Larry Summer is worried the Fed might lose money. If only.

Larry Summers finally has something to say on monetary stimulus.  I think it’s fair to say he erases all doubts as to why Obama had no idea that monetary stimulus was desperately needed in 2009:

What does all this say about macroeconomic policy? Many in both the U.S. and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy inaction to current economic weakness than to overreacting.

However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to undertake with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.

There is also an oddity in this renewed emphasis on quantitative easing. The essential aim of such policies is to shorten the debt held by the public or issued by the consolidated public sector comprising both the government and central bank. Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates – exactly the opposite of what central banks are doing. In the U.S. Treasury, for example, discussions of debt-management policy have had exactly this emphasis. But the Treasury does not alone control the maturity of debt when the central bank is active in all debt markets.

Well at least he sees the need for stimulus.  But have you ever seen a more half-hearted endorsement?  Obvious he suffers from the fallacy that monetary stimulus works by lowering interest rates—he hasn’t read Nick Rowe’s posts on upward sloping IS curves.  That’s certainly forgivable, as Nick’s theory is controversial.  But what’s this concern about the Fed paying high prices for T-debt?  Yes, the Fed could lose some money, but of course the Treasury would gain far more if the economy recovered.  And don’t you recall people making that same argument when the 10 year was at 3.5%?  And then at 2.5%?  Greg Mankiw does:

About a year ago, I pointed out a fashionable trend: Some pundits were saying that long-term interest rates couldn’t go much lower.  Since then, the yield on a 10-year Treasury bond has fallen from 3.18 to 1.65 percent.

The lesson: Don’t try to time the market.

I’m not saying Summers is wrong, I also find it hard to believe the yields will go much lower.  But does anyone really trust the Federal government to consistently out-smart the bond market?

The Fed does have inside information, but I doubt Bernanke had some evil master plan to push the economy into the toilet so that the Fed could profit from falling T-bond yields.   Recall the Fed also bought some riskier debt.  Even so, the Fed has seen enormous profit growth in recent years; from about $30 billion a year, to close to $80 billion per year.  As everyone worries that the Fed is going to lose a fortune, the Fed is making a fortune.  Unfortunately it’s coming at the expense of the real economy.

PS.  Brad DeLong thinks he can outsmart the bond market (from last year):

Greg Mankiw thinks that Google is likely making a mistake by borrowing long now because long-term U.S. interest rates are probably coming down–and it will be cheaper to borrow later  .   .   .

It is certainly true that most of the time when the yield spread is high the way to bet is that long-term bond rates are coming down and long-term bond prices are going up.

But somehow I can’t see U.S. nominal interest rates falling much lower than they are now…

In Mankiw’s first post he singled out DeLong as one of those “pundits who thought rates couldn’t fall much lower, when they were at 3.18%.

HT:  Liberal Roman

Update: Steve sent me the following from Bloomberg, almost too good to be true:

Dec. 18 (Bloomberg) — Anne Phillips Ogilby, a bond attorney at one of Boston’s oldest law firms, on Oct. 31 last year relayed an urgent message from Harvard University, her client and alma mater, to the head of a Massachusetts state agency that sells bonds. The oldest and richest academic institution in America needed help getting a loan right away.

As vanishing credit spurred the government-led rescue of dozens of financial institutions, Harvard was so strapped for cash that it asked Massachusetts for fast-track approval to borrow $2.5 billion. Almost $500 million was used within days to exit agreements known as interest-rate swaps that Harvard had entered to finance expansion in Allston, across the Charles River from its main campus in Cambridge, Massachusetts.

The swaps, which assumed that interest rates would rise, proved so toxic that the 373-year-old institution agreed to pay banks a total of almost $1 billion to terminate them. Most of the wrong-way bets were made in 2004, when Lawrence Summers, now President Barack Obama’s economic adviser, led the university. . . .

Summers, who left Harvard in 2006, declined to comment. As president and as a member of the Harvard Corp., the university’s seven-member ruling body, Summers approved the decision to use the swaps.


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65 Responses to “Larry Summer is worried the Fed might lose money. If only.”

  1. Gravatar of Morgan Warstler Morgan Warstler
    5. June 2012 at 11:31

    CBO’s debt formula breaks!

    http://blog.american.com/2012/06/cbo-massive-rise-in-u-s-debt-crashes-our-economic-forecasting-model-in-2035/

  2. Gravatar of Morgan Warstler Morgan Warstler
    5. June 2012 at 11:35

    Evan Solitas makes my argument for me!

    http://esoltas.blogspot.com/2012/06/feds-chickenhawks.html

    He gets 100% WRONG how the conservative Fed (and Ron Paul) will respond to a far stronger dollar over US History.

    He also has no grip the awesome political effects effects of capping RGDP growth at 4.5% (unless there’s some awesome productivity deflation).

    But still, I’m so glad to see Evan’s mind going down the path mine went down when I started in on Sumner’s thinking.

  3. Gravatar of Saturos Saturos
    5. June 2012 at 11:37

    “Obvious he suffers from the fallacy that monetary stimulus works by lowering interest rates””he hasn’t read Nick Rowe’s posts on upward sloping IS curves.”

    Even worse, he thinks interest rates are the only transmission mechanism.

    Scott, please read this, it is Awesome: http://www.theatlantic.com/business/archive/2012/06/save-us-ben-bernanke-youre-our-only-hope/258037/

  4. Gravatar of johnleemk johnleemk
    5. June 2012 at 11:46

    Saturos, agreed. Ease or ease not, there is no try! Explicit communication of monetary policy goals is key. FDR understood this. There is resounding consensus among economists that FDR’s strong resolve on the devaluation of the dollar is the best thing he did for the US economy at the height of the Depression. Why has Obama failed to take anything from FDR’s playbook when it comes to a key lever of stimulus?

  5. Gravatar of Saturos Saturos
    5. June 2012 at 11:50

    “Why has Obama failed to take anything from FDR’s playbook when it comes to a key lever of stimulus?”

    Didn’t you read the post?

  6. Gravatar of johnleemk johnleemk
    5. June 2012 at 12:08

    Saturos, but all left-leaning economists agree that monetary policy is still effective and must be tried! At least, that’s what all those people over at Marginal Revolution and Mother Jones tell me. Brad DeLong, too.

    Gosh, I just don’t know why Obama is ignoring the economic consensus. Surely it’s beyond the pale that left-leaning economists would have watered down the case for monetary stimulus to the point that hardly any layperson listening to them would grasp the viability or necessity of monetary stimulus!

  7. Gravatar of Saturos Saturos
    5. June 2012 at 12:16

    Well there’s a political consensus that capital taxation is inefficient, do you see Obama paying any heed to that? Obama gets the advice he wants. And I don’t entirely disagree with the characterization of Summers here (though I’m not a massive fan of Kotlikoff’s either) http://bloggingheads.tv/videos/8935?in=08:20&out=19:12 (I think that’s the right segment).

  8. Gravatar of Saturos Saturos
    5. June 2012 at 12:16

    Well there’s an economic consensus that capital taxation is inefficient, do you see Obama paying any heed to that? Obama gets the advice he wants. And I don’t entirely disagree with the characterization of Summers here (though I’m not a massive fan of Kotlikoff’s either) http://bloggingheads.tv/videos/8935?in=08:20&out=19:12 (I think that’s the right segment).

  9. Gravatar of Saturos Saturos
    5. June 2012 at 12:17

    Sorry for the double post, obviously there’s no political consensus on anything.

  10. Gravatar of Saturos Saturos
    5. June 2012 at 12:22

    Matt O’Brien is turning it into a twitter meme: #StarWarsFed

  11. Gravatar of johnleemk johnleemk
    5. June 2012 at 12:26

    Tongue not in cheek any more, but I’ve never been assured by economically literate left-leaners that there is economic consensus about what should be done with respect to capital taxation. On the other hand, whenever I’ve taken them to task for failing to convince the public and policymakers of the importance of monetary stimulus, they get all in a tiff and complain “What are you talking about, we clearly support it! Krugman and DeLong are Bernanke’s biggest critics demanding he do more!”

    Well no effing s***. Then why the heck haven’t the president or the Democratic majority in the Senate done more? Why are all the laypeople reading Kevin Drum and Paul Krugman convinced that the ZLB is insurmountable, and fiscal stimulus is the only possible option? Why is there an obvious political consensus that monetary stimulus isn’t worth spending time or energy on?

    To me, the fact that the median voter of the FOMC remains unconvinced of monetary policy’s ability to address the demand crisis, the fact that the median voter of the Senate remains unconvinced that the Senate should have moved faster than a timeline of years to fill the empty FOMC seats with people committed to monetary accommodation, and the fact that the median voter of the US, if he or she is aware of monetary policy at all, thinks the ZLB is a meaningful barrier to monetary policymaking, are all damning. The economic establishment of the left, if it has tried to move the needle on monetary stimulus at all, has clearly failed.

  12. Gravatar of W. Peden W. Peden
    5. June 2012 at 12:28

    johnleemk,

    “Surely it’s beyond the pale that left-leaning economists would have watered down the case for monetary stimulus to the point that hardly any layperson listening to them would grasp the viability or necessity of monetary stimulus!”

    If Obama thought that a monetary stimulus was necessary, then perhaps he wouldn’t think that fiscal stimulus was so essential. SOMEONE has to be telling Obama that monetary policy has “blown its wad”, and presumably it isn’t Joseph “marginalised” Stiglitz. Therefore, one has to suspect Larry Summers: maybe he wrote a memo to Obama arguing for Keynes’s liquidity trap and Obama just didn’t realise it was a joke; he’s got a subtle sense of humour, ol’ Larry.

  13. Gravatar of Neal Neal
    5. June 2012 at 12:28

    “… monetary stimulus works by lowering interest rates …”
    This seems to be a much more common fallacy than I’d thought. Even in Macro 100 I learned that the interest rate is a price and the Fed conducts stimulus by increasing demand, so that falling interest rates are a byproduct, not cause, of stimulus.

  14. Gravatar of Saturos Saturos
    5. June 2012 at 12:28

    So far I think this is the best one:

    You’ve never heard of Lars Svennson? He’s the central banker who got Sweden’s NGDP back on trend in less than 12 parsecs.

  15. Gravatar of Negation of Ideology Negation of Ideology
    5. June 2012 at 12:30

    Great post. Once again it makes me wish Obama had listened more to Christina Romer.

    And thanks for the link Morgan, that was another great post by Evan Solitas, especially the graph and this:

    “That to me a clear sign that NGDP targeting constitutes hawkish monetary policy. ”

    Wasn’t there a famous quote by someone that there should be no hawks or doves on foreign policy, only eagles? Well, I feel that way on monetary policy. NGDP targeting is hawkish when it’s appropriate and dovish when it’s appropriate.

  16. Gravatar of Saturos Saturos
    5. June 2012 at 12:31

    Neal, where did you go to school?

  17. Gravatar of dwb dwb
    5. June 2012 at 12:40

    if Summer was serious about monetary policy (i mean very serious) he would have told the president to pay for stuff with 2Tn newly minted platinum coins. now THAT would be some monetary policy for the fed to counteract.

  18. Gravatar of Neal Neal
    5. June 2012 at 12:44

    A regional school in the midwest of the US. Why?

  19. Gravatar of Full Employment Hawk Full Employment Hawk
    5. June 2012 at 12:46

    “Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates”

    But the role of the government in the economy is not the same as the objectives of a firm. The objective of the firm is to maximize the wealth of the stockholders. The objective of the government’s economic policy should be to promote the general welfare. When the economy is in a depression, getting it back to full employment should be the highest priority. Therefore the optimal policy for the government with respect to the term structure of its debt should be to give the economy a badly needed stimulus by bringing long term interest rates down (for any given level of expectations).

    If the treasury has been lengthening the term stucture of its debt while the Fed is engaging in operation twist, it is clearly a case of the right hand not paying attention to what the left hand is doing. The two things cancel each other out and operation twist has no stimulative effects on the economy. And the Treasury extending its maturity structure is contractionary. If the clueless Geithner has been doing this, he has been sabotaging the objective of the Obama administration to bring the unemployment rate down.

  20. Gravatar of Full Employment Hawk Full Employment Hawk
    5. June 2012 at 12:52

    “Lars Svennson”

    Clearly instead of reappointing Bernanke, we should have hired him away from the Swedish Central Bank.

  21. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. June 2012 at 13:23

    @Negationof Ideology,
    You wrote:
    “Wasn’t there a famous quote by someone that there should be no hawks or doves on foreign policy, only eagles? Well, I feel that way on monetary policy. NGDP targeting is hawkish when it’s appropriate and dovish when it’s appropriate.”

    That reminds me of the scene in the musical 1776 where Adams, Franklin and Jefferson are fighting over what should be the national bird:

    “John Adams: The eagle.
    Thomas Jefferson: The dove.
    Dr. Benjamin Franklin: The turkey.
    John Adams: The eagle.
    Thomas Jefferson: The dove.
    John Adams: The eagle!
    Thomas Jefferson: [considers] The eagle.
    Dr. Benjamin Franklin: The turkey.
    John Adams: The eagle is a majestic bird!
    Dr. Benjamin Franklin: The eagle is a scavenger, a thief and coward. A symbol of over ten centuries of European mischief.
    John Adams: [confused] The turkey?
    Dr. Benjamin Franklin: A truly noble bird. Native American, a source of sustenance to our original settlers, and an incredibly brave fellow who wouldn’t flinch from attacking a whole regiment of Englishmen single-handedly! Therefore, the national bird of America is going to be…
    John Adams: [insistently] The eagle!
    Dr. Benjamin Franklin: The eagle.”

    With respect to monetary birds, may I propose the pigeon? A homing pigeon can find its way to its target over hundreds of miles through all kinds of weather.

    Ladies and gentlemen, the pigeon!

    @Scott,
    Here’s Steve Williamson’s latest response to Miles Kimball:

    http://newmonetarism.blogspot.com/2012/06/more-on-unconventional-open-market.html

    I thought it was one of the clearest explanations of the differences between a channel and a floor system of monetary policy I’ve ever read. Any comments?

  22. Gravatar of Steve Steve
    5. June 2012 at 13:34

    Larry Summers lost $1 billion for the Harvard endowment betting on a rise in interest rates. I guess he still wants to bet on higher rates by refraining from QE and terming out treasury debt.

    “The swaps, which assumed that interest rates would rise, proved so toxic that the 373-year-old institution agreed to pay banks a total of almost $1 billion to terminate them. Most of the wrong-way bets were made in 2004, when Lawrence Summers, now President Barack Obama’s economic adviser, led the university.”

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaZGpGgHsVGw

  23. Gravatar of Neal Neal
    5. June 2012 at 13:38

    I should add: when we were going over monetary policy in class, I was confused and specifically asked whether the interest rate was the cause of stimulus or a byproduct, and the professor answered that the Fed was increasing the money supply to stimulate demand, and the interest rate decrease was a byproduct.

  24. Gravatar of Steve Steve
    5. June 2012 at 13:42

    Of course what really matters is the unified Fed-Treasury balance sheet. If the Fed buys from the Treasury and profits or loses, that the only affect its remittance back to Treasury.

    I wish you had focused more on the fallacy of Summers’ private sector analogy for macroeconomics: “Any rational business leader would use a moment like this to term out its debt. Governments in the industrialized world should do so too.”

  25. Gravatar of Andy Harless Andy Harless
    5. June 2012 at 13:44

    I don’t think anyone is suggesting that the federal government should try to outsmart the bond market. What they’re suggesting is that the government should take advantage of differences in risk preferences between itself and bondholders. In general long-term debt is riskier for lenders, and short-term debt is riskier for borrowers. At the moment, lenders are apparently willing to take that risk: for some reason (at which I could try to make an educated guess, but that’s not the point), the maturity risk premium is low. (Who can say why various risk premia change over time, but surely they do, and there’s not necessarily anything foolish or irrational about such changes, nor is anyone who takes advantage of them “outsmarting” the market.) The argument is that, if private agents are willing to accept that risk on such favorable terms, the federal government would be rational to transfer that risk to the private sector.

    I basically agree with that argument, as far as it goes. I favor additional Treasury buys by the Fed to the extent that it is (at the margin) the only stimulus option on the table, but it shouldn’t be the only option. A much better idea right now would be for the Fed to take on more default risk, which is being well rewarded by the market, rather than taking on more duration risk.

    But there’s also another thing about outsmarting the bond market. Treasury yields are low in part because the market doesn’t expect policymakers to provide adequate stimulus. (Some will of course disagree, but at these yields, it’s pretty obvious to me that Nick is right about the upward-sloping IS curve.) If the Fed buys Treasuries, or if the Treasury refuses to issue long-term bonds, they are betting on the failure of their own macroeconomic management. They will come out ahead financially if their policies fail. It’s like compensating managers with put options instead of call options. It makes a lot of sense to say that the government should take advantage of low yields when it is in a position to render such actions advantageous. And it also sends the right signal. This is another reason why I think the Fed should be buying default risk instead of duration. Default risk is a call option on the Fed’s macroeconomic management rather than a put option.

  26. Gravatar of Steve Steve
    5. June 2012 at 13:48

    Let me clarify my last Summers criticism:

    “Any rational business leader would use a moment like this to term out its debt. Governments in the industrialized world should do so too.”

    Substitute “repay” for “term out”. Does Summers believe in radical austerity, too? Is Summers really advocating that governments should do what business leaders do? The Summers piece was unspeakably bad, I’m really speechless.

  27. Gravatar of dwb dwb
    5. June 2012 at 13:48

    you can ble summers, but with idiots like this on the FOMC, there is plenty of blame to share.

    yes,lets pocket those low yields. its Pirate Day aarrrgh:

    http://mobile.bloomberg.com/news/2012-06-05/fed-s-bullard-says-jobs-slump-hasn-t-changed-economic-outlook?category=%2F

    “One possible FOMC strategy is to simply pocket the lower yields and continue to wait-and-see on the U.S. economic outlook,” Bullard said. While Europe’s turmoil is driving global problems, “a change in U.S. monetary policy at this juncture will not alter the situation in Europe.”

  28. Gravatar of dwb dwb
    5. June 2012 at 13:49

    ^^ blame Summers

  29. Gravatar of Morgan Warstler Morgan Warstler
    5. June 2012 at 13:49

    Negation,

    The point is only the whole since X, NGDPLT is a far more hawkish disciplinarian then we have had before.

    This is the KEY selling point for a huge swath of voters.

    FINALLY! We will whip inflation for good!

  30. Gravatar of Tommy Dorsett Tommy Dorsett
    5. June 2012 at 14:04

    Summers’ hodgepodge Keynesian reasoning (lower rates=easier money) is as pitiful as it is painful. If the Fed succeeds in lifting expected future NGDP, rates should move back to 3-4% on the long end and the 30yr/2yr spread should widen. Just the opposite of what Sumners would define as success.

    P.S. I heard Stiglitz on Bloomberg radio today arguing that capital should be taxed at dramatically higher rates and that taxes should apply to gains before they are even realized. And then he had the audacity to argue this would boost economic efficiency! Summers-Stiglitz, the economic dream team from effing hell.

  31. Gravatar of dtoh dtoh
    5. June 2012 at 14:24

    “You’ve never heard of Lars Svennson? He’s the central banker who got Sweden’s NGDP back on trend in less than 12 parsecs.”

    FWIW, the author either doesn’t know the definition of a parsec or else thinks that Lars Svennson is a lousy central banker.

  32. Gravatar of Mike Sax Mike Sax
    5. June 2012 at 14:25

    “I thought it was one of the clearest explanations of the differences between a channel and a floor system of monetary policy I’ve ever read. Any comments”

    Yeah I got to say I was impressed by Williamson too. I never really got him before other than he seems to have a pathological hatred for Krugman-for attacking Macro back in 2009 for missing crisis-yet at the same time Williamson claims to be a big Obama supporter. Then it seemed that he was an inflation phobe.

    Though it turns out this was last year he now doesn’t see inflation as a likely threat now. So because of all this I could never figure him out. But reading him a bit more I’m beginning to see he has a lot to offer even if he is kind of eccntric and runs on about Krugman too much.

  33. Gravatar of ssumner ssumner
    5. June 2012 at 14:27

    Morgan, Soltas is great.

    Saturos, That’s going into my next post, in about an hour.

    johnleemk, Heh! I used that Yoda quote a year ago!

    Neal, I’d say they are a symptom of monetary stimulus (fiscal stimulus raises rates.) But yes, I agree.

    Negation, I have often argued that there should be no hawks and doves on monetary policy.

    FEH, Exactly.

    Mark, Two comments:

    1. If Williamson believes in liquidity traps, why in the world does he call himself a “monetarist?” Not believing in liquidity traps is pretty much the definition of monetarism.

    2. If he thinks QE doesn’t work, how does he explain the huge impact of rumors of QE on the asset markets?

    Steve, Great, I’ll have to add that!

    I thought I did criticize that analogy, but maybe not explicitly enough.

    Andy, Good comment. I didn’t even get into the deeper questions of how far off course Summers really is, I was tacitly assuming he was on the right track, and showing the implication of his argument. He was actually on the wrong track. I don’t think the Fed should add any sort of risk (duration or default), I’d like to see a much smaller balance sheet and a much higher NGDP growth target, like Australia.

    dwb, That’s depressing.

  34. Gravatar of ssumner ssumner
    5. June 2012 at 14:29

    Tommy, Unrealized cap gains taxes? That’ll be a big voter winner for the Dems when house prices start rising again.

  35. Gravatar of dtoh dtoh
    5. June 2012 at 14:55

    The liberals haven’t been pushing monetary policy very hard because:

    A) If monetary policy works there is no need for fiscal stimulus
    B) If there is no need for fiscal stimulus, the likelihood of bigger government is close to zero.
    C) Bigger government is a central goal of liberals. Ergo they can’t /won’t push monetarism.

    This is so self-evident it’s not even worth thinking about. The bigger questions is how to sell market monetarism to conservatives/Republicans. They’re going to be the ones making decisions after November.

    The less support there is from the liberals for market monetarism, the easier it will be to sell it to the conservatives, and the more likely it will be to actually get implemented.

    DeKrugman are not stupid. Within a couple of months, they’ll realize Obama is doomed and start thinking about political/ideological redemption. At that point, they will be all over market monetarism like leeches so they can either use it as a hammer against the Republicans or claim credit if it’s actually adopted.

    Scott, stop seeking support from the liberals. Instead encourage them to continue to paint themselves into their fiscal stimulus corner.

    I suspect a lot of smart conservatives economists have been keeping mum on market monetarism because they don’t want to give Obama any hints on how to save himself. Once November rolls around they will be an easy sell especially since they won’t have to worry about the Ron Paul brand of economic know-nothingism for another four years.

  36. Gravatar of Jim Glass Jim Glass
    5. June 2012 at 14:59

    Speaking of unanticipated moves in interest rates (and in inflation expectations)…

    http://soberlook.com/2012/06/tips-curve-has-inverted.html

    The US inflation indexed treasury curve (TIPS curve) has inverted sharply in the short end. The one-year TIPS yield went from negative 2.5% to zero in a matter of four months. The one-year treasury (nominal) yield on the other hand has held fairly steady near zero (between 12bp and 20bp over the past 4 months).

    That means that the market is now pricing near zero percent inflation over the next year (down from over 2.6% expected just 4 months ago!) – as near-term inflation expectations collapse.

    Is the Fed is about to give us a second leg to the Great Recession, 1937 redux?

    Ben promised Milton he wouldn’t do it again. Looks like he had his fingers crossed and his nose has grown a couple inches.

  37. Gravatar of dtoh dtoh
    5. June 2012 at 15:07

    “Tommy, Unrealized cap gains taxes? That’ll be a big voter winner for the Dems when house prices start rising again.”

    Could be. As long as you lower the rate to reflect the fact that people are paying sooner, and make a provision for negative taxes so that if someone makes a bad bet on a Florida condo or on the stock market, they’ll get an annual check from Uncle Sam.

  38. Gravatar of happyjuggler0 happyjuggler0
    5. June 2012 at 16:08

    Regarding the Harvard swaps issue, I think it is egregiously unfair to blame Summers for the losses. He put the position on in 2004 when it was a reasonable position, and he was booted out in 2006. Once someone else was in charge, the blame properly accrues to her, especially for waiting three years to unload or hedge the position.

    Think in terms of mutual funds as an analogy. Imagine a mutual fund manager for XYZ Fund buys home-builder equities for the fund in 2004. He then leaves the fund in 2006, when a new manager takes over the fund. The new manager then sells the home-builder equities at a massive loss in 2009.

    Who is to blame for the massive loss, the person who initiated the position at a time when it made sense, or the new person who held onto the position long after it made economic sense to hold it?

  39. Gravatar of dwb dwb
    5. June 2012 at 16:12

    i find it tremendously amusing when people “pay” to exit an interest rate swap. *especially* PhD economists. its like swapping one bond for another at the market price: the only guy who makes money is the I-Bank that prepared that 48 page deck. lol. remember the line from the original Willy Wonka movie where Wonka rolls his eyes and the kid and mutters “no, stop, dont.” been there, done that.

  40. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. June 2012 at 16:28

    @Jim Glass,

    Here’s another post on the strange goings ons in the TIPS market:

    More on the Recent Anomaly in the Real Term Structure of Interest Rates – David Glasner

    “In this context what is striking about the recent anomaly in the real term structure of interest rates is the steepness with which the difference between the yields on the 10- and the 5-year TIPS has been falling. The drop seems steeper than any but the one that started around October 6, 2008, three weeks after the failure of Lehman Brothers, but the day on which the Fed announced that it would begin paying interest on reserves. By the end of October, the difference between the yields on the 10-year and 5-year TIPS had fallen by over a percentage point. Since May 3, the difference between the yields on the 10-year and 5-year TIPS have fallen 37 basis points, so we are clearly not in a panic. But the signs are disturbing.”

    http://uneasymoney.com/2012/05/30/more-on-the-recent-anomaly-in-the-real-term-structure-of-interest-rates/

  41. Gravatar of dwb dwb
    5. June 2012 at 16:30

    @happyjuggler0
    Who is to blame for the massive loss, the person who initiated the position at a time when it made sense

    no, that is not a good analogy. lets see of i can explain. perhaps its a bit complex for a blog post, but an interest rate swap is an exchange of (basically) a fixed-rate payment for a floating rate payment. lets say floating rates are expected to be 1% and 2%, then the fixed rate will be (about) 1.5% (the average of the floating rates).

    there are perfectly good reasons for swapping: lets say you only can borrow 3 months at a time, but want to lock in 5 year financing. Or, lets say you can only borrow for 5 years, but your assets have a maturity profile of 2 years. swaps let you “maturity match.” Or, lets say you are building a big building and you want to “lock in” the cost of financing it until its built (banks might only gove you project finance or a credit line until its mostly completed and credit lines are often variable rate deals). There are good reasons why people want to smooth their cashflows.

    At inception, the fair value of the fixed and floating side are the same, and you have a 50% change of being “right” meaning there is a 50% chance rates will go up, a 50% chance rates go down.

    Now, suppose time passes. rates are different. The floating side is worth more or less than the fixed side (the net present value of the swap is no longer zero). hopefully, if you are maturity matching/hedging the PV of the swap is offset by the PV of whatever you have offset.

    However, when it comes to “unwind” the swap or exit it, its too late to “pay” to exit it. You can either pay *now* or pay over time. If you pay now, you are paying the present value of the same amount you would otherwise pay over time except Goldman Sachs has kindly also added a hefty fee to do the additional cancellation.

    If they were using it to finance something, i have no idea whether it was a “bet” on rates or not (maybe the losses on the swaps offset the theoretical gain on the bond they issued at lower rates, so effectively they locked in their financing when they did the swaps, not when they issued the bonds), although I would not bet against Summer making a rate pley. wild-eyed brilliant people are well known for thinking they can beat the markets. and no i am not naming names.

  42. Gravatar of Morgan Warstler Morgan Warstler
    5. June 2012 at 16:34

    “This is so self-evident it’s not even worth thinking about. The bigger questions is how to sell market monetarism to conservatives/Republicans. They’re going to be the ones making decisions after November.”

    This is perhaps the meanest thing anyone has ever said to me, but I shall endeavor to keep my upper lip stiff.

    dtoh, selling NGDPLT to conservatives is the only thing I think about.

    Because:

    1. they are the only group that matters (talk to them like this).

    2. just as NK increases govt. NGDPLT DECREASES government with the same gusto.

    It is very hard for me to imagine a 4.5% LT that doesn’t both FREEZE GOVT. SPENDING (outside of entitlements) in REAL TERMS and force it into productivity gains (firings) to pay the surviving public employees more.

    NGDPLT will do more damage to unions than Scott Walker, it will be RELENTLESS.

    3. NGDP futures weakens the masters of the universe ties between Wall Street and DC. psst… I would not be surprised if Rand Paul endorsed it.

    4. “Since 1980 your dollar would be worth X% more under 4.5% NGDPLT!”

    5. Nothing is going to sell it to conservatives more than watching DeKrugman SCREAM NOOOOOOOOO!!!!

  43. Gravatar of happyjuggler0 happyjuggler0
    5. June 2012 at 16:58

    dwb,

    I’m sure most of the readers here will be glad with your explanation. However the point I am making is that after Summers left, the entirety of Harvard’s portfolio became someone else’s responsibility. One can reasonably blame Summers if something blew up in the first couple of weeks before they had time to exit positions or hedge them, but after that in no way can Summers be held to blame.

    I also have no idea if Summers was really hedging Harvard’s real estate development position(s) or if he was merely speculating on interest rates.

    If he was speculating on interest rate direction, then it was a relatively simple matter to hedge away the position immediately if the new person didn’t like the speculative bet.

    If it was the former however, then things become more complicated. However she could still have shorted commercial REIT’s while also hedging away the swaps position, for an imperfect (due to the REIT[s] in question not being a perfect hedge against an illiquid development project) hedge of the whole shebang. Such a hedge would have made money on the short REIT position which would have made up for some or all of the real estate loss Harvard suffered, depending on how large the short had been.

    However as near as I can tell, both Harvard’s new President, and their new portfolio manager (or CFO?, I’m too lazy to look up her actual title) did absolutely no damage control as losses started occurring. They simply held onto positions that were hemorrhaging, at for that they can in no way, shape, or form blame Summers for, noting that the article says they dumped their swaps position three years after Summers had left.

    And *that* is the point of my analogy, that the new management deserves the blame for the piss poor risk control that turned a formerly reasonable position into a massive disaster.

  44. Gravatar of anon anon
    5. June 2012 at 16:59

    dtoh, it makes no difference either way. If liberals adopt market monetarism, then they’ll be forced to shed much of their big government advocacy and move closer to neoliberalism, which is a very good thing from a long-run policy-making POV. Conservatives will then find it very easy to jump on the bandwagon, since macro policy will no longer be an ideologically-painted issue.

    If liberals don’t adopt MM to a significant extent, then small-government folks can easily paint their proposals for stimulus spending as outdated and unscientific. Appearances aside, market monetarists are not merely seeking “support” from prominent liberal economists: they are also challenging current policy choices in a very clear and pointed way.

  45. Gravatar of Morgan Warstler Morgan Warstler
    5. June 2012 at 17:11

    Clinton tosses Obama under the bus on Bush Tax Cuts, backs up over top of him:

    http://www.cnbc.com/id/47693595

  46. Gravatar of StatsGuy StatsGuy
    5. June 2012 at 17:43

    I think the title of this post is your answer to a previous post:

    “Where did Obama get the idea that fiscal stimulus was the only answer?”

    Answer – the big blustery bombastic fool who always thinks he’s the smartest fellow in the room.

  47. Gravatar of dwb dwb
    5. June 2012 at 18:00

    @happyjuggler0

    There is some really bad reporting in this Bloomberg article you have to cut through. Reporters *always* write “bet” and “interest rate swaps” together kinda like “oil futures” and “speculators.”

    Setting this aside, it says:

    In 2004, Harvard used swaps for $2.3 billion it planned to start borrowing four years later. The AAA-rated school would have paid an annual average rate of 4.72 percent if it had borrowed all the money for 30 years in December 2004, according to data from Municipal Market Advisors. The swaps let it secure a similar rate for bonds it planned to sell as it constructed the campus expansion during the next two decades.


    While the university could have paid banks for options on the borrowing rates, the swaps required no money up front.

    I don’t know who Peter Shapiro is but forward starting swaps are pretty plain vanilla, ok maybe not “plain” vanilla but “french” vanilla, certainly not even close to exotic. I bet i could call around and get 10 quotes for these before noon in 4 currencies.

    Yes: this is a trap many executives fall into pay up front for options vs no-upfront payment for the swap.

    So, as a risk manager, three key questions in 2004 on this swap:
    1. what is the probability they complete the project on time and finance the debt as expected.
    2. is this a reasonable hedge (swap rates are only one component – there is also credit spreads)
    3. liquidity risk – the banks are going to call for collateral if the swap goes against them.

    I cannot comment on #2, but they were looking to lock in 4.62% so any losses on the swaps would have offset the lower coupon on the debt.

    Now #3 is what bit them:

    Harvard’s failed bet helped plunge the school into a liquidity crisis in late 2008. Concerned that its losses might worsen, the school borrowed money to terminate the swaps at the nadir of their value, only to see the market for such agreements begin to recover weeks later.

    Although the contracts required Harvard to post collateral, or set aside cash when the values reached certain thresholds, such provisions weren’t unusual, Rothenberg said.

    the real issue was not just #3, the liquidity issue: the real issue is that the asset value of the fund plunged 30% and they needed to post collateral at exactly the wrong time, when the markets were plunging!

    I don’t like Summers, but i would say the real fault is not failure to monitor this swap (they were watching it), but overall the fault seems to be not being mindful of liquidity risk (lots of companies got hammered, so this was not unique to Summers or Harvard).

    I would not agree that they should have taken action when the losses were “hemorrhaging” The idea of a hedge is that if the hedge loses money, the offsetting thing gains (in this case, markets rates are lower and they issue lower coupon debt). the fact of life is hedges “hemorrhage” 50% of the time.

  48. Gravatar of Major_Freedom Major_Freedom
    5. June 2012 at 21:31

    The Fed does have inside information, but I doubt Bernanke had some evil master plan to push the economy into the toilet so that the Fed could profit from falling T-bond yields. Recall the Fed also bought some riskier debt. Even so, the Fed has seen enormous profit growth in recent years; from about $30 billion a year, to close to $80 billion per year. As everyone worries that the Fed is going to lose a fortune, the Fed is making a fortune. Unfortunately it’s coming at the expense of the real economy.

    I think the Fed loves booms AND busts. Booms because they like to take credit for when times are good, and busts because they can inflate more than they otherwise could have when times are bad, because prices won’t rise as much. A depression is the ideal time to print zillions of dollars to finance a war. Prices will be contained, but the state can soak more wealth from the economy.

  49. Gravatar of Prakash Prakash
    5. June 2012 at 23:09

    A liquidity trap based set of questions.

    Do the standards to start a new bank change during a depression?

    Why aren’t pension funds creating new banks and borrowing at nearly zero rates to outbid loan sharks? Consumer loans are almost a perpetual business and properties must be available at better prices nowadays.

    Is it only because the Fed has not declared a NGDP target?

  50. Gravatar of Saturos Saturos
    6. June 2012 at 00:36

    dtoh, according to Wikipedia: “On the A New Hope DVD audio commentary, Lucas comments that, in the Star Wars universe, traveling through hyperspace requires careful navigation to avoid stars, planets, asteroids, and other obstacles, and that since no long-distance journey can be made in a straight line, the “fastest” ship is the one that can plot the “most direct course”, thereby traveling the least distance.”

    That makes sense, given everything Scott’s been saying.

    New favorite:

    Matt O’Brien“Krugman never told you what happened to Bernanke.” “He told me you killed him.” “No, I AM Bernanke.” “NOOOOOOOO” #StarWarsFed

    amaeryllis calls it “the single nerdiest hashtag of all time”.

  51. Gravatar of ssumner ssumner
    6. June 2012 at 05:28

    dtoh, God help us if your cynical view is correct, it means there’s no hope for America–as the GOP certainly can’t save us. Unfortunately you may be right.

    And that cap gains tax would be insanely unpopular. People would have to sell investments (and homes) to pay the tax.

    Jim Glass, Inflation will fall, but probably not to zero. Part of that is falling oil prices depressing headline inflation.

    happyjuggler0, If it really was a hedge (as you suggest) Harvard would not have lost money. But you may be right in the sense that it started out being a hedge, and then Harvard re-arranged its affairs so that it wasn’t–I can’t say.

    Summers forgot that rates are highly correlated with NGDP growth, and hence Harvard resources from donations. That’s because he doesn’t read The Money Illusion.

    Mark, I saw that–perhaps spreads tend to get compressed as all rates fall toward zero.

    Statsguy, That’s right.

    Prakesh, Just because rates are low doesn’t mean it’s a good time to start a bank–as lending rates are also low, and risk is higher.

  52. Gravatar of Morgan Warstler Morgan Warstler
    6. June 2012 at 05:55

    “as the GOP certainly can’t save us.”

    The right has been saving us since 1980.

    On Wisconsin!

    I’m thinking the apt metaphor is Scott Walker is Batman and Scott Sumner is Robin.

    Walker is an imperfect character, certainly isn’t the standard bearer for conservatism, but in that way he’s the Lonely Blogger from Bentley College.

    —–

    And that’s our bet Scott, if Obama wins, the you are Batman and Walker is Robin.

    If however Obama loses… then I’m right, and monetary is just the handmaiden of the capitalists.

  53. Gravatar of TallDave TallDave
    6. June 2012 at 07:00

    It’s surprising that so many highly placed people seem to think monetary policy begins and ends at interest rates.

    On dtoh’s point, I think if the GOP wins they could be sold on using NGDP targeting to shrink gov’t spending and debt, as I mentioned in the other thread. You won’t get the Tea Partiers to sign on to this idea en masse, but Romney is an extremely bright guy who actually has some understanding of how a private economy works.

  54. Gravatar of Peter N Peter N
    6. June 2012 at 08:37

    “Obvious he suffers from the fallacy that monetary stimulus works by lowering interest rates””he hasn’t read Nick Rowe’s posts on upward sloping IS curves. That’s certainly forgivable, as Nick’s theory is controversial.”

    Part of the problem is that the Fed does conduct monetary policy through interest rates when it’s not at the lower bound. It sets the discount rate and declares a target for the federal funds rate. A number of interest rates are specified relative to the federal funds rate.

    Of course lowering the discount rate is also a signal, and it’s hard to disentangle the effects. You can see that if you don’t understand why things are different now, you might think the Fed couldn’t do anything.

    I think Bernanke is trying to keep his powder dry for a Euro blowup. If he did a big QE and then had to fund a Euro rescue he might not have the support to make the balance sheet so big. Europe needs to get another 2 trillion euros from somewhere. There are a very limited number of somewheres.

  55. Gravatar of Saturos Saturos
    6. June 2012 at 12:37

    John Cochrane seems to agree with Summers
    http://johnhcochrane.blogspot.co.uk/2012/06/i-almost-agree-with-summers.html

  56. Gravatar of Saturos Saturos
    6. June 2012 at 12:38

    Meanwhile Mankie, after quoting Summers earlier is now endorsing Barro’s politicized New Classical line (he’s advising Romney) http://gregmankiw.blogspot.com.au/2012/06/barro-on-slow-recovery.html

  57. Gravatar of Cthorm Cthorm
    6. June 2012 at 14:19

    Meh – I wouldn’t tar and feather Summers over the IRSW loss either. Although it’s pretty foolish to get into such a longterm contract (sounds like a 5 year IRSW) without actively managing it. I’m not going to name names, Google could definitely answer, but there were other prominent people leading the Harvard Endowment from 2006-2007 when Summers got kicked out. Again though, even in 2007 the IRSW bet wasn’t horrible, but they should have looked into closing out the position or opening an inverse agreement. Should we really blame investment managers for not forseeing another Fed-induced collapse?

  58. Gravatar of orionorbit orionorbit
    6. June 2012 at 14:50

    Summers misses that monetary stimulus at this point does not (mainly) work through encouraging business to invest (which is really not that relevant given the excess capacity). If monetary stimulus is “convincing” it works by raising inflation expectations, so that if I am anticipating that inflation will erode the value of my savings (say 100K that I have put in a money markets account to buy a home) I am more likely to spend it and even apply for a loan in order to profit from today’s prices, or buy some other kind of good or service and thereby use some of the economy’s excess capacity.

    But even if it fails to raise inflation expectations, QE also works by “cornering” the bonds market, so in CAPM language, QE where the fed buys long dated bonds (i.e. as low beta bonds as possible) works by diminishing the expected return of safe paper and leading investors to riskier portfolios (such as those that include real estate). The portfolio frontier “rotates downwards” and the weights of the assets in the market portfolio shift towards riskier assets.

    Luckily, Bernanke understands all this.

  59. Gravatar of dtoh dtoh
    6. June 2012 at 15:56

    Morgan,

    dtoh, selling NGDPLT to conservatives is the only thing I think about.

    I know that’s why I said it’s the important question. What is self-evident is the liberal thought process…not worth thinking about.

    NGDPLT will do more damage to unions than Scott Walker, it will be RELENTLESS.

    Nothing is going to sell it to conservatives more than watching DeKrugman SCREAM NOOOOOOOOO!!!!

    DeKrugman are not stupid. They will not scream no. They will spin and say “we told you so…we’ve always been in favor of a more accommodative monetary policy.”

    Agree but only with a low enough NGDPLT that you have little inflation. However, get rid of inflation and I think it makes it harder for the private sector to reduce real wage costs when they need to adjust….and not just when you have a nominal shock.

    NGDP futures weakens the masters of the universe ties between Wall Street and DC.

    Disagree. They way to weaken Wall Street is to get rid of the implicit TBTF guarantee and replace it with an explicit guarantee and stricter asset/equity ratios for banks.

  60. Gravatar of Morgan Warstler Morgan Warstler
    6. June 2012 at 17:32

    When the Fed and her satellites do not primarily deal in Treasuries as the method of moving the dime, but instead in a system more like Forex…

    Having insight into govt. GDP numbers will be considered insider trading. 🙂

    I’d personally like to simply remove FDIC from all but Local Mutual banks – there won’t be TBTF then.

    Little guys will cheer when big guys eat it.

  61. Gravatar of Max Max
    7. June 2012 at 00:59

    There a couple things wrong with Summer’s article:

    1) Use of “negative feedback” to mean “undesirable positive feedback”.

    2) His argument (while correct) is strictly microeconomic, and doesn’t remotely address our actual (macro) problems.

  62. Gravatar of ssumner ssumner
    7. June 2012 at 11:23

    Talldave, Let’s hope so.

    PeterN, There’s some truth to that.

    Saturos, That’s an odd alliance.

    Cthorm, You said;

    “Should we really blame investment managers for not forseeing another Fed-induced collapse?”

    We should blame them if they say they are hedging, and they are actually speculating. We should blame them if they claim to be financial experts and don’t understand that deeply plunging nominal yields on government debt imply a severe recession.

    orionorbit, Good comment.

    Max, Good point.

  63. Gravatar of Saturos Saturos
    7. June 2012 at 11:33

    orionorbit, funny, Scott has previously criticized that approach to QE (cornering the market), or “Qualitative Easing”.

  64. Gravatar of orionorbit orionorbit
    7. June 2012 at 17:22

    Saturos, yes, I criticize it too, in the sense that it’s not really what QE is about (i.e. creating enough inflation expectations to stabilize AD).

    That said there are some by-products of QE such as relatively profits for the FED the get credited to the gov’t and also the move in the portfolio frontier (market cornering is used VERY loosely here) which normally are negligible. However, if the fed fails to convince the market that it’s serious about easing enough to close the GDP gap, and thus does like Bernanke-FED with QE little by little, it will eventually amass enough inventory to corner the market, which means that investors have to take more risk than they otherwise would simply because there aren’t enough safe assets around.

    But the fed shouldn’t have to even go there. In a perfect world where the market believes the fed will credibly stick to its GDP gap target no matter what, the fed doesn’t need to buy one dollar worth of bonds, all it needs to do is tell the market that it has a more pessimistic forecast of the economy.

  65. Gravatar of Major_Freedom Major_Freedom
    8. June 2012 at 06:50

    Max:

    His argument (while correct) is strictly microeconomic, and doesn’t remotely address our actual (macro) problems.

    There is no such thing as macro-economic problems that aren’t in reality micro-economic problems.

    All macro-economics that claim to be independent of micro-economics is either wrong, or a misguided understanding of micro-economics.

    You show me ANY macro-economic “problem”, and I’ll show you that you’re really talking about micro-economic phenomena.

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