Archive for the Category Crisis of 2008

 
 

Gavyn Davies on 4 types of shocks

James Alexander pointed me to a fascinating piece by Gavyn Davies in the FT.  In this table, he summarizes the impact of 4 types of shocks on the various markets:

Screen Shot 2015-09-10 at 6.20.33 PMI don’t think those results always hold up (tight money can sometimes reduce real rates) but it’s pretty reliable in most cases.  Davies then argues that in recent months the behavior of markets is most consistent with monetary tightening by the Fed:

There are important conclusions from these charts:

  • The behaviour of US equities since mid 2014 has been impacted on by two supportive shocks, and two depressing shocks.

  • The supporting shocks have been a decline in risk aversion (presumably driven by a drop in the risk of a major crisis in the euro area after quantitative easing by the European Central Bank became likely), and a positive aggregate supply shock from lower oil prices.

  • The depressing shocks have been a significant monetary tightening shock as the Fed has approached lift-off, and more recently a minor negative demand shock that could have stemmed from China or the domestic US economy.

  • These shocks roughly cancelled each other out until May 2015, since when the negative shocks have started to outweigh the positive ones.

  • The sharp decline in equity prices since June 2015 has been mainly driven by a monetary tightening shock, rather than by a negative demand shock from China or elsewhere. This was initially partially offset by a beneficial supply shock from lower oil prices, but in the last couple of weeks this has reversed as oil prices have rebounded.

  • In September, the monetary shock has dampened slightly as Fed speeches have reduced expectations of a September lift off for US interest rates.

This methodology is not infallible so a sanity check is important: does it seem plausible that the model attributes much of the weakness in risk assets to a “monetary shock”? Some people will be sceptical about this, because there has been no increase in US interest rates, and no change in the Fed’s balance sheet in recent months. However, the rise in real bond yields and the decline in break-even inflation rates is clearly indicative of perceived monetary tightening. And indicators of overall financial conditions have clearly tightened. No other shocks can plausibly explain this combination [2].

Furthermore, over the past couple of weeks the timing of the ups and downs in the markets has been exactly what would be expected from the varying signals thatWilliam Dudley, Stanley Fischer and John Williams have given the markets. So this result seems fairly robust.

The most likely inference is that the markets have observed the adverse developments emerging from China, especially the possibility of further devaluations in the renminbi, and have concluded that the Fed would normally ease policy in response to these deflationary risks. Yet the Fed has seemed to be on a pre-determined path to announce lift-off before the end of the year, and has been very reluctant to deviate from that tightening path. This has been interpreted by the markets as a hawkish shift in the Fed’s policy framework.

The case for postponement of lift-off was argued strongly by both Martin Wolf andLarry Summers in the FT yesterday. The Fed will probably heed these arguments. If they do not, financial turbulence could swiftly return.

Great stuff.  Let me just add one point.  Between July and November 2008 there was a shock to the stock market, real bond yields, and TIPS spreads that was almost an order of magnitude bigger than the recent shock.  A huge shock, and according to the model presented by Davies it must have been a contractionary monetary shock.

Funny that everyone thought I was crazy when I first made that claim.

We are making progress if the FT is now publishing claims of a contractionary monetary shock during a period of very low interest rates and a bloated monetary base. Next time another 2008 happens, we MMs won’t be laughed at.  (Even better, this recognition makes another 2008 less likely.)

Still crazy after all these years?

Here’s Alexander Humboldt:

First they ignore it, then they laugh at it, then they say they knew it all along.

In late 2008, I wrote op eds saying that tight money was driving the US into recession. No newspaper was willing to publish them.  Then in early 2009 I started a blog, and people laughed at my claim that money was very tight.  “How can that be, with ultra low rates and all the QE.”  It was difficult to find anyone who agreed with me—until today. Now it looks to me like Paul Krugman agrees with me.  This is from a recent post entitled, “It’s Getting Tighter.”

When thinking about the market madness and its possible real effects, here’s something you “” where by “you” I mean the Fed in particular “” really, really need to keep in mind: the markets have already, in effect, tightened monetary conditions quite a lot.

First of all, if break-evens (the difference between interest rates on ordinary bonds and inflation-protected bonds) are any guide, inflation expectations have fallen sharply:

Why only go back to 2011?  Let’s see what monetary policy was like in late 2008:

Screen Shot 2015-08-26 at 10.58.41 AMNow that’s tight money!

Krugman continues:

Second, while interest rates on Treasuries are down, rates on private securities viewed as even moderately risky are up quite a lot:

So real borrowing costs are up sharply for many private borrowers.

Again, that makes me wonder what real borrowing costs looked like in 2008:

Screen Shot 2015-08-26 at 11.03.12 AM

Now you might argue that this isn’t really tight money.  Good borrowers could still borrow cheaply in 2008.  It was default risk.  Nope, good borrowers couldn’t borrow cheaply, as liquidity had dried up.  How do we know?  While yields on conventional Treasuries fell sharply, the real yield on TIPS soared higher during the second half of 2008.  The 5-year TIPS yield soared from 0.57% to over 4%.  There is no default risk with TIPS, it was purely a liquidity story.  Because of the Fed’s tight money policy, liquidity had dried up:

Screen Shot 2015-08-26 at 11.07.50 AMJust to be clear, real interest rates are not a good indicator of whether money is easy or tight.  But the spike in BBB yields was not just a default risk story; it was also a liquidity story.

Over at Econlog I have a post discussing a related issue, could a quarter point interest rate increase later this year do great harm?

I suppose we attach the label ‘crazy’ to people who believe things that are not socially acceptable and seem irrational.  Now that a Nobel Prize winner is making similar claims, I guess I can’t claim to be crazy any longer.

We all know how it developed.

Matt Yglesias has a post describing how Hjalmar Schacht cleaned up after not one but two monetary policy disasters:

I was reading recently in Hjalmar Schacht’s biography Confessions of the Old Wizard (thanks to Brad DeLong for getting me a copy) and part of what’s so incredible about it are that Schacht’s two great achievements””the Weimar-era whipping of hyperinflation and the Nazi-era whipping of deflation””were both so easy. The both involved, in essence, simply deciding that the central bank actually wanted to solve the problem.

.   .   .

The institutional and psychological problem here turns out to be really severe. If the Federal Reserve Open Market Committee were to take strong action at its next meeting and put the United States on a path to rapid catch-up growth, all that would do is serve to vindicate the position of the Fed’s critics that it’s been screwing up for years now. Rather than looking like geniuses for solving the problem, they would look like idiots for having let it fester so long. By contrast, if you were to appoint an entirely new team then their reputational incentives would point in the direction of fixing the problem as soon as possible.

This reminded me 1936-37, when the Fed made the mistake of doubling reserve requirements.  Late in the year the economy slumped badly, and it was clear that the decision had been a mistake.  At the November FOMC meeting they discussed the possibility of reversing the decision:

“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.)”

This is one of the most chilling statements I have ever read.  The opening sentence is the sort of thing juvenile delinquents say to each other when their prank has gone horribly awry, and they are nervously working on a joint alibi.  An incredible effort at denial runs all through the piece.  First he admits that they raised reserve requirements because “some recession was desirable.”  Then he claims it was just a “coincidence in time” that the downturn followed the reserve requirement increase, even though the express purpose of the increase was to cause a “recession.”  Then he claims that if they reverse their decision it will look like the previous decision had caused the recession.  Then he said that a depression can’t be happening, because there is no good reason for a depression.  Well it was happening, unemployment rose to almost 20% in 1938.  In the end, they decided to stick with the high reserve requirements throughout the rest of 1937.  Reading that quotation one can almost see the perspiration on Mr. Williams’ forehead.

In a recent comment section a Fed employee named Claudia Sahm took me to task for some intemperate remarks I made about the Fed.  I think her criticism was valid.  I should not throw around terms like “criminally negligent.”  I don’t doubt that the vast majority of Fed employees are well-meaning.  Maybe all of them are.  But Matt’s piece reminds me that human psychology is very complex.  We often don’t know why we do things.  Why am I blogging?  Is it the valiant crusade I’d like to believe I’m engaged in, or am I just fooling myself?   (As Robin Hanson would presumably argue.)  Suppose Ben Bernanke had been at Princeton for the past 5 years.  Now suddenly the Fed chairman is “promoted” to Secretary of the Treasury, and replaced with Bernanke.  (As G. William Miller was replaced mid-term with Volcker.)  What would happen next?  My guess is that Bernanke would immediately set out implementing some of the bold policies that he recommended the Japanese adopt back in 2003.

In 2008 the Fed did what the consensus of economists thought they should be doing.  If we could go back in time to the meeting right after Lehman failed, most economists would now say the Fed should slash interest rates sharply (they actually left them unchanged.)  If John Taylor is appointed Fed chairman in 2014, and if aggregate demand is still quite depressed, I very much doubt he’d adopt the tightening of monetary policy that many on the right are now calling for.

Update: Speaking of Robin Hanson, his new post relates to his very issue.  And I also enjoyed this recent post:

For example, to impose punishments bigger than lifetime exile, beat them a bit first.

Some worry about variation in how much people dislike exile. But there is also variation in how much people dislike fines, prison, torture, and public humiliation. The best way to reduce punishment variation is probably to bundle together many kinds of punishment. Maybe fine them some, beat them a little, humiliate them a bit, and then exile them for a while.

In 2006 the US spent $69 billion on corrections, and 2.3 million adults were incarcerated at year-end 2009. A state prisoner cost an average of $24,000 per year in 2005 (source). Why waste all that money?!

Not so much the ideas, but the way they are expressed.  Only an economist can write like that!

Don’t think we don’t see what’s going on here

The Fed is clearly ignoring its dual mandate.  After the last meeting they basically admitted as much:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.

In a previous post, this is how I responded:

We expect to fail, but we’ll keep a close watch on things just to make sure.

Yet the inflation rate is close enough to their informal target that lots of average people are being fooled into thinking the Fed is “doing its job.”  But not the experts.  Here is James Hamilton’s reaction:

In almost identical language that it used November 2, the Fed is saying that it expects unemployment will remain higher than it wants, inflation will likely be lower than it wants, and that it has significant concerns about where events in Europe might lead. In normal times, that trio would surely signal that policy would become more expansionary.

But the Fed opted instead to keep things more or less on hold, again using almost identical language as in its previous statement:

I vaguely recall similar statements made at various times by progressives like Krugman, DeLong, Yglesias, etc.  It’s very clear what’s going on here.

Unfortunately there is a long delay in releasing the minutes from Fed meetings.  When the minutes for the November 1937 meeting were released, we learned that the Fed was almost criminally negligent.  They had doubled reserve requirements earlier in the year.  Now the economy was clearly sliding into a deep slump.  But they did not reverse course.  One governor indicated that if they cut reserve requirements the Fed would be embarrassed, as its previous decision would look incorrect–thus putting his “feelings” ahead of the welfare of millions of cold, hungry and unemployed men and women.

I expect similar revelations from the minutes of the past four years.  Just consider the slump in NGDP between June and December 2008.  There was the August meeting where Fisher voted for tighter money.  The meeting after Lehman failed in mid-September, where the Fed refused to cut rates out of fear of inflation, even as TIPS spreads (correctly) showed 1.23% inflation over the next five years.  The decision to raise the interest rate on reserves to roughly 1% in November 2008, in a successful attempt to keep excess reserves bottled up in the banking system.  All the various decisions not to use their ammunition, despite the obvious need for more demand.

Some will argue the Fed’s doing a good job; that it’s all about low inflation.  Unfortunately, the Fed itself does not agree.  Frequent commenter Benjamin Cole has an eloquent post over at Lars Christensen’s blog.  Here he points out that there’s never been anything magical about 2% inflation:

The United States economy flourished from 1982 to 2007″”industrial production, for example, doubled, while per capita rose by more than one-third””while inflation (as measured by the CPI) almost invariably ranged between 2 percent and 6 percent. That is not an ideology speaking, that is not a theoretical construct.  It is irrefutably the historical record.  If that is the historical record, why the current hysterical insistence that inflation of more than 2 percent is dangerous or even catastrophic?

The Fed has frequently eased monetary policy when inflation was well above 2%, most recently in late 2007 and early 2008.  You might argue that those easings were done in response to fear of a banking crisis.  That’s right, they’re willing to ease to help the banks, but not to help the unemployed.  BTW, employment is part of their dual mandate, banks aren’t.

You might wonder how I can be so sure that the Fed minutes will expose all sorts of embarrassing admissions.  It’s not hard at all, just look at what Fed officials are saying publiclyMarcus Nunes directs us to a recent speech by Richard Fisher.  Here’s a passage he didn’t quote:

My colleague Sarah Bloom Raskin””one of the newest Fed governors, and a woman possessed with a disarming ability to speak in non-quadratic-equation English””recently used the example of the common kitchen sink to illustrate a point. I am going to purloin her metaphor for my description of our present predicament. You give a dinner party. The guests leave and you are washing the dishes. When you are done, you notice the remnants of the party are clogging the sink: bits of food, coffee grinds, a hair or two and the like. You have two choices. You can reach down and scoop up the gunk, a distinctly unpleasant task. Or you can turn the water on full blast, washing the gunk down the drain, providing immediate relief from both the eyesore and the distasteful job of handling the mess. You look over your shoulder to make sure your kids aren’t looking, and, voilà, you turn the faucet on full blast, washing your immediate troubles away.

From my standpoint, resorting to further monetary accommodation to clean out the sink, clogged by the flotsam and jetsam of a jolly, drunken fiscal and financial party that has gone on far too long, is the wrong path to follow. It may provide immediate relief but risks destroying the plumbing of the entire house.

Fisher would have been quite at home on the Herbert Hoover Fed.

Fisher’s speech produces two reactions.  First, how could he be so clueless about monetary policy.  But when you stand back and start to think about what it all means, a second question begins to emerge.  Why are such fools allowed on the FOMC?  How is it that the world’s greatest economic policy institution, the central bank that tends to set the tune for world aggregate demand, is managed by people who are so obviously incompetent?  Let’s see where we can connect the dots:

1.  Stiglitz develops a theory that unemployment is caused by rapid technological change, which makes workers redundant.  This in some mysterious way reduces aggregate demand.

2.  Stiglitz meets with Obama, to offer a Nobel Prize winner’s expert advice on our predicament.

3.  Christy Romer and Larry Summers are horrified to find Obama spouting theories that the unemployment problem isn’t lack of demand, rather it’s ATM machines stealing  jobs.  Christy Romer can’t convince Obama that the Fed still has ammunition.

4.  Obama never pays any serious attention to the Fed.  When the Dems had a filibuster-proof majority in the Senate, he fails to even nominate people for several positions for a period of 18 months.  Even today he is ignoring the problem, several seats remain empty.

The following quotation is from Fisher, but it might just as well have been Stiglitz:

My reluctance to support greater monetary accommodation has been based on efficacy: With businesses’ cash flow””driven by record high profits and bonus depreciation””at an all-time high, both absolutely and as a percentage of GDP; with every survey, including those of small businesses, indicating that access to capital is widely available and attractively priced;[6] with balance sheets having been amply reconfigured; and with bankers and nondepository financial institutions sitting on copious amounts of excess liquidity, I have argued that further accommodation was unlikely to motivate the private sector to put people back to work. It might even prove counterproductive should it give rise to fears the Fed is so hidebound by academic theory as to be blind to the practical consequences of harboring an ever-expanding balance sheet. This inevitably raises concerns we are creating distortions in the fixed income markets that inhibit proper market functioning, or concerns that””despite our protestations to the contrary””we are given to monetizing the government’s debt, an impulse that ultimately destroys a central bank’s credibility.

I have argued that other, nonmonetary factors are inhibiting the robust job creation we all seek.

Monetary policy is one of those areas where the fringe right and the fringe left meet and shake hands.  And right now they are influential enough to prevent the Fed from doing what it knows needs to be done.  Not powerful enough to prevent all action—the Fed will prevent deflation, I have no doubt about that.  But powerful enough to prevent the Fed from fulfilling their dual mandate.  History will see all this very clearly, and judge the Fed harshly.  How ironic after Bernanke promised Milton Friedman that the Fed would never repeat the errors of the Great Depression.  How ironic after Bernanke eloquently spoke out against the passivity of the Bank of Japan (an institution that also cut rates to zero and did massive QE.)

On a positive note, Fisher will be off the FOMC in January.

HT:  Morgan Warstler

Robert Hetzel on liquidity traps and NGDP targeting

Here is Robert Hetzel discussing a Tim Congdon essay on liquidity traps:

If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

What drives the conclusion that the central bank can control the dollar expenditure of the public is that the central bank can conduct monetary policy as a strategy, say, by altering the monetary base and the money stock by whatever amount necessary to maintain nominal expenditure on track. Historically, however, the FOMC has never been willing to communicate its behavior as a “policy” in the sense of systematic procedures designed to achieve an articulated, quantifiable objective (a reaction function). Instead, it communicates individual policy actions such as changes in the funds rate or, since December 2008, changes in the size and composition of its asset portfolio. Just as importantly, it explains those individual policy actions using the language of discretion.

The FOMC Minutes released after each meeting package the current policy action as optimal taken in the context of the contemporaneous state of the economy. As a matter of political economy, the FOMC can then attribute adverse outcomes to powerful real shocks originating in the private sector. In the event of inflation, as in the 1970s, it can blame the greed of powerful corporations. In the event of recession, as in the Great Depression and now with the Great Recession, it can blame the greed of bankers who made excessively risky, speculative bets. From this political-economy perspective, a “policy,” which requires a numerical objective, say, steady nominal expenditure, and an articulated strategy, say, a feedback rule running from a path for nominal expenditure to money creation, suffers two defects.

First, the explicitness of an objective communicates to the political system that the FOMC can take care of a problem that the FOMC considers to have been not of its making. A problem arising as a real shock should possess a solution coming from the political system, for example, through expansionary fiscal policy. Second, an explicit objective, by its nature, highlights misses. As a matter of accountability, however, that is the point. The FOMC must then explain rather than rationalize the miss by defending the miss as a real shock originating in the private sector rather than as arising from faulty policy based on a misunderstanding of the economy.

Hetzel has a new book coming out that will revolutionize the way economists look at the Great Recession, much as Friedman and Schwartz changed the way we look at the Great Depression.  Here is the title:

Hetzel, Robert L. The Great Recession: Market Failure or Policy Failure? Cambridge: Cambridge University Press, 2012.

HT:  David Levey