Losing face

A commenter named Marcus Nunes just sent me one of the most chilling quotations I have ever read, and it was from the minutes of a Fed meeting.  But first a bit of background.  In October 2008 the Fed made the same mistake as in early 1937; they put into effect regulations that increased the demand for bank reserves, just at the moment we were entering a recession.   The 1937 action was actually more justifiable, because the recession was not yet visible.  In both cases many economists made a logical error.  In 1937 they assumed that higher reserve requirements wouldn’t be a problem because banks had lots of excess reserves—forgetting that they held ERs for a reason.  In 2008 most economists focused on interest rates as the indicator of monetary policy, not expectations of future policy actions.  The interest on reserves (IOR) program did not immediately raise rates, but did prevent them from immediately falling to zero.  Much worse, it made future QE much less effective, as markets understood that any future increases in the monetary base would now be held as excess reserves.  

Now the Fed is considering eliminating IOR as a way of stimulating the economy.  Of course if they do that, it will be an implicit admission that the October 2008 action was contractionary in effect, and it will go down in the history books as an even worse mistake than the 1937 RR increase.  Will the Fed be willing to “lose face” and admit its error? 

My wife tells me that the Chinese don’t like to lose face.  I assure her that we don’t have that problem here, Americans have no difficulty in admitting their mistakes and moving on.  But the quotation that Marcus sent me has caused me to re-evaluate my view of Americans.  Could the Fed really put losing face ahead of the well-being of hundreds of millions of Americans, many without jobs?  It seems unthinkable, almost unimaginably cruel, but the following excerpt suggests that it did happen in 1937.  Read it and then I’ll explain why.  By the way, the opening and closing passage are from a paper by Orphanides

On May 1, 1937, the final leg of the tightening was completed. With that in place, excess reserves fell back to levels as low as had not been seen since several years earlier (Figure 4). May 1937 also marked the peak of the incomplete expansion from the Great Depression of 1929-1932. The economy promptly returned to recession. Though the extent of the sharp decline in activity was not immediately evident, by Fall it became fully clear to the Committee that the economy was thrown back to a severe recession, once again. The following evaluation of the situation by Williams at the November 1937 meeting is informative, both for offering a frank admission that the FOMC apparently wished for a slowdown to occur and also for outlining the case that the recession, nonetheless, had nothing to do with the monetary tightening that preceded it. Particularly enlightening is the reasoning offered by Williams as to why a reversal of the earlier tightening action would be ill advised.

“We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. …  In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)”

The Federal Reserve made every effort to build a convincing case that the cause of the 1937 downturn could be more than accounted for by factors other than the monetary tightening and that policy action by the rest of the government and not by the Federal Reserve were needed to restore prosperity.

I suppose someone will say that Williams is denying that the RR increase caused the 1937 depression.  Yes, he’s denying it, but you’d have to be even more naive than me (and that’s a pretty bad insult by the way) to believe he is sincere:

1.  He admits that the policy was intended to be contractionary, indeed intended to cause a “recession.”

2.  By November 1937 it was clear that the “recession” was becoming a depression.

3.  They are discussing lowering RRs as an expansionary device.

4.  Later on when the depression got worse (in 1938) they did lower RRs.

Let’s put him on the couch:

“We all felt, as a result of that, that some recession was desirable”

I.e., it wasn’t just my fault, we all felt that way.

If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn.

Do I even need to comment?

It makes a bad record and confused thinking.

Yes, we mustn’t let the public become “confused.”

I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression

A depression can’t be happening now, because that would mean I was wrong. 

I would rather not muddy the record with action that might be misinterpreted

Muddy the record, or muddy my reputation?

A depression did occur, as NGDP fell roughly 5%.  To give you an idea of just how bad it was, the largest yearly decrease since then was only 1.7%.  BTW, that occurred in 2009, just after the Fed started the IOR.

Although I am generally a non-interventionist, for some strange reason I supported the Iraq War.  (Actually 6 or 7 reasons, none of which seem very good today.)  Sometimes in conversation I will mention how the Iraq War was a mistake, and people will say “But I thought you supported the war.”  And I think to myself, “Yes, and your point is . . . “  Sometimes you just have to bite the bullet, admit your mistake, and move on.

I’ve led a sheltered life.  I wasn’t in the room when Nixon conferred with his advisers after Watergate, or Kennedy met with his legal team after Chappaquiddick.  So I am pretty naive about people.  This transcript was a real eye-opener for me.

You probably think that I’m getting ready to accuse the Fed of being evil if they don’t get rid of the IOR.  I’m afraid my naivete is so deeply ingrained that within days I’ll again be assuming they are well-intentioned civil servants doing the best they can.  You guys are free to draw your own conclusions.


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26 Responses to “Losing face”

  1. Gravatar of JKH JKH
    31. July 2010 at 10:44

    Timely:

    http://macroblog.typepad.com/macroblog/2010/07/some-observations-regarding-interest-on-reserves.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+typepad/RUQt+(macroblog)

  2. Gravatar of Luis H Arroyo Luis H Arroyo
    31. July 2010 at 11:11

    Very good and ilustrative, Scott.
    In discharge of Bernanke and central Bankers, I would to say that they are, as you said in previous post, “conservatives (or reactionaries) well intentioned”. They cannot do other think.
    I know only one capable of risk his prestige: Greenspan. But the end of Greenspan -unjustly condemned by many of his colleagues – is not an stimulus to his succesors, I think.
    Losing face is another cuestion, sure, but people need certainty, not confessions.

  3. Gravatar of Benjamin Cole Benjamin Cole
    31. July 2010 at 11:12

    Well, better a dash of niavete than too much cynicism.

    Yes, losing face is something most people put up there with castration.

    I also initially supported the Iraq intervention–though in my defense, I did not consider it would become a decade-long war/ occupation, and I was lied to (along with all other Americans).

    This was yet another excellent and thought-provoking blog by Sumner.

    I do wonder if the Fed regards the psychic income it receives from zero inflation-deflation to be equal to the real income lost by Americans in obtaining that result.

  4. Gravatar of Silas Barta Silas Barta
    31. July 2010 at 11:34

    Yeah, it’s definitely stupid not to make banks lend when all the lending opportunities are extremely questionable. Obviously, the best way to get the Economy (the god, I mean) jumpstarted is to contort banks’ incentives to the point where they think throwing good money after bad looks like their best option.

    I would *not* want our god to be upset with us.

  5. Gravatar of Bonnie Bonnie
    31. July 2010 at 12:31

    It really is no wonder that payment of interest on reserves was outlawed. I always thought the pundits were crazy when they said deregulation caused the financial crisis. I see the point now. Although it may be different than the point most of them were actually making, it appears to have merit after all.

  6. Gravatar of happyjuggler0 happyjuggler0
    31. July 2010 at 16:51

    Bonnie,

    In some situations, payment of interest on reserves is a wonderful idea. There are times when reducing MV is the right thing to do, and as such IOR is a nice tool to have. Especially when you want to tighten monetary policy without “everyone” noticing what you are doing.

    The problem of course is that at the time that the Fed instituted IOR, what was a more appropriate tool would have been negative IOR. Oh well, millions of needlessly unemployed people, needlessly large amounts of personal wealth lost, and needlessly large amounts of explicit and implicit new national debt are no big deal….

    Cough.

    Please note Bonnie that my rant above was not aimed at you. I’m just venting due to what I’ve learned from Scott since he started blogging.

  7. Gravatar of scott sumner scott sumner
    31. July 2010 at 17:10

    JKH, I saw that, and am working on a response post. All I can say is “bizarre.”

    Luis, Good point. I think Greenspan got too much praise, and now gets much too much criticism.

    Benjamin, I agree.

    Silas, I agree. I oppose all government policies to encourage banks to lend. The Fed should stick to monetary policy, not credit policy.

    Bonnie, Yes it was a bad time to start paying interest on reserves.

    happyjuggler0, That’s right.

  8. Gravatar of woupiestek woupiestek
    31. July 2010 at 22:31

    As long as you don’t admit your mistakes, most people will give you the benefit of the doubt. Sad but true.

  9. Gravatar of Mike Sandifer Mike Sandifer
    1. August 2010 at 03:31

    Scott,

    Are you more open to the idea now that the subprime mess was the result of purposeful neglect by the decision makers in the financial markets?

    And I never believed Iraq had WMD, simply because there was no evidence they did, especially when applying the scientific method. I didn’t think they didn’t have them, I just didn’t know.

    It also occurred to me that Saddam may have been bluffing to keep Iran and Syria at bay, and that he thought the US should be smart enough to pick up on it. It turns out the FBI(?) has concluded that was the case.

    The point is that people have told me the scientific method is impractical to apply to foreign policy, given the often fuzzy nature of threats. However, it is perhaps safe to say that at least in some cases, it can save us from making enormous strategic blunders.

    In the case of Iraq however, readers of the London Times were privy to leaked minutes of national security meetings at 10 Downing at which there was open talk of trumping up evidence to support the invasion. There have been some similar leaks in the US.

    Unfortunately, it is far more often accurate to assume the worst intentions, especially vis-a-vis politicians and too many in corporations.

  10. Gravatar of scott sumner scott sumner
    1. August 2010 at 05:17

    woupiestek, That makes me think of a certain famous blogger.

    Mike, No, because I see no reason why decision-makers would suddenly want to drive their companies into the poorhouse.

    If the banks had sold those toxic bonds to the public, the conspiracy theory might have made sense, but when they bought them back and held them in their own portfolio, that convinced me it was an honest mistake.

    I never believed Saddam had WMD. Governments lied before every war in history, so the fact that lies occur is not very informative.

  11. Gravatar of B.B. B.B.
    1. August 2010 at 09:18

    In fairness, the FDR administration did make mistakes.

    There were large tax increases implemented, notably, on capital and corporate income, which would have raised the cost of capital and reduced projected profits.

    FDR also thought he had achieved his goal of raising the price level back to what it was before the Depression. At that point, no further increases in the price level were considered desirable. That means expected inflation fell from positive to zero, raising the expected real interest rate.

    Finally, FDR moved to greater anti-business rhetoric and attacked business executives by name. Investors had every reason to be nervous.

    We are repeating monetary mistakes, fiscal mistakes, regulatory mistakes, and rhetorical mistakes.

  12. Gravatar of Mike Sandifer Mike Sandifer
    1. August 2010 at 18:38

    Scott, you wrote:

    “Mike, No, because I see no reason why decision-makers would suddenly want to drive their companies into the poorhouse.”

    But, what if the opportunities to do so didn’t exist until some other factors were in place, such as extremely low interest rates, lax regulatory enforcement, or opportunities to fill voids in the market after Fannie and Freddie withdrew some? In other words, the same question would be why weren’t these derivatives merely used irresponsibly previously, as you suggest? It’s not as if mortgage-backed securities were new.

    “If the banks had sold those toxic bonds to the public, the conspiracy theory might have made sense, but when they bought them back and held them in their own portfolio, that convinced me it was an honest mistake.”

    Maybe I’m missing something here, which is perhaps likely, but why wouldn’t padding the financials with these derivatives be consistent with rather narrow selfish gain on the part of decision makers? Afterall, many of these bonds were considered AAA and were rising steadily in value for a whilewhile providing income. Maybe the bankers just didn’t know when to get out, as Greenspan’s suggested.

    I recall you mentioning in the past that perhaps the decision makers wreen’t smart enough to understand the risks their firms were taking, but even a cursory look at the fact they were increasing leverage and lowering lending standards, while pushing arms, makes that claim unkikely in my mind. Sure, maybe many were convinced by esoteric arguments, but is that really the parsimonious explanation?

    In any event, I don’t see these as being resolvable questions.

  13. Gravatar of Lorenzo from Oz Lorenzo from Oz
    1. August 2010 at 22:49

    This post would be improved if it included the actual chilling quote.

  14. Gravatar of scott sumner scott sumner
    2. August 2010 at 04:57

    B.B. Yes to both points. FDR made a lot of mistakes, and we are repeating many of them.

    Mike, I still don’t see why they’d want to drive their companies into the poorhouse, opportunities or not. And they had plenty of opportunities during earlier periods—look at the S&L fiasco of the 1980s.

    You said;

    “Maybe I’m missing something here, which is perhaps likely, but why wouldn’t padding the financials with these derivatives be consistent with rather narrow selfish gain on the part of decision makers? After all, many of these bonds were considered AAA and were rising steadily in value for a while providing income. Maybe the bankers just didn’t know when to get out, as Greenspan’s suggested.”

    First of all, I am pretty sure that Greenspan wouldn’t agree with your interpretation. Why in the world would you want to buy a toxic asset if you didn’t know when to get out. I think you are actually agreeing with me, they couldn’t have known these assets were toxic, it would have been madness to buy them.

    Regarding your last point: The fact that they were increasing leverage doesn’t show they understood the risks, if anything it shows they didn’t understand the risks. They thought housing prices would never collapse, and hence kept increasing their leverage. I am not the one arguing banks are stupid, it is those who claim they knowingly bought toxic assets who are arguing they are stupid.

  15. Gravatar of scott sumner scott sumner
    2. August 2010 at 04:59

    Lorenzo, It is the middle section of the long quotation.

  16. Gravatar of Mike Sandifer Mike Sandifer
    2. August 2010 at 07:19

    Scott,

    It seems to me the S&L crisis was a very different animal for a variety of reasons, including how regulations structured S&Ls. There were very long-term problems that came to head in the late 80s.

    And again, since the real estate derivatives market proved so popular, why weren’t the major firms involved much sooner? Perhaps due to low interest rates, Fannie and Freddie retrenchment, and insufficient government oversight, due in part to reckless deregulation, much of which may have occurred under the Clinton administration?

    And actually, I’m not arguing the banks are stupid, but that the more immediate, more certain short-term gains overcame any desire to properly protect their institutions. Afterall, any institutional manager risked more immediate personal capital losses(stock compensation) and losing their jobs had they not sought to expand their profits and revenues to at least protect market share.

    And when it comes to investors, I find it difficult to believe there was a lack of momentum regarding stock prices within financials, for example, while even institutional investors were loading up on the real estate derivatives that were helping to drive the stock prices higher. Given a lack of understanding of these derivatives among non-specialists, how could they have been said to even have attempted anything like rational analyses? Even depending on rating agencies wouldn’t take away the incentives to buy the stocks of companies profiting from mortgage derivatives.

    And Citing a lack of evidence for stock price momentum over most periods in the past has nothing to do with the run up to the financial crisis. Perhaps this time things were different in this sense.

    Also, risk managers within the major financial sector firms were warning about the risks associated with mortgage derivatives, but were ignored. For example:

    http://www.reuters.com/article/idUSN3024325420100701

    http://www.bloomberg.com/news/2010-06-16/u-s-bank-reform-efforts-lacking-as-risk-managers-overlooked-rossi-says.html

    And more generally, are we really expected to believe that many in the upper eschelons of management believed that real estate prices could rise faster than incomes sustainably? It’s not as if this business was new to most of them, Chuck Prince aside.

    So to my mind, the evidence I’ve seen is much more consistent with the idea that managers of financial firms didn’t care much about the long-term viability of their firms, as the the more immediate net incentives simply didn’t demand it.

  17. Gravatar of Mike Sandifer Mike Sandifer
    2. August 2010 at 07:39

    For a specific example of the deregulation mentioned above, take the case of Brooksley Born, former head of the Commodity Futures Trading Commission. She tried to begin to regulate the markets for what later became toxic assets and was overruled by Congress and President Clinton. She was eventually run out of Washington.

    http://www.pbs.org/wgbh/pages/frontline/warning/view/

    So again, maybe this time really was different in terms of banks having the opportunities to neglect the long term interests of their firms for more immediate and certain gains.

  18. Gravatar of scott sumner scott sumner
    3. August 2010 at 05:25

    Mike, I believe in the EMH, for all sorts of reasons. So I can’t really buy your argument. There is of course a moral hazard problem associated with too big to fail and FDIC, but that wasn’t banks ripping of their shareholders, that was banks ripping of the taxpayers. And even that doesn’t really explain much, as the losses the big banks incurred were many times higher than the TARP bailout’s net cost to taxpayers.

    Stock markets are efficient. It was no secret the big banks were loading up on RE bonds. Everyone knew these bonds represented mortgages made to anyone who could fog a mirror. There was no secrecy here, no conspiracy, it happened in broad daylight and even sophisticated investor like Buffett lost a ton of money. People simply miscalculated.

    I agree that “deregulation” which is a misleading term, as it actually increased the role of the government in banking, was a problem.

  19. Gravatar of Mike Sandifer Mike Sandifer
    3. August 2010 at 09:25

    Well, I appreciate your perspective.

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    Mike, I plan another big EMH post in the fall.

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