Should we laugh or cry?

From today’s WSJ:

But excess reserves have surely made banks feel safer, something backed up by history. The Fed’s moves to trim excess reserves in the late 1930s, by raising minimum requirements, arguably helped create another economic downturn. “The Fed apparently wasn’t aware that banks wanted to hold these reserves,” says Paul Kasriel, economist at Northern Trust. “The result was that banks started to cut lending.”

The current Fed has extra tools to avoid such mistakes, such as the ability to pay higher interest on excess reserves to keep them dormant if necessary.

More and more I think this whole crisis was caused by mysterious bout of mass stupidity.

PS.  I suppose calling the whole world stupid, is well. . . kind of stupid.  So just treat this as a cry of frustration.



31 Responses to “Should we laugh or cry?”

  1. Gravatar of Doc Merlin Doc Merlin
    30. November 2009 at 10:01

    “More and more I think this whole crisis was caused by mysterious bout of mass stupidity.”
    Heh, couldn’t have said it better. We had what amounted to coincidence of stupidity in what amounted to SIX separate government groups.

    1. The fed’s policies which have been talked about here before.
    2. Agriculture/energy policy (biofuels subsidies, new restrictions on land use etc) which caused a massive global food price spike.
    3. Fanny Mae and Freddy Mac’s behavior towards subprime
    4. The Strategic Oil Reserve continuing to buy oil when the oil price was phenomenally high and rising (which helped push up the price.)
    5. A roughly 40% increase in the minimum wage.
    6. A rules changing capitalization requirements for banks made banks that were fine before, suddenly near insolvent.

    This level of mass stupidity and bad incentives makes me call for less government power. Their monopoly behavior, and huge power amplifies any bad decisions they make.

  2. Gravatar of marcus nunes marcus nunes
    30. November 2009 at 10:14

    It´s better for one´s health to laugh than to cry. Check this also “laughable” news.

  3. Gravatar of JimP JimP
    30. November 2009 at 10:27

    And Dec 3 Bernanke appears before the Senate Banking Committee to defend the Fed policy of deflation forever.

    If there were only some way to get a member of that committee to ask him about the Woodford paper that defends price level targeting over inflation rate targeting – this paper, to which I have linked before.

    This paper makes the main points of this blog in a way Bernanke simply could not deny. Will someone tell him – You will do price level targeting – or we the Congress will take the Fed back and do it for you.

    The paper says that price level targeting is “much much” better than inflation rate targeting in the situation we are in now. If only a single Senator would just read that passage into the tv I think Bernanke would have no choice at all. Do that sir, or lose the Fed.

    Now that would be political interference in monetary policy. We are not Japan and we are not going to let the Fed deflationists make us into Japan.

    How to get a copy of that paper into the hands of the staff of one of the Senators on that committee.

  4. Gravatar of JimP JimP
    30. November 2009 at 11:30

    And here the Fed says they are warming up for the deflationary attack. Just to let us all know that they AIM to fulfill their own expectations, of inflation substantially below target for a number of years.

    Their AIM is deflation – and they are determined to get it. charming.

  5. Gravatar of D. Watson D. Watson
    30. November 2009 at 11:53

    You will appreciate how confused Gary Becker seems in discussing how to increase employment

    “If rigid nominal wages were the culprit, inflation would reduce the real value of labor costs, and hence stimulate demand by companies for workers. But deflation rather than inflation is the greater worry now, so this approach does not seem feasible at this time.”

    I am stunned at the hubris of imagining I see something a Nobelist of his stature doesn’t and would like your reassurance that he is missing the point entirely. ‘We’re more concerned about deflation right now, so we can’t inflate.’ What??

  6. Gravatar of Ralph Musgrave Ralph Musgrave
    30. November 2009 at 13:01

    D.Watson: I too was flabbergasted at what seems to me to be the nonsense coming from Becker and Posner. They are advocating the myth which I thought had been buried in the 1930s namely that cutting wages increases demand for labour, hence reducing unemployment. More details at my own blog:

  7. Gravatar of ssumner ssumner
    30. November 2009 at 14:09

    Doc Merlin, Those are good examples.

    Marcus, That was pretty funny,

    JimP, I couldn’t figure out that NYT story. The Fed needs to practice doing open markets sales or repos? It’s like a 40 year old saying “maybe I need to practice driving the car around the block a few times before driving to work.”

    Ralph, That totally puzzled me as well. Becker is a smart guy–does anyone have any idea what he is talking about there? It almost seems like a typo, but I can’t figure out what point he would have been trying to make (even assuming it was a typo.)

  8. Gravatar of fred fred
    30. November 2009 at 14:28

    Hey Scott!

    I love your blog, but in that particular case: I wonder what part you are disagreeing with.
    If that’s the 1st part, I have to admit I don’t understand why.
    If that’s the last statement, i.e., “The current Fed has extra tools to avoid such mistakes, such as the ability to pay higher interest on excess reserves to keep them dormant if necessary.”, I understand.

    Thanks and keep up the good job!

  9. Gravatar of JimP JimP
    30. November 2009 at 14:33

    Scott –

    It was a warning shot – across the bow. Just as soon as the economy gets a bit better we are going to destroy it. have a nice life.

  10. Gravatar of JimP JimP
    30. November 2009 at 14:41

    I think Bernanke is fully aware of the Woodford paper – of the optimal nature of price level targeting. But he did a deal with the deflationists early in the crisis – to describe what he did not as reflation but as credit manipulation. And the deal also included this deflationary squeeze we are seeing now. He does not have the votes to do anything different – and does not have the backbone to reveal a split on the Fed board now. I don’t think he believes in what he is doing. But of course I have no evidence for any of this.

    Amazingly enough – there are two empty seats on the board. Obama could put more aggressive people on there – but I guess he is too busy destroying his own political future to be bothered.

  11. Gravatar of JimP JimP
    30. November 2009 at 14:48

    What I actually think is that they all are worried worried worried about a gigantic dollar crisis – and they figure high unemployment and deflation is the only choice we have.

  12. Gravatar of StatsGuy StatsGuy
    30. November 2009 at 16:14


    Thank you, I think I’ve found a new hero.

    My guess is that ssumner would agree with the reco (devalue dollar) but not the general tone (which has a zero-sum mentality with regard to exports/currencies). I am curious tho…?

    I do believe there is a valid reason for this zero sum mentality – the fact that being a net creditor requires that someone else be a net debtor, and as many countries have learned (Latin America, Southeast Asia, Eastern Europe) being a net debtor is risky. In a sense, the dominance of the Dollar as reserve currency alleviated that – so long as the US was willing to go deeper into debt and other countries believed the US would pay it off, other countries could build up reserves (i.e. national savings) while supplying the US with consumption-related imports.

    With the dollar’s hegemony being challenged as demand for the dollar wanes, and the structurally-import-dependent US economy teetering as beliefs that the US will repay the debt in full waver, demand for the dollar is weakening (and the Fed is fearful of this). But if the US WERE to devalue 30%, one can certainly expect that the Emerging market countries would act to preserve their trade surpluses – being a creditor is just much safer than being a debtor.

    In a sense, it’s the Paradox of Thrift at the level of the international economy. Except there is no super-national reserve bank.

  13. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    30. November 2009 at 17:08

    ‘But deflation rather than inflation is the greater worry now, so this approach does not seem feasible at this time.’

    Becker above has written clumsily, but I think he means that the usual inflationary bias from monetary policy that would help alleviate the too high wage level is absent now, so maybe we’d better do something else to accomplish the same thing.

  14. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    30. November 2009 at 17:11

    ‘I suppose calling the whole world stupid, is well. . .’


  15. Gravatar of Bob Murphy Bob Murphy
    30. November 2009 at 18:10

    Well if you guys are going to call the whole world stupid, I get to call you all naive. 🙂 Do you guys really think Bernanke is just making an intellectual mistake?

    I am not saying I know what Bernanke’s ultimate game plan is, but (a) he’s not calling the shots and (b) whatever group of people (of which Bernanke may well be an influential member) is calling the shots, is fully aware of how to get banks lending. For some reason they are happy with banks not lending right now.

  16. Gravatar of marcus nunes marcus nunes
    1. December 2009 at 02:40

    This is Buiter´s reply to comments on his appointment as CitiBank´s Chief Economist:
    November 30th, 2009
    10:52 pm GMT
    [permalink] I joined Citi for two reasons. First, because Citi is the one truly global bank. Second, because Citi is an institution that, following its challenges during the global financial upheaval of late 2008 – early 2009, changed course resolutely and radically to return to its core strengths: global commercial banking, financial infrastructure services and investment banking.

    The global scope of Citi’s activities and its presence in every systematically important asset market mesh very well with my long-standing interest in open economy macroeconomics and in the joint determination of economic activity, inflation and asset prices and rates of return.

    I am pleased, proud and honoured that this Citigroup has appointed me its Chief Economist.

    – Posted by Willem H. Buiter

  17. Gravatar of David Heigham David Heigham
    1. December 2009 at 06:10

    Was the outbreak of mass stupidity all that mysterious? Only some of it I think. Which bits?

    1. The financial community in a real estate boom mistook bad collateral for good. Long familiar behaviour for which explanations exist.
    2. The financial community mistook bad insuance on the value of this collateral for good. That seems new, and not adequately explained.
    3. Everyone commenting and acting knew from at least October 2007 that the banks were badly undercapitalised, and from at the latest March 2008 tha they were not recapitalising adequately in the market:
    a) The bank managements, after Bear Stearns, refused to pay the market price for extra capital; presumably because the first to do so was likely to be fired by its shareholders.
    b) The US authorities could not act to force recaptalisation for the twin reasons that the Bush administration was incapable of giveng a lead on that and that, barring Presidential emergency action, congress would need time and preparation to do it.
    c) The other set of relevant authorities, in London, had the powers and political opportunity to start the process of forced recapitalisation, but inexpicably put it off until we were in full crisis.

    Plenty of stupidity, but the only mysterious bits are why insurance against default suddenly became credible on a very large scale? and why the Brits sat on their hands all through the summer of 2008?

  18. Gravatar of JimP JimP
    1. December 2009 at 07:42

    I agree with Bob Murphy. The Fed knows exactly what they are doing – and is happy that the banks are not lending. Look at the following quote from the most recent Fed minutes – as taken by me from Tim Duy –

    begin quote
    …Overall, many participants viewed the risks to their inflation outlooks over the next few quarters as being roughly balanced. Some saw the risks as tilted to the downside in the near term, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public’s concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation. To keep inflation expectations anchored, all participants agreed that it was important for policy to be responsive to changes in the economic outlook and for the Federal Reserve to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.
    end quote

    Translation – Get this and hear it clearly, any company that is thinking of expanding or hiring people. Don’t you dare do that – because “all participants agree” that as soon as the banks start to lend we the Fed will raise rates and kill the recovery. We like things just as they are.

    The deflationists are running the show. They like things just like this.

  19. Gravatar of Scott Sumner Scott Sumner
    1. December 2009 at 08:46

    fred, Mostly the second part. But in context, the first part makes no sense either. The Fed’s mistake in 1937 was to implement a regulation that increased bank demand for reserves (i.e. was deflationary.) Their recent policy of interest on reserves did the same.

    But the second part is especially weird. How would higher interest on reserves avoid the problems of 1937–it would push us even further toward deflation.

    JimP, Bernanke also depleted his political capital on banking fixes that weren’t effective. So now even if he does have a preference for more stimulus, he would have trouble getting the inflation hawks to go along.

    Statsguy, There may be political problems with targeting the exchange rate. But I agree that monetary stimulus may involve currency depreciation (depending on what the Japanese and Europeans do) so I don’t worry about the weak dollar unless NGDP growth expectations become excessive.

    Patrick, Yes, you may be right. But it isn’t very smart to argue that policy X is not a feasible because it is unlikely to be adopted. Better to say it is feasible, but is unlikely to be adopted.

    Bob, But how does Bernanke’s support for the massive fiscal stimulus fit into this secret game plan? What is the purpose of the massive fiscal stimulus if not to boost NGDP? So even if you are right, the Fed is still wrong. Or else maybe I’m stupid.

    Thanks Marcus, I don’t have any problem with him taking that job. (Except of course I wasn’t offered the job) 🙂

    David, Good points. But recall that as late as mid-2008 many experts still thought we could avoid any recession at all. So no action was taken because many thought the worst of the crisis had passed. But I agree that more aggresive action was needed. If we are to have a TBTF policy, then the government should have forced these leeches, I mean big banks, to raise additional capital.

    JimP, Thanks for that quotation. And again, if the Fed really feels these risks are equally balanced, why not call for the fiscal stimulus to be repealed, and replaced with easier monetary policy?

    And what about real growth? Is the Fed a strict inflation targeter? That isn’t their mandate. And they clearly weren’t targeting inflation in late 2007 and early 2008 when they slashed rates to stave off recession. Now the recession is far worse than in early 2008, and they seem to feel no stimulus is needed. Krugman is right, they are just making up policies as they go along. There is no consistency or transparency to Fed policy.

  20. Gravatar of Fred Fred
    1. December 2009 at 09:47


    well, actually, what does not make any sense IMHO is to link the two statements: indeed, raising rates on XS reserves is a way to prevent inflationary pressures to arise, not to trim XS reserves…

    I fail to see his point then…

  21. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. December 2009 at 13:49

    Talk about hedging your bets:

    Federal Reserve Bank of Philadelphia President Charles Plosser reiterated Tuesday that the Fed must act preemptively to withdraw its extraordinary monetary stimulus in order to protect its credibility and anchor price expectations.

    “Since expectations play an important role in the dynamics of inflation, it is important that policy act in a manner that keeps expectations well-anchored near the Fed’s inflation objective,” Plosser said in a speech in Rochester. “If expectations do become unanchored, then the Fed will have lost its credibility and either inflation or deflation could arise….

  22. Gravatar of Crissa Crissa
    1. December 2009 at 16:02

    What does the minimum wage have to do with bank reserves?

  23. Gravatar of Joe Calhoun Joe Calhoun
    1. December 2009 at 16:39

    What is the connection between Bernanke’s support of fiscal stimulus and the apparent willingness to let banks sit on excess reserves? Maybe this is just way too obvious but if the banks start to lend they’ll also be buying fewer Treasuries. Maybe that was the quid pro quo: support the fiscal expansion, keep the banks buying Treasuries and you get to continue being Chairman of the Fed. Obama and the Democrats seem much more interested in expanding government than economic recovery. My guess is that they don’t care a whit whether the banks lend to private industry as long as they keep funding the deficits.

  24. Gravatar of marcus nunes marcus nunes
    1. December 2009 at 19:30

    The principle put forth by Plosser (target the forecast)by way of a hockey analogy: “Hockey great Wayne Gretzky was once asked about his success on the ice. He responded by saying, “I skate to where the puck is going to be, not to where it has been.” He didn’t chase the puck. Instead, Gretzky wanted his hockey stick to be where the puck would be going next. He scored many goals with that strategy, and I believe monetary policymakers can better achieve their goals, too, if they follow the Gretzky strategy”, is correct. What feels wrong in this day and age of negative YoY NGDP growth is the target itself. Targeting inflation (not even a price path) is much less effective than targeting an NGDP growth PATH. Since we are way below that, an inflation target will only put us further and further away from it.

  25. Gravatar of marcus nunes marcus nunes
    2. December 2009 at 04:58

    Krugman also wants to see NGDP growth:”I’d be more sanguine about all of this if there were any indications that private, final demand is taking off “” consumers, business investment, whatever. But I haven’t seen anything suggesting that sort of thing.

    The chances of a relapse into recession seem to be rising”.

  26. Gravatar of Scott Sumner Scott Sumner
    2. December 2009 at 07:04

    Fred, I agree.

    patrick, Plosser seems to focus on inflation, but the Fed is supposed to be concerned with inflation and real growth. Indeed why else would the Fed have slashed rates in 2007? There was no concern about low inflation in 2007, just the opposite. If Plosser really wants to anchor expectations, how about first telling us what the Fed is trying to achieve. Until they do that, they cannot expect expectations to be well-behaved.

    Crissa, Nothing. Reserves affect AD, minimum wages affect AS.

    Joe, Perhaps, but it is a bit too conspiratorial for me. But I have no answer.

    marcus, Good analogy, if only the Fed would do it.

    marcus#2, I agree with Krugman, although I think we’ll avoid a double dip. But AD is far too low right now.

  27. Gravatar of Doc Merlin Doc Merlin
    2. December 2009 at 07:51

    “Crissa, Nothing. Reserves affect AD, minimum wages affect AS.”

    Minimum wage causes unemployment, however, which affects AD. It also causes strong drawdowns in savings accounts which should lower bank reserves.

    AS/AD is an odd model because a firm’s supply is based on their expected demand for their goods and their demand for goods is also based on expected demand for their goods. I.e.: one man’s S is another man’s D and vice versa. This is one reason why I support NGDP futures convertibility.


    “YoY NGDP growth is the target itself. Targeting inflation (not even a price path) is much less effective than targeting an NGDP growth PATH.”
    ABSOLTELY! Expectations matter a lot more than they are given credit for in modern econ.

  28. Gravatar of Doc Merlin Doc Merlin
    2. December 2009 at 07:52


  29. Gravatar of Scott Sumner Scott Sumner
    3. December 2009 at 05:37

    Doc Merlin, I think you are confusing shifts in AD and movements along the AD curve. Certainly if monetary policy is efficient a AS shock should not have any affect on AD.

  30. Gravatar of Doc Merlin Doc Merlin
    3. December 2009 at 14:27

    “Doc Merlin, I think you are confusing shifts in AD and movements along the AD curve. Certainly if monetary policy is efficient a AS shock should not have any affect on AD.”

    I don’t think you can treat AD and AS like ‘regular’ supply and demand curves, and hence I don’t think that monetary policy is efficient. For a single individual I would agree. D would have no effect on S, but in the aggregate they are related.

    Let me give you one example: Lets say labor buyers adjust their demand for labor because of different market conditions. They then begin to reorganize and lay off workers, to adjust their output accordingly. Labor providers have lost their jobs so they find themselves in a different financial place than they were before. Recently laid off workers have to adjust their individual D curves to account for their lower income. This change causes AD to drop. I think its dangerous to treat AD and AS as actual demand and supply curves , because of this. The curves nonlinearly affect each other.

    In micro, D and S have no relation to each other, but when you look at the whole economy AD and AS should with a time lag between them.

  31. Gravatar of ssumner ssumner
    6. December 2009 at 10:52

    Doc Merlin, I don’t see why the change you describe should cause AD to fall. The Black Death killed 1/4 of Europe, but didn’t reduce AD. That’s because it didn’t kill gold and silver coins. Instead AS dropped sharply and prices rose sharply.

    Many people I talk to assume the Black Death reduced AD, as there were fewer shoppers.

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