that they needed to convince markets that they would not allow NGDP to plunge.  He understood that they needed to target the forecast, not rely on 20th century techniques like the Taylor Rule.  His comments basically explain why the stock market crashed right after the vote was announced, and why the Great Recession happened.  The Fed did not do their job—it’s as simple as that.

Mishkin’s only mistake was that when he saw he’d lost the battle he decided to support his pal Bernanke, to avoid an embarrassing split at the Fed.  But that’s certainly forgivable, as a dissent would have been merely symbolic.  I’m not sure I would have done any different.

This raises the question of why Bernanke supported a 1/4% cut.  Didn’t I just argue that only monetary policy experts like Bernanke/Mishkin/Yellen should serve on the FOMC?  Yes I did, and I’ll consider Bernanke’s views in the next post.


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85 Responses to “December 2007, part 2: Mishkin explains how the Fed caused the Great Recession.”

  1. Gravatar of Suvy Suvy
    5. February 2013 at 07:53

    Frederic Mishkin same guy also bragged about how successful Iceland’s financial system was in the bubble days.
    http://www.vi.is/files/555877819Financial%20Stability%20in%20Iceland%20Screen%20Version.pdf

    Wait, there are some really funny quotes:
    “The economy has already adjusted to financial liberalization, which was already completed a long time ago, while prudential regulation and supervision is generally quite strong.”

    “The analysis in this study suggests that although Iceland’s economy does have imbalances that will eventually be reversed, financial fragility is not high and the likelihood of a financial meltdown is very low.”

    The quotes above were written in 2006; right before Iceland went under. In the same paper, Mishkin talks about Iceland being financially stable even though he has a graph in the paper showing that their external debt was 2.5 times their national income in 2005. I don’t know how anyone could consider a country whose banking assets were 10 times its GDP to be financially stable. Think about it, if a country were in that situation and their assets move by 3%, its finished. It doesn’t take rocket science to figure that out. Same thing with the issues of external debt. Once external debt gets to around 75% of GDP, that creates issues; never mind 250%.

    I wouldn’t take anything that this Mishkin guy says seriously. He was just another typical person that got caught up in bubble hysteria. The stuff he says reminds me of the guys that wrote these books(one guy was Romney’s economic advisor):
    http://www.amazon.com/Dow-36-000-Strategy-Profiting/dp/0609806998/ref=sr_1_1?ie=UTF8&qid=1360079469&sr=8-1&keywords=dow+36000

    http://www.amazon.com/Real-Estate-Boom-Will-Bust/dp/0385514352/ref=sr_1_3?ie=UTF8&qid=1360079469&sr=8-3&keywords=dow+36000

    The reason that Iceland’s recovery has been so successful is because they let a failed banking system collapse. They also used a currency devaluation rather than trying to prop up the value of their currency. Iceland also successfully liquidated bad debt and were able to reset their debts. They basically did the exact opposite as the rest of Europe(who has been trying to support an unproductive banking system by imposing massive pain on their middle class through higher taxes and austerity). The kind of stuff that we usually talk about and recommend on this blog is what Iceland did and now they’re recovering.

  2. Gravatar of ssumner ssumner
    5. February 2013 at 07:57

    Suvy, You said;

    “I wouldn’t take anything that this Mishkin guy says seriously.”

    Mishkin knows 10 times as much macro as you’ll ever know. I wish his colleagues at the Fed had taken him seriously when he warned of disaster if money was too tight.

  3. Gravatar of Saturos Saturos
    5. February 2013 at 08:02

    So are you still completely sure that all those things Mishkin was worrying about (at the beginning there) would not have been a big deal had NGDP expectations remained stable? Remember Mishking wasn’t actually thinking about NGDP, and even inflation/deflation he regards as a seperate dangerous side-effect of stabilization policy. He’s really thinking in credit terms here, thinking about the the path of interest rates as being an influence most importantly on output via credit conditions, and only secondarily on prices. Whereas you argue credit has nothing to do with NGDP.

  4. Gravatar of Suvy Suvy
    5. February 2013 at 08:07

    “Mishkin knows 10 times as much macro as you’ll ever know. I wish his colleagues at the Fed had taken him seriously when he warned of disaster if money was too tight.”

    Then how do you not see warning signs with countries whose banking systems are 10 times their GDP? How do you write a paper that says that a country like that is financially stable? Any sort of shift in volatility at that level blows the entire country up. He had graphs in that same paper that should be HUGE red flags, yet thought that there was no issue. External debt at 250% of GDP, you’ve got to be kidding me. That’s the kind of stuff that I didn’t even think could happen; usually when external debt reaches around 75%, you start having (major) issues.

    The funniest part is saying “the likelihood of a financial meltdown is low” when a country has a whose size is 10 times GDP and external debt at 250% of GDP.

  5. Gravatar of Suvy Suvy
    5. February 2013 at 08:08

    Correction on the last paragraph on the previous post. It should say:
    The funniest part is saying “the likelihood of a financial meltdown is low” when a country has a banking system whose size is 10 times GDP and external debt at 250% of GDP.

  6. Gravatar of Greg Ransom Greg Ransom
    5. February 2013 at 08:32

    By Dec. of 2007 most of the damage had already been done by the Federal Reserve and the U.S. government — the Titanic had already slammed into the iceberg, the compartments were already full of water, and the Titanic was headed to the bottom.

    The only only role of the Federal Reserve and the U.S. government was not to begin sinking the life boats and to build a sustainable ship put on a sustainable course the next time.

    The Federal Reserve and the U.S. government mostly failed at both of these tasks — both entities began sinking life boats and immediately initiated pathological programs that didn’t choice and build a healthy new ship and a sustainable course.

  7. Gravatar of marcus nunes marcus nunes
    5. February 2013 at 08:34

    Scott
    Mishkin “undid himself” when he added in his comments:
    “I feel strongly that the one thing a central bank can never afford to do is to lose its nominal anchor. If we do that, it’s a disaster. With that viewpoint, I should say that, if shocks occurred such that recession was going to occur and the only way we could stop a recession from occurring was to inflate the economy, we couldn’t allow that to happen. We actually have to preserve the nominal anchor because, in the long run, the pursuit of price stability is what makes good monetary policy and has been a key reason for the remarkable success of monetary policy by the central bankers throughout the world in recent years that I think nobody would have predicted.”
    At a minimum it shows the dangers of thinking exclusively in terms of inflation. Nominal stability is a more encompassing concept.

  8. Gravatar of Greg Ransom Greg Ransom
    5. February 2013 at 08:36

    By the way, Calculated Risk has a great recent post which explains a good part of why Scott Sumner is constantly talking non-sense and falsehoods when he talks about construction and construction unemployment:

    http://www.calculatedriskblog.com/2013/01/kolko-here-are-missing-construction-jobs.html

  9. Gravatar of ssumner ssumner
    5. February 2013 at 08:38

    Saturos, He doesn’t use the term NGDP, but he is clearly referring to the danger of a spiral where financial distress reduces NGDP which creates more financial distress which further reduces NGDP.

    Don’t pay much attention to the fact that he never uses the term NGDP—almost no one did before I started blogging (not impying cause and effect. :))

    He is worried about a big drop in AD. If it was AS reducing output, then it would not be something the Fed could address.

    I am confident that stable NGDP growth would have made both the financial crisis and the recession much milder. On the other hand the economy still would have struggled—probably with stagflation. Perhaps 1% RGDP growth and 4% inflation.

  10. Gravatar of Greg Ransom Greg Ransom
    5. February 2013 at 08:39

    If only the genius macroeconomists running the Fed had built the right cargo cult radio control tower using exactly the right reeds and sticks, getting the signals to the magic cargo planes just right:

    “And of course Mishkin was right, 700 points on the Dow were separated by a mere 25 basis points in the fed funds rate. It’s all about expected future policy, as Sumner (1993)/Krugman (1998)/Eggertsson/Woodford, etc., keep insisting.”

  11. Gravatar of ssumner ssumner
    5. February 2013 at 08:45

    Greg, I see you are still peddling the lies that I based my jobs argument solely on housing starts. Wrong again. As you well know housing completions tell the same story. How many times do I have to tell you that before it sinks in?

    Marcus, Yes, but I would cut him some slack in that one. The Fed should not abandon its nominal anchor. However, as you say, the nominal anchor should be NGDP, not inflation.

  12. Gravatar of Ravi Ravi
    5. February 2013 at 09:59

    this is like a serialized whodunit from the old days – looking forward to the bernanke expose. why has mishkin apparently changed his mind (or moderated his view of the importance of expectations, at least in his textbook)?

  13. Gravatar of Adam Adam
    5. February 2013 at 10:13

    All this makes me think the FOMC is too big. We don’t seem to have any trouble getting a qualified Fed chair and a qualified handful of members of the BOG. Why aren’t they the ones makes the important policy decisions?

  14. Gravatar of Geoff Geoff
    5. February 2013 at 10:27

    Dr. Sumner:

    “Reading that almost brings tears to my eyes, especially when I think of all the totally unqualified people who serve on the FOMC. People who are not experts in monetary policy and yet who make decisions costing millions of people their jobs.”

    Serious question: What makes an economist an “expert” in monetary policy? Do they just have to be on board with NGDP targeting? Seems like that is the case. But a monkey could be trained to press “print more” when a light turns green, and “print less” when a light turns red, where green is above 5% NGDP growth and red is below 5% NGDP growth.

    I would argue that the people on the Fed now are all “experts”. Educated at Ivy league schools, published in top journals, and so on. It’s just that most of them are of the untrained monkey type who won’t press “print more” when the NGDP rule light blinks red. That’s probably why you say they’re not experts whereas others might disgree.

    You obviously don’t trust most of the people at the Fed to ensure healthy growth and employment. Well, I don’t trust you or anyone in the same intellectual clique to run the Fed either. I don’t even trust myself (even though I would like to be the money issuer). It is an unwinnable game, because central banking is a constant frustration to markets, even when it “successfully” performs the “rule” you want. The Fed is not a market institution. Institutions that are not market institutions can’t mix with market institutions the way market institutions can mix with other market institutions.

    A price inflation economist who looked at 1980 – 2007 could very well conclude price inflation targeting is the best, and yet it eventually failed. An NGDP targeting economist might look at Australia and conclude NGDP targeting is the best, until it fails. And mark my words, as a random internet poster who is 100 times less smart than Mishkin, NGDP targeting will eventually fail too.

    You just can’t expect a permanent peace or stable cooperation between market institutions and non-market institutions. At some point, one or the other will eventually be overcome. It may not be today, it may not be 20 years or even 50 years, or more, from now, but at some point, the legacy turnover of non-market institutions, if they are to not completely take over and eliminate the market, MUST constantly evolve and change to accommodate the constantly evolving and changing market.

    Sorry, but for the Fed, the alleged “evolving” and “changing” solely in terms of when and how often to press “print”, won’t cut it. The whole reason every single past Fed inflation rule has been abandoned, is because NONE will work permanently. The market can only adapt so far in the direction of the current Fed rule and co-exist in a roughly stable fashion with the Fed. But once it adapts further, it makes the existing rule antiquated, and the rule must change.

    At some point, the Fed is going to run out of new printing rules. NGDP targeting may have to give way to nominal wage targeting, then real side employment targeting, and so on, until there is no other rule conceivable. But by that time all the opportunists will be dead, so who cares.

  15. Gravatar of Geoff Geoff
    5. February 2013 at 10:33

    Dr. Sumner:

    “It’s true that headline inflation was elevated due the the oil price shock in early 2008, but by the time of the Fed meeting 5 year TIPS spreads showed only 1.23% inflation (a prediction that will eventually prove fairly accurate.)”

    Oil prices began spiking much earlier than in early 2008.

    http://i.imgur.com/c2BgSnv.png

    Just look at the price of oil from 1861 to 1972 or so. Almost completely flat. Then there was a large increase during the 1970s (inflation??), with a downward trend during the 1980s (Volckerism??), and then starting in the early 2000s again there was another spike (Greenspan boomism???), and then a collapse in late 2008 (deflation??), and then finally another spike (Bernankeism??).

    I would think that this is strong evidence that inflation expectations are a primary driver for oil price volatility.

  16. Gravatar of Doug M Doug M
    5. February 2013 at 10:43

    Suvy,

    if you want some giggles…

    Gramlich on Sub-prime lending.

    http://www.federalreserve.gov/boarddocs/speeches/2004/20040521/default.htm

    or Greenspan on OTC derivatives.

    http://www.federalreserve.gov/boarddocs/testimony/1998/19980724.htm

  17. Gravatar of Doug M Doug M
    5. February 2013 at 10:48

    Regarding experts on the FOMC — you should read the wisdom of crowds. A crowd only has superior decision making properties if their opinions are diverse and one member of the crowd is unable to influence the opinions of the others.

    This is part of the rationale that half the members of the FOMC are appointees, and half come from the regional banks.

    However, you have given me the thought — at least when the Fed is off the zero-lower bound — why doesn’t the Fed target rates drictly off the FF futures market implication.

  18. Gravatar of Geoff Geoff
    5. February 2013 at 11:18

    Doug M:

    “A crowd only has superior decision making properties if their opinions are diverse and one member of the crowd is unable to influence the opinions of the others.”

    This is rather silly, on multiple levels. One, if wisdom requires diversity, how can there be agreement on reality, given that reality is one set of truths and no other? Progress on truth requires agreement on truth, or else everyone (minus one perhaps) would be wrong. Two, wisdom is improved when a person communicates with, learns from, and teaches others. If there is to be no influencing of opinions, then people who are wrong can’t learn how they are wrong, and people who are right can’t teach others what is right.

    The reason why half are appointees and half are from the regional banks has more to do with power and control, incentives, and sufficient diversity of opinion (not extremist isolation of opinions).

  19. Gravatar of Don Don
    5. February 2013 at 11:31

    Bloomberg radio had a 30+ minute interview with Fisher this week. He is smart, but dumb when it comes to money. He seems to confuse QE with that Don’t Spill the Beans game. I’ll be happy when Bloomberg gives equal time to someone like Scott Sumner.

  20. Gravatar of Scott Sumner Scott Sumner
    5. February 2013 at 11:32

    Ravi, I’m not sure, but the recent changes to his textbook have been very disappointing.

    Adam, I want the FOMC expanded to 7 billion people.

    Geoff, You said;

    “Serious question: What makes an economist an “expert” in monetary policy? Do they just have to be on board with NGDP targeting? Seems like that is the case.”

    If that’s a serious question, I’d hate to see you in a nonserious mode. An expert is someone who understands monetary economics. There are only a few hundred people like that in the entire world.

    You said;

    “I would argue that the people on the Fed now are all “experts”. Educated at Ivy league schools, published in top journals, and so on.”

    Are you being sarcastic? Is this a joke?

    You said;

    “And mark my words, as a random internet poster who is 100 times less smart than Mishkin, NGDP targeting will eventually fail too.”

    Of course, all policies eventually fail, and then we improve upon them with new policies that fail less often and less painfully. That’s how the world works.

    You said;

    “Oil prices began spiking much earlier than in early 2008″

    I suggest you spend more time thinking and less time typing. That comment has no bearing on my claim.

    Doug, I’ve read The Wisdom of Crowds, but you have misinterpreted its message. It calls for diverse viewpoints, not uniformed viewpoints. My list of names includes diverse viewpoints. Would you rather have 3 trained pilots fly your Boeing 747, or three people with “diverse” flying talent rounded up in a bar?

    The Fed can’t rely solely on fed funds futures, as the economy would have no nominal anchor.

  21. Gravatar of dtoh dtoh
    5. February 2013 at 12:09

    Scott,

    How do you think the inflation hawks within the FOMC view the mechanism by which monetary policy gets translated into inflation. Is it just more money equals more inflation? What are you views.

    Reading the accounts from the FOMC meeting, I was struck by how much inflation-phobia seems to be the main deterrent to better monetary policy….before I thought it was just stupidity.

  22. Gravatar of Geoff Geoff
    5. February 2013 at 12:25

    Dr. Sumner:

    Wow, did I say something wrong? I am just being honest, open minded, and perhaps a little caustic, but it’s all good intentions. It’s sometimes hard to see that with only words, so I won’t be so offended, but just so you know, I am definitely not in any confrontational mode or anything. I am not an enemy combatant.

    Yes, I actually was serious when I asked what makes an economist an expert in monetary policy.

    You say an expert is someone who understands monetary economics. Well of course, but that to me is just saying that an expert in monetary economics is…an expert in monetary economics.

    OK, what makes a person “understand” monetary economics? Serious question still! Is it someone who supports NGDP targeting? I am not being flippant here. How do you distinguish a good monetary economist from a bad one? What separates the people on the list of those you say should sit on the FOMC, from those who you say should not? What is specifically that signals to you that most of those at the Fed don’t understand monetary economics?

    I wasn’t being sarcastic when I proposed that “expert” economists are just those who are educated at top schools and published in top journals. Why is that a joke? Isn’t that how most people define expert economists? I was just going with what I thought was the flow on that one.

    Anyway, you seem to agree that all monetary policies eventually fail. Can I ask you what your reason(s) are for why all monetary policies eventually fail?

    Then you said something that was really interesting to me. You said “then we improve upon them with new policies that fail less often and less painfully. That’s how the world works.

    I would argue that’s how a certain intellectual approach to action (philosophy) works. The world of human life isn’t one where we MUST have institutions of monopoly privilege. They’re choices, aren’t they? If they’re choices, then they can’t be described as if they’re laws of nature.

    To me you’re essentially saying that your philosophical approach is to insist on the existence of a monopoly privilege institution, for whatever reason, intentional or through helplessness (we’re in the same boat here don’t forget!) and that your only room for adaptation and evolution is on the side of tactics and rates of activity of that institution.

    Well, OK, fine, I won’t say you can’t think that, because I desire monopoly privilege institutions myself, but I prefer not to have the wool pulled over my eyes and told like a child “That’s the way ‘the world’ works” like my name is little Billy and I have to obey it and accept it. I would like to think I deserve more than that treatment.

    I wouldn’t say that my philosophy is the world’s philosophy.

    You said I should read more and type less. Seriously, what’s with the condescending hostility? I am just asking questions and making honest comments. I am not attacking you. I am not trying to upset anyone here.

    The reason why I pointed out oil price spiking starting before early 2008 was because I really did think it had a bearing on your claim. My point is that oil price volatility is probably related to inflation volatility, and so when you said price inflation picked up because of oil prices, you made it seem like, to me at least, that this particular price inflation episode had little or nothing to do with monetary inflation or monetary inflation expectations.

    Well, I think it stands to reason that if price inflation expectations from oil price speculators affects oil prices, which then affects prices in the tracked indexes, then wouldn’t it be the case that the price inflation episode was caused by monetary inflation expectations, not some unexplained oil price “shock”, and hence it might be the case that the Fed tightened up in 2008 in part because it saw oil prices increasing too much and thought it was going to overshoot?

    I guess I just don’t like the word “shock” because it is often used as a cop out explanation. I like to go deeper to core principles, and not refuse to look for the causes of such shocks. I realize we do that sometimes out of convenience, sometimes because it may threaten our explanation for what the shock allegedly did on its own and end up working against our theory or policy prescriptions, sometimes out of time constraints, and sometimes out of lack of sufficient knowledge, or whatever.

    I feel like I am being told to shut up and I don’t know why. Is merely saying something wrong sufficient to being outcasted? Sounds like there isn’t much diversity permitted here.

  23. Gravatar of Suvy Suvy
    5. February 2013 at 12:43

    “Regarding experts on the FOMC — you should read the wisdom of crowds. A crowd only has superior decision making properties if their opinions are diverse and one member of the crowd is unable to influence the opinions of the others.”

    I’ll throw out the caveat that I haven’t read the wisdom of crowds. However, one major thing that plays an essential role in the markets is crowd behavior. Policymakers have to be able to not get caught up in the hype of a bubble. For example, people buying houses on credit with 0% down is not a good thing. Especially when they can’t afford the houses with their incomes and the only thing that makes these “investors” solvent is the fact that they are reliant on capital gains. This was worsened by the consistent bailing out of the financial sector since 1980 and the build-up of debt in the system. Greenspan thought that rewarding bad behavior was the right thing to do, but that the markets were able to regulate themselves; not realizing that the market’s regulation mechanism(bankruptcy) was the mechanism that he removed from the system by the Greenspan put.

    I think the key problems started happening right around 1975ish. That was the point where the financial system went from being robust to fragile. This was worsened by the idiocy of people like Greenspan in charge. I still, to this day, do not understand why LTCM was not allowed to fail. Then you add in all of the idiocy that happened on Wall Street with the securitization of loans and the spreading of risk through OTC derivatives. In addition to that, Greenspan and Co. starts to push for the removal of prudent regulations like Glass-Steagall.

    The sad part is that we still haven’t fixed the real problems. Banks that were too big to fail are now even bigger. The people that run those banks still don’t have any skin in the game; the losses are socialized while the gains are privatized. Nothing has been done to bring certain OTC derivatives–like credit default swaps–onto an exchange where they margin requirements can be used. Very little of the debt has been liquidated or restructured; some of it has been inflated away. When you add on to the fact that all of those people who made bad decisions(whether this was an individual, a household, or a bank) haven’t really suffered the consequences. No one has been persecuted when I’m pretty sure there had to have been a lot of fraud going on in the financial system. Then, you add to that point that there has been nothing to make sure that all of the credit that is taken out will be put to a productive purpose.

    Basically, I’m saying that the financial system of the entire world needs to be reset at some point. The current path is just unsustainable. You cannot sustainably support the unproductive with the productive. We still have a massive financial sector that doesn’t produce anything and none of the bad debt has been liquidated. Instead, those that made bad decisions have been rewarded while those that made good decisions have been punished.

  24. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    5. February 2013 at 12:54

    Doug M, thanks for this link to the 2004 Gramlich speech;

    http://www.federalreserve.gov/boarddocs/speeches/2004/20040521/default.htm

    Housing Cause Denialists should hate it, because his figures show that sub-prime began to expand in the mid-90s, right after the assault by the fed–GSE Act of ’92, HUD Best Practices Initiative, Clinton Housing Initiative, Expansion of the CRA in ’95–on the home loan industry.

  25. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    5. February 2013 at 13:04

    Scott, maybe you should offer S&P your services (get your 7 figure retainer up front) in the lawsuit just filed against them;

    http://seattletimes.com/html/businesstechnology/2020289036_apusstandardpoorslawsuit.html

    ‘The lawsuit alleges that S&P knew the subprime mortgage market was collapsing by 2006, yet it didn’t issue a mass downgrade of subprime-backed securities until mid- 2007.’

    If the key is a meeting in Dec. 07, then they’re home free, it would seem.

    Of course, this isn’t a real lawsuit, it’s a political maneuver by Holder. One that S&P will settle after they determine how many millions it will cost to litigate. The Martha Stewart Gambit.

  26. Gravatar of Daniel Daniel
    5. February 2013 at 13:23

    Suvy,

    Yes, moral hazard has been institutionalized in the financial system – nobody with a sane mind would argue otherwise.

    But how that was capable of bringing down the entire economy is up to you to explain.

  27. Gravatar of Geoff Geoff
    5. February 2013 at 13:33

    Daniel:

    “But how that was capable of bringing down the entire economy is up to you to explain.”

    Woah, talk about exaggeration. Nobody has to explain how it was capable of bringing down the entire economy, because the entire economy did not get brought down.

    An additional 5 out of 100 people lost their jobs, and an additional few companies went bankrupt, and an additional few percentage points of growth were taken off the total.

    I am not trying to belittle this, or minimize the tragedy of the millions who lost their jobs, but the financial sector is a core component of the economy. If there are problems there, it can have huge impacts all over. Why can’t moral hazard be an explanation on par with monetary deflation? I guess I just don’t like so much one track thinking, as if one factor is the biggest no if ands or buts and is the only one to be seriously addressed with detailed inquiry.

    The “Greenspan Put” really did have a huge impact on investments. The Bernanke Put is even larger. Corruption is the norm. Sometimes I ask myself when others are talking about the market this or the market that: “What market?”

  28. Gravatar of Daniel Daniel
    5. February 2013 at 13:44

    If there are problems there, it can have huge impacts all over.

    Please explain the mechanism.

  29. Gravatar of Geoff Geoff
    5. February 2013 at 13:51

    Daniel:

    “Please explain the mechanism.”

    Oh come on. Really? Money is one half of every single trade. I could point you to half a dozen finance and economics journals that contain decades of research that shows the core importance of finance.

    ……..

    http://www.businessinsider.com/startups-with-billion-dollar-valuations-2013-2?op=1

    Another dot-com bubble?

  30. Gravatar of Daniel Daniel
    5. February 2013 at 13:55

    Yes, really.

    Either you explain the mechanism that leads from a financial crisis to a massive increase in unemployment (under a fiat money regime, I would add) – or admit you’re relying on gut feelings instead of facts and reasoning.

    Because “oh come on” is not a valid answer.

  31. Gravatar of Geoff Geoff
    5. February 2013 at 14:06

    Daniel:

    “Either you explain the mechanism that leads from a financial crisis to a massive increase in unemployment (under a fiat money regime, I would add) – or admit you’re relying on gut feelings instead of facts and reasoning.”

    Yay false dichotomy based on a straw man.

  32. Gravatar of flow5 flow5
    5. February 2013 at 14:15

    “It is extremely important not to be in the Taylor-rule type of framework, where you wait to see actual inflation and output outcomes to drive your policy”

    Frederic Mishkin was prescient. Ben Bernanke conducted a contractionary monetary policy that directly caused the Great-Recession. But where is your training? I e-mailed you a trillion dollar big stick. You were indignant.

  33. Gravatar of Steve Steve
    5. February 2013 at 14:16

    Mishkin gets a “B+” for the mid-term exam. Unfortunately a course grade for “Monetary Economics in Practice” cannot be computed until the final exam, the 2008 transcripts, have been evaluated. Unfortunately, Mishkin did not complete the requirements for an honors degree, as he retired immediately prior to September 2008.

  34. Gravatar of Steve Steve
    5. February 2013 at 14:19

    The grading committee initially considered giving Mishkin an “A-” but ultimately decided it was important to fight grade inflation in order to provide a nominal anchor to allow for grade comparability over time.

  35. Gravatar of dtoh dtoh
    5. February 2013 at 14:20

    Suvy,
    The sad part is that we still haven’t fixed the real problems. Banks that were too big to fail are now even bigger. The people that run those banks still don’t have any skin in the game; the losses are socialized while the gains are privatized.

    You have exactly hit the nail on the head, and there are two easy solutions.

    1. Eliminate TBTF (I don’t think this is politically possible nor would the market believe it).

    2. Institutionalize it with an explicit guarantee program that large financial institutions are required to participate in, and as part of that program allow the Fed to dynamically set asset/equity ratios by asset class.

    BTW – I think securitization and derivatives are good things, and I don’t there was significant illegal behaviour…just rationale behaviour responding to bad regulation that led to bad results.

  36. Gravatar of Geoff Geoff
    5. February 2013 at 14:26

    Citigroup (C), Wells Fargo (WFC), and Goldman Sachs (GS)—held more than $8.5 trillion in assets at the end of 2011, equal to 56 percent of the U.S. economy, according to the Federal Reserve. That’s up from 43 percent five years earlier.

    http://www.businessweek.com/articles/2012-04-19/big-banks-now-even-too-bigger-to-fail

  37. Gravatar of Geoff Geoff
    5. February 2013 at 14:29

    I’d love to see the Fed try to increase NGDP the way they want within a context of widespread financial sector panic, unheard of rush for cash, and the top 5 banks going bankrupt.

    I’d love to see the Fed try to make a point and prove Sumner right. I’d definitely grab my popcorn and slippers.

  38. Gravatar of flow5 flow5
    5. February 2013 at 14:34

    Remarks on the Role of Central Bank Interactions with Financial Markets

    http://www.newyorkfed.org/newsevents/speeches/2012/pot121127.html

    Re: Simon Potter’s remarks:

    “Kindleberger’s ‘Manias, Panics and Crashes’ ”

    Nothing’s changed in 100 years. Nothing’s more complex.

    It has been repeatedly stated that the only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves (today the FRBNY’s “trading desk” uses interest rates as their monetary transmission mechanism).

    The monetary authorities must use two tools to control the money supply, (1) legal reserves & (2) reserve ratios. Furthermore, the reserve assets that all money creating institutions are required to hold should be of a type the monetary authorities can quickly ascertain and absolutely control.

    The only type of bank asset that fulfills this requirement is inter-bank demand deposits in the Federal Reserve Banks owned by the member banks. This was the original definition of the legal reserves of member banks in the Federal Reserve Act of Dec. 23, 1913 –(Owen-Glass Act) and it is still the only viable definition (pre-Dec 1959 requirements pertaining to assets).

    The time is long past for the Congress to recognize & require that balances (IBDDs) in the Federal Reserve Banks be the sole legal reserves of all banks. If this reform is not made all other reforms will be of little consequence (e.g., the Great-Recession is prima facie evidence).

    Similarly the monetary authorities have to have complete discretion over changes in reserve ratios. This is essential since under fractional reserve banking (the essence of commercial banking) these ratios determine the minimum volume of legal reserves a bank must hold against a specified volume and type of deposit liability.

    In 1931 a commission was established on Member Bank Reserve Requirements – The commission completed their recommendations on Feb. 5, 1938. The study was entitled “Member Bank Reserve Requirements — Analysis of Committee Proposal”

    It’s 2nd proposal: “Requirements against debits to deposits”

    This research paper was DECLASSIFIED on March 23, 1983. By the time this paper was declassified, required reserves had become a “tax” [sic].

    What Bernanke did was treason. He conducted a contractionary monetary policy which was directly responsible for causing the Great-Recession. Bernanke should be jailed just as the banksters should be.

  39. Gravatar of Daniel Daniel
    5. February 2013 at 15:08

    Geoff (and other adepts of alternate macroeconomics),

    I’m still waiting for an explanation on how financial sector trouble lead to a massive increase in unemployment and drop in output.

    Rolling your eyes and saying “it’s obvious” doesn’t count.

  40. Gravatar of ChargerCarl ChargerCarl
    5. February 2013 at 16:18

    Geoff:

    “I’d love to see the Fed try to increase NGDP the way they want within a context of widespread financial sector panic”

    1987

  41. Gravatar of Suvy Suvy
    5. February 2013 at 16:49

    Daniel,

    “I’m still waiting for an explanation on how financial sector trouble lead to a massive increase in unemployment and drop in output.”

    If you start with the idea that the creation (and destruction) of debt is not demand neutral, then the conclusion directly follows. However, the easiest way to explain it is from a balance sheet perspective.

    Every balance sheet has assets and liabilities. During a boom, as credit gets expanded the liabilities rise; however, if the credit issued is put to good use, there will be a cash flow to pay you back. However, if rising leverage is used to buy financial assets and this leverage is what drives asset prices up, both sides of a balance sheet are increasing, but debt/income ratios increase over time. However, the feedback loop created by rising leverage which causes asset prices to rise all the while the the expectations of rising asset prices get stuck in some market participants. However, debts cannot sustainably rise relative to incomes and thus asset prices cannot rise at the unsustainable rate they have been(this is exactly what happened around 2000-2008 when people expected house prices to keep rising 10% annually which is clearly not sustainable when NGDP was growing at 4-5% max). If you read The Big Short by Michael Lewis, you see these things happened not just from 2000-2008, but from 1980-2008 on a smaller scale. Anyways, when the volatility of asset prices increases as asset prices stop rising/fall; the balance sheets are now underwater as the assets fall while the liabilities remain. If this happens to an entire economy all at once, you get a fall in aggregate demand.

    This also has a fundamentally different view of the banking system. When the banking sector issues credit, this adds to money and aggregate demand while not taking away anyone else’s spending power. When everyone in the entire economy is paying down debt, this takes money away from circulation, and thus, aggregate demand falls. So you got from aggregate demand being greater than income because debt is greater than income in this model to aggregate demand being less than income because it is being paid off.

    If the debt cannot be serviced, you start getting into a debt deflation scenario where mass liquidations cause assets to be sold at firesale prices and asset prices plunge as do the income streams the assets generate. What you get is a situation where debt/income ratios rise while debts are falling in nominal terms because incomes fall faster. This is why printing money is such an instrumental tool in preventing a depression; the money starts flowing through an economy and prevents asset prices from falling and also increases nominal incomes so that debt/income ratios do not fall.

  42. Gravatar of Geoff Geoff
    5. February 2013 at 16:52

    ChargerCarl:

    I’d love to see the Fed try to increase NGDP the way they want within a context of widespread financial sector panic, AND unheard of rush for cash, and the top 5 banks going bankrupt.

    I mean something like 2008 over again, but without any direct Fed bailouts, below market rate loans, or nationalizations, just straight up massive OMOs like Dr. Sumner proposes is sufficient.

    BTW, 1987 was nowhere close to 2008 in terms of financial panic, even before NGDP took a nose dive.

  43. Gravatar of ChargerCarl ChargerCarl
    5. February 2013 at 16:53

    Scott, MM is dead RIP:

    http://bastiat.mises.org/2013/02/the-rise-and-fall-of-market-monetarism/

    /sarcasm

  44. Gravatar of Suvy Suvy
    5. February 2013 at 17:02

    dtoh,

    I had something very similar in mind. The way I would’ve have handled the financial crisis would be to swap debt for equity warrants across the entire financial system. If that was not doable for whatever reason or that would not work in some cases, then nationalize the banking system and find a way to shut the bad firms down. We should’ve done to Citigroup what we did to AIG. The worst possible thing to do is to bail them out.

    One of my friends pointed this out to me and I think he’s right: the problem isn’t the derivatives themselves, it’s the leverage. As for credit default swaps and other OTC derivatives, I’d bring all of them onto exchanges and impose margin requirements immediately. I would also put a minimum 20% down payment on anyone who wants to buy a house and reduce the maximum amount of leverage that can be held. I think another important thing to do is to reintroduce the concept of bankruptcy and make sure the proper incentives are in place for everyone involved.

  45. Gravatar of Geoff Geoff
    5. February 2013 at 17:21

    Suvy:

    “The way I would’ve have handled the financial crisis would be to swap debt for equity warrants across the entire financial system. If that was not doable for whatever reason or that would not work in some cases, then nationalize the banking system and find a way to shut the bad firms down.”

    Yay communism.

  46. Gravatar of ant1900 ant1900
    5. February 2013 at 17:24

    Nikkei 225 Heads for Biggest Rise in Week on BOJ, Toyota:
    “The market expects the next BOJ head and deputy governors to be supportive of monetary easing,” said Hiroichi Nishi, an equities manager in Tokyo at SMBC Nikko Securities Inc. “An earlier transition will keep up optimism for a weaker yen and an end to deflation.”

    http://www.businessweek.com/news/2013-02-05/japan-s-nikkei-225-heads-for-biggest-rise-in-week-on-boj

  47. Gravatar of Saturos Saturos
    5. February 2013 at 18:40

    Suvy, aggregate demand is necessarily equal to income. You are talking about the (not very heterodox) money multiplier. For an example of how the Fed can restore NGDP regardless of the money multiplier, see 1933. But I agree that Scott’s refusal to consider credit money at all has got to be amiss.

  48. Gravatar of Suvy Suvy
    5. February 2013 at 18:42

    Geoff,

    “Yay communism.”

    Doing that is better than socializing the losses and privatizing the gains; which is the worst of both capitalism and socialism. Doing what I suggest is effectively what bankruptcy would do, you’d just be preventing the financial panic that would result.

  49. Gravatar of Saturos Saturos
    5. February 2013 at 18:43

    Scott, so do you think that Bernanke was consciously considering NGDP at this stage? (Having endorsed it four years ago as the best measure of monetary policy)

  50. Gravatar of OhMy OhMy
    5. February 2013 at 19:19

    The Fed caused the recession? There is zero proof of that.

    If you say the Fed caused the recession it means you claim there would be no recession if the Fed acted differently. There is zero proof of that.

    If the NGDP was stable then the housing collapse wouldn’t spill into the broader economy? There is zero proof of that.

    Plus, how to make NDGP stable when people cannot service their debts and have to sell houses at a loss because, ahem, the housing is collapsing. You assume these are disconnected. People who predicted the crisis, unlike you, think they are very connected.

  51. Gravatar of Doug M Doug M
    5. February 2013 at 20:55

    Suvy, Dtoh,

    I agree that TBTF has only become a worse problem. My best solutions…

    1) brute force — break up big banks into small banks…I don’t like it very much, but I like it better than institutionalizing TBTF.

    2) require banks to divide themselves internally. Each unit must be below some threashold size, each unit must pass stress tests indvidually, no unit gurarantees the the debts of any other unit, each unit must be able to fail without sinking the whole.

    3) the soft approach — charge banks for TBTF insurance — a progressive tax based on assets. This will create dis-economies of scale. Shareholers will demand that banks divest units to maximize profitability.

  52. Gravatar of Wednesday Morning Links | Iacono Research Wednesday Morning Links | Iacono Research
    6. February 2013 at 05:30

    [...] Mortgage News Daily Fed’s Duke Says Stronger Housing Market to Spur Growth – Bloomberg Mishkin explains how the Fed caused the Great Recession – The Money Illusion Fed says internal site breached by hackers – Reuters No [...]

  53. Gravatar of ssumner ssumner
    6. February 2013 at 06:15

    Dtoh, I wasn’t at all surprised that inflation was holding them back. I’m not sure how they view the transmission mechanism.

    Geoff, You said;

    “The reason why I pointed out oil price spiking starting before early 2008 was because I really did think it had a bearing on your claim.”

    Why? Did I claim they didn’t rise in 2007?

    As far as experts: Suppose you put 20 Nobel prize winning physicists in a room. What would make you think they know more physics than you? Or than Joe the plumber? If you can answer that question you’ll be halfway there.

    As far as the Fed boosting NGDP in the midst of a huge financial crisis–I take it you know nothing about 1933. Is that right?

    Patrick, Going after S&P is like the Salem witchcraft trials.

    Saturos, Probably subconsciously.

    OhMy, Depends what you mean by “proof”. This blog is full of empirical evidence supporting all my claims. Airtight proof is hard to come by in macro.

  54. Gravatar of Suvy Suvy
    6. February 2013 at 06:18

    Saturos,
    “Suvy, aggregate demand is necessarily equal to income. You are talking about the (not very heterodox) money multiplier. For an example of how the Fed can restore NGDP regardless of the money multiplier, see 1933. But I agree that Scott’s refusal to consider credit money at all has got to be amiss.”

    Aggregate demand is not income. Aggregate demand is income plus the change in debt. Think about it, if you’re an individual, you can spend your money from income or from debt. It’s the exact same for an economy. The only caveat here is that you have to reject the traditional view of the financial system in an economy. If you view the banking sector as creating money rather than simply taking money from savers and transferring them to borrowers, then this view of aggregate demand is very easy to show. I’m not using the money multiplier model; I’m using the endogenous money model. I think the money multiplier is a useless number in practice.

  55. Gravatar of Suvy Suvy
    6. February 2013 at 06:22

    By the way, there is a really good paper by Keynes on the same issue. It’s called The Ex-Ante Theory of the Rate of Interest. He basically talks about endogenous money and how investment will still occur regardless of how much savings is available; the gap, he says(and I agree), is filled by finance. Then the money that is created goes into the flow of finance to create the corresponding investment, and thus, savings–since savings is defined as income not consumed. It’s a really good paper that I recommend reading.

  56. Gravatar of dtoh dtoh
    6. February 2013 at 08:25

    Scott, You said;
    I wasn’t at all surprised that inflation was holding them back. I’m not sure how they view the transmission mechanism.

    At some point, could you comment on how you view the relationship between NGDP growth and inflation. Presumably there is some correlation not only with the growth rate of NGDP but also with changes in the growth rate of NGDP. Do you think the Fed believes it’s harder to get inflation to go down than it is to get inflation to go up? Are wages and prices stickier in one direction than the other? Be curious to hear your views on this.

  57. Gravatar of Fed Up Fed Up
    6. February 2013 at 10:16

    “So Mishkin got almost everything right.”

    Nonsense! The guy is worse than greenspan. He is/was wrong about asset bubbles and Iceland.

  58. Gravatar of dtoh dtoh
    6. February 2013 at 10:38

    Suvy, Geoff, Doug,

    As I said, I really think the way to prevent the moral risk is to have the Fed dynamically set asset/equity ratios by asset class. This would be relatively simply and if the Fed did it, it would be less political. IMHO, 95+% of the problems in the recent financial crises are the result of subsidized credit in the form of the TBTF guarantee.

    I’m not a fan of making banks TSmallTF. In order for this to work, you need to make the banks really small, and I think you lose efficiency doing this. Maybe limitations on mergers that increase market share above a certain percent would be OK.

    I think the other measure that might make sense is to require that bank compensation above a certain level be in the form of equity which is paid out over a five year period following end of employment. This was the GS model until they went public. Made for very good governance.

  59. Gravatar of Fed Up Fed Up
    6. February 2013 at 10:40

    Let’s try this.

    Scott, do you believe that the money supply = monetary base?

  60. Gravatar of dtoh dtoh
    6. February 2013 at 11:32

    Scott,
    I have mixed feelings about S&P. I do agree the prosecution is a witch hunt. Businesses have to deal with conflicts all the time, and the government’s case seems based entirely on the fact that there was internal discussion of those conflicts.

    On the other hand, S&P was rating stuff they really didn’t understand. Not sure how you deal with that.

  61. Gravatar of Doug M Doug M
    6. February 2013 at 11:57

    Dtoh,

    I am not sure that Mega-banks are more efficient. When I started in finance there were 40-odd primary dealers. Now there are 20. Is it really more efficient?

  62. Gravatar of dtoh dtoh
    6. February 2013 at 13:23

    Doug,
    I don’t disagree. I wasn’t really thinking about transactional efficiencies. Rather I think larger banks have a better ability and the capital to: innovate, undertake risk, market more illiquid securities,etc. I don’t think you need mega-banks to do this, but if a bank is small enough to be politically TSTF, I think they will have more limited capabilities.

  63. Gravatar of Suvy Suvy
    6. February 2013 at 14:19

    dtoh, Doug M, Geoff,

    One possible solution that would immediately fix all of these problems is imposing a 100% reserves backing to any credit issued. It would completely solve the problem of having banking runs completely. However, I have doubts about the practicality of such a policy.

    I think one good way is to maybe split the financial system into two classes: hedge funds and banks. The banks wouldn’t be allowed to take any risk at all; there would be very, very strict conditions on them and at the first sign of trouble, the banks would be nationalized immediately. However, hedge funds would be able to take as much risk as they want, but they don’t get bailed out ever. This would only be a slight modification to our current system and would be very easy to implement.

  64. Gravatar of Suvy Suvy
    6. February 2013 at 14:26

    Fed Up,

    I said the exact same comment about Mishkin. Take a look at the paper that he wrote that I posted. It’s really funny. He’s saying Iceland has a stable financial system when he knows that Iceland’s external debt/GDP at the time was 250% of GDP and the assets owned by their banking system was 10 times greater than Iceland’s total GDP. He doesn’t realize that any sort of shift in volatility would blow them up. It’s hilarious when you actually read it.

  65. Gravatar of Doug M Doug M
    6. February 2013 at 15:15

    Suvy,

    Banking is risky. If we go back to the 1930s veiw of bankers who lend and investment banksers who underwrite securities, banking has all of the credit risk. Investment bankers passed their risks onto their customers. Banking was risky and investment banking was realtively low risk. Glass-Steagall had it backward.

    In a modern investment bank (combined bank) where there is market making, prop trading, derivatives underwringing and securitization, the risk of I-banking increased dramatically between 1980 and today.

    I like the Volker rule in theory — spin the high risk activities into some sort of hedge-fund-like limited partnership. I do see there being practical problems such as separating prop-trading from market making

  66. Gravatar of Suvy Suvy
    6. February 2013 at 21:09

    Doug M,

    I agree there is a certain degree of risk to banking, but the way investment banks were run from 1980 to 2008(especially from 2000-2008) was just stupid. People were using volatility to measure risk. They were using the ridiculous VaR models that allowed them to take massive risk without realizing that the past is not the future. Worst of all, they were using massive amounts of leverage to play in a game that they didn’t understand and blew up in the process. They were basically running a huge Ponzi scheme that was based on an ever-increasing amount of people taking on more and more debt that could never be paid back.

  67. Gravatar of JN JN
    7. February 2013 at 02:26

    Suvy,

    If banks used “ridiculous VaR models”, it’s also because regulators not only allowed and endorsed them to do so in the first place, but also because regulations (Basel) started to force them doing so. Market risk capital requirements are defined using VaR. As a result they can’t escape from it.

  68. Gravatar of Suvy Suvy
    7. February 2013 at 04:23

    “If banks used “ridiculous VaR models”, it’s also because regulators not only allowed and endorsed them to do so in the first place, but also because regulations (Basel) started to force them doing so. Market risk capital requirements are defined using VaR. As a result they can’t escape from it.”

    That’s a huge part of the problem. You have regulators that have no clue what they’re doing; these regulators have never actually worked in the field and don’t understand what risk is. There are several problems with VaR.
    1. You’re using past data to try and predict the future. This is akin to driving a car using the rear-view mirrors.
    2. Second, volatility does not measure risk. There’s a very simple argument to show this. For an investor, the value of an asset today is worth the discounted present value of the sum of all the future cash flows resulting from the asset. If you have an asset where the sum of the future cash flows are estimated to be $1, but the asset was trading at $.5, $.6, and $.4 over the past 3 years and you buy it for 40 cents; you’re getting a bargain and there’s very little risk. However, VaR would give a much higher risk profile than the actual risk of buying the asset.

    I still laugh when I see that people actually use VaR today. I don’t know why it’s still taught. It is absolutely absurd to think that you can predict the future using the (recent) past. Not only that, but when they do use these models, they usually only go back to around 5 years or so. I think one of the funniest things is when the guys that came up with Black-Scholes started a hedge fund and went bust in about 4 years and had to be bailed out my the federal government.

    Honestly, I think most of the “risk management” tools to manage risk taught today are just nonsense. If you’re using the past to predict the future, you will get in trouble; especially when using data that doesn’t go back very far. There is a use in backtesting portfolios and using some models to try and understand risk, but you cannot rely on any model. The models used in economics and finance aren’t like those in physics; they don’t have any predictive power.

  69. Gravatar of ssumner ssumner
    7. February 2013 at 05:49

    dtoh, I think wages are stickier downward. For prices I think that’s less important.

    Fed up. It’s not a question of “believing” the money supply is the base, it is regarding it as the base. It’s merely a question of semantics, there is no right answer. There are all sorts of ways money can be defined.

  70. Gravatar of JN JN
    7. February 2013 at 06:36

    Suvy,

    “especially when using data that doesn’t go back very far.”

    Many large banks have reduced the time horizon of the VaR model recently.
    Their defense? “It was approved by regulators”…
    See there:
    http://www.economist.com/blogs/freeexchange/2012/10/financial-crises-0

  71. Gravatar of Suvy Suvy
    7. February 2013 at 07:00

    JN,

    That’s the problem when you have regulators that haven’t worked in the field. They don’t understand what risk is; they actually think that volatility can measure risk. I would like to see a strict maximum leverage ratio for all banks set at 5:1; no more than that.

    I’d also stop using VaR, period, forever. I’d stop teaching it in business schools and economics classrooms immediately. Using historical data to measure risk is like driving a car using only the rear view mirrors. It just doesn’t make any sense.

  72. Gravatar of JN JN
    7. February 2013 at 07:20

    Suvy,

    I agree with you.
    I would just add one thing:
    It doesn’t only concern people who haven’t worked in the field.
    There are also plenty of bankers and other financiers who believe in the power of mathematics to be able to accurately model everything in economic and financial life. They are wrong (and were the ones who created all those complex and often misleading mathematical financial models).

  73. Gravatar of Doug M Doug M
    7. February 2013 at 10:02

    Suvy,

    I have been working in the risk management field for most of the last 10 years.

    A few rebuttals — historical data is not irrelevant. After all what is experience. It is the grey hair that comes with haveing seen something before and having an idea as to what to do about it. That doesn’t mean that there will not be times when something novel happens.

    Risk managers build models and as George Box said — “All models are wrong but some are usefull.” It is vital that risk managers and the traders / managers who consume their reports understand this, understand the assumptions and weakness of the models.

    Risk models make lousy compliance rules. Once a risk stat is introduced as a rule rather than an indication, the limits become threasholds. Traders will figure out how to game the model and exploit its weaknesses.

    VaR has a few gaping holes in it. Its dependence on historical data is one of the smaller holes. VaR describes the best thing that can happen to you on a bad day. Is that really useful? Most bank VaR models are daily VaR. They say that I should not lose more than 100 million dollars 19 days in 20. It doesn’t say that I couldn’t lose $200 million. And it doesn’t say that that I can’t lose $100M+ 5 days in a row.

  74. Gravatar of Suvy Suvy
    7. February 2013 at 11:40

    Doug M,

    I use models all the time; I have nothing against models. Don’t you remember how many arguments I got into with MF on the use of models? I actually think the study of history, and historical data, is very important. For example, I think the work that Kindleberger has done along with Reinhart and Rogoff is very important. My point with historical data is simple, just because it hasn’t happened so far doesn’t mean it won’t happen. I use historical data and models all the time. I think that studying history and using historical data is critical. I think back-testing portfolios over various periods of time can be very helpful; I think stress-testing portfolios can be very helpful too.

    I just have a problem when people come out and say that there is a probability p of some event happening. You can’t put numbers on events that are inherently uncertain. Especially when the probabilities are of rare events, any sort of measurement error or model error propagates and compounds over all the other errors of the model. In the end, the only way is to be safe is to make sure the risk of ruin is 0.

  75. Gravatar of Geoff Geoff
    7. February 2013 at 19:10

    Suvy:

    ““Yay communism.””

    “Doing that is better than socializing the losses and privatizing the gains;”

    Yay communism is better than fascism?

    Is that it? Talk about low standards!

  76. Gravatar of Geoff Geoff
    7. February 2013 at 19:40

    Dr. Sumner:

    “The reason why I pointed out oil price spiking starting before early 2008 was because I really did think it had a bearing on your claim.”

    “Why? Did I claim they didn’t rise in 2007?”

    Because I thought it was important to your claim in the sense of adding to it, not contradicting it, so that nobody gets any impression that the oil spike was somehow specific to 2008, as if there was no previous spiking.

    If oil prices are instead identified as spiking since the early 2000s, rather than just 2008, then that paints a significantly different picture. It could be the difference between treating the oi price increase of 2008 as a blip, or part of a longer term trend that is worrisome to price inflation.

    Also, by considering the oil price spiking for years prior, it can make it easier to ask what made the oil prices rise so much, so that we don’t only say price inflation occurred because of oil prices, but also consider the other possibility that oil prices rose for the same reason 2008 price inflation occurred (Fed policy?), which would make the oil price and price inflation a correlation relationship but not necessarily a singularly causal one (the way you explained the price inflation of 2008).

    The possibility that monetary policy had anything to do with the run up of both oil prices and consumer prices leading up to 2008 should at least be considered. I don’t think “2008 price inflation went up because of oil prices….” is sufficient, or even non-misleading.

    “As far as experts: Suppose you put 20 Nobel prize winning physicists in a room. What would make you think they know more physics than you? Or than Joe the plumber? If you can answer that question you’ll be halfway there.”

    I don’t trust either the Nobel winners who were given that award by a central bank, or Joe the plumber who wasn’t.

    If we put 20 astrologers into a room, we could ask if they know more about the stars than Joe the plumber. Sure, they know more about the stars, but do they really know anything useful or accurate? Knowing more than Joe the plumber doesn’t mean one knows a whole lot.

    How do you know monetary economists have a good understanding of monetary policy? I see you chastising my understanding, but you’re not really showing me what’s right.

    What I know is that the knowledge that exists throughout the market, the knowledge that affects market prices, the knowledge that affects production, consumption, and other phenomena, doesn’t just include the knowledge of 20 Nobel winners. And not only that, but the superior abstract knowledge of Nobel winners doesn’t necessarily include the knowledge of how to do a good job being in charge of the entire country’s money which is used by others of whom they don’t know.

    Maybe some jobs are going to be done poorly no matter who is in charge? Ever considered that possibility? I mean, I don’t think anyone can do a good job being a communist dictator. Maybe being in charge of an economy’s money is up there in the same “Everyone will do a poor job” category, with varying degrees depending on the extent of control.

    I don’t even trust the smartest people who ever lived to do this. I follow Milton Friedman when he said “Money is much too important to be left to central bankers.”

    “As far as the Fed boosting NGDP in the midst of a huge financial crisis–I take it you know nothing about 1933. Is that right?”

    Well, since you asked, no, that’s not right.

    1933 was already well past the financial crisis of 1929-1931. What are you talking about? NGDP plummeted during the financial crisis of 1929-1931:

    http://i.imgur.com/LZLUixR.png

    Yet the Fed inflated quite a bit during that time (by historical standards).

    I could have been as flippant and asked “I take it you know nothing of 1929-1931″, but then I am not a PhD economist with a bug up his arse. Seriously, why are you so hostile? Am I being punked?

  77. Gravatar of Suvy Suvy
    7. February 2013 at 21:45

    “Yay communism is better than fascism?

    Is that it? Talk about low standards!”

    Well, that’s certainly one view. My idea was to do an orderly bankruptcy, but there certainly are valid arguments to say that the entire system should just collapse by itself. I think a method like what Iceland did with their banking system would be appropriate.

    Either way, there are 3 main issues at hand:
    1. Protect prudent savers and those that made good decisions
    2. Liquidate/restructure bad debt
    3. Punish those that made poor decisions and put those that committed fraud in jail
    Now, inflation is a way of wiping out the debt debt in real terms; however, it is also a tax and it also distorts the way that the price system communicates information.

  78. Gravatar of ssumner ssumner
    8. February 2013 at 06:52

    Geoff, I said:

    “Why didn’t they act? Because they were worried about high inflation. It’s true that headline inflation was elevated due the the oil price shock in early 2008, but by the time of the Fed meeting 5 year TIPS spreads showed only 1.23% inflation (a prediction that will eventually prove fairly accurate.)”

    Even if you were 100% correct in all your claims it would have zero bearing on my argument here. None.

  79. Gravatar of Geoff Geoff
    8. February 2013 at 08:29

    Dr. Sumner:

    I vehemently disagree. If there is something to what I said, then it would have all the bearing in the world on your argument there.

    For if oil prices have been spiking since the early 2000s, then there really isn’t any “the” oil price shock of 2008, but rather, 2008 would be just one year in a series of years of which oil prices were spiking, so in that sense, I think it is more clear, to myself for sure, and perhaps to others here, that oil prices did not suddenly spike in 2008 from some normal growth trend lasting decades. It would like saying “the housing bust of Tuesday, November 4th 2008 at 3:35 PM.” OK, sure, house prices were falling around that time, but it would be more clear (to me) to put that fall in a context of a larger period of falling prices.

    For if you agree that oil prices were spiking since the early 2000s, then the “elevated prices” you mentioned would seem to be part of a longer period trend. Elevated prices would then begin to include monetary policy, rather than oil prices specifically (even though higher oil prices can increase prices through cost push inflation).

    Maybe the Fed was worried about price inflation not because of oil price shock of 2008, but because they saw a longer term trend of oil prices rising, and perhaps feared they had something to do with the oil prices AND the final goods prices.

    How can you say this has NOTHING to do with your arguments? I am honestly baffled why you are jealously guarding against what I am becoming more and more convinced is a misleading (unintentionally, probably) explanation of elevated prices in 2008.

  80. Gravatar of Geoff Geoff
    8. February 2013 at 08:48

    Suvy:

    “Well, that’s certainly one view. My idea was to do an orderly bankruptcy, but there certainly are valid arguments to say that the entire system should just collapse by itself.”

    What distinguishes “orderly bankruptcies” from “collapses”?

    Entire system? You mean every single businessman would go bankrupt and every employee would be laid off?

    “I think a method like what Iceland did with their banking system would be appropriate.”

    Iceland let troubled banks fail. That is not the nationalization recommendation you made above.

    You seem to be recommending mutually exclusive alternatives as if they’re interchangeable or similar.

    “1. Protect prudent savers and those that made good decisions”
    “2. Liquidate/restructure bad debt”
    “3. Punish those that made poor decisions and put those that committed fraud in jail”

    These are things I can get on board with.

    “Now, inflation is a way of wiping out the debt debt in real terms; however, it is also a tax and it also distorts the way that the price system communicates information.”

    I think there is some truth to that, and agree, but with one main caveat: Since inflation takes time to affect prices, since not all prices instantly increase by virtue of OMOs, inflation really only helps debtors on the side of their nominal incomes, i.e. if their income rises before, or more than, their expenses (cost of living) rises. It doesn’t help them if their income doesn’t rise as much as their expenses, because then not only do they owe the same nominal debt obligations, but they also incur a higher cost of living.

    For example, if Bernanke inflates, and you have $50k in debt, then only if your nominal income rises will your debt become a lower sized expense compared to your total expenses. Unless you have some special inflation index related debt obligation, your outstanding debt and interest obligations will not be reduced just because Bernanke inflates. Inflation, assuming it does not make your income rise as much as your cost of living, will put you in a deeper hole, because you will pay higher prices for energy, food, clothing, etc, and you will have the same debt obligations.

    Basically, inflation only benefits you as a debtor if you get a raise (if you’re an employee) or a capital gain/dividend/interest income increase that exceeds the increase in your cost of living. If you get a raise but only after prices have gone up, and your raise just puts you back to where you were before in terms of purchasing power, then you’re no better off. Indeed, you incurred a sunk cost and lost in absolute terms.

    Other than that I agree with what you said. I wish more economists would take a more serious look at how inflation could affect the economy’s price structure, for the worse. Every time it’s mentioned, it seems it swept under the rug, minimized, or worse, completely ignored. My guess is that there was an unjustified break of economics into micro and macro, where the market cannot handle the macro side, only wise and Nobel winning economists who believe EMH theory can protect their desires for inflationary and spending control by the state from charges of destructive side effects: “What? You believe the market is so weak, so brittle, so ridiculously unable to accommodate something as little as monetary policy, that monetary policy might have a destructive effect of some sort? Get an education and read up on EMH you fool!”

    Things are in a pretty bad shape right now.

  81. Gravatar of Geoff Geoff
    8. February 2013 at 08:54

    Suvy:

    Just FYI: Please don’t misunderstand my post above to mean I am against central banking. I just do not care about other random people I have never met, to want to help them avoid the costs of inflation by advocating for an elimination of central banking. As long as I am in a position to gain through inflation by more than I lose, as well as my family, and my closest friends and colleagues, then I would consider anti-central bankers to be a threat to my standard of living, even if I am gaining at the expense of others via the state.

    If inflation does distort prices, then I really do not care, provided that these distortions benefit me and my family in some sense. My ideal would be for me to be the sole money issuer. I could finance anything I wanted, buy whatever I wanted, and never have to work for the sovereign consumer ever again. Joy!

  82. Gravatar of Fed Up Fed Up
    9. February 2013 at 17:47

    Suvy, it is funny except that the guy is still working instead of unemployed for being wrong to that degree.

    Price inflation targeting and NGDP targeting both suffer some of the same flaws. They basically ignore the current account deficit, gov’t debt, and private debt. Plus, I am pretty sure they assume real aggregate demand is unlimited.

  83. Gravatar of Fed Up Fed Up
    9. February 2013 at 17:56

    ssumner said: “There are all sorts of ways money can be defined.”

    So I say the term money should never be used and inflation and income should never be used without some sort of qualifier (price inflation, national income, etc.).

    Plus, what should currency plus demand deposits be called? With no commodity standard, I call them medium of account and medium of exchange.

    Lastly, $800 billion in currency, $200 billion in (central bank) reserves, and $6.2 trillion in demand deposits with no commodity standard. Next, bank run happens. How much currency is there now?

  84. Gravatar of Suvy Suvy
    10. February 2013 at 20:14

    Geoff,

    Iceland nationalized the domestic part of their banks; they let the non-domestic parts fail.

  85. Gravatar of TallDave TallDave
    4. March 2014 at 07:51

    “the managing of expectations that really matters”

    Expectations uber alles. That’s going to be the lesson of this era.

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