"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Thursday, December 30, 2010

Really good links - Germany and the solution for the Eurozone crisis - Krugman in 1998 - Money and Metaphysics - Deflation - Equilibrium and institutional process - Consumer confidence - Taxes and government spending

Crispin Odey - Towards a more balanced Eurozone - "The key feature of the European “now” is not government debt nor under-capitalised banks. It is Germany with an inflationary boom under way. German growth means rapid growth of imports from the eurozone worth significant percentage points on non-German eurozone GDP and a far easier path out of recession for the European periphery than is priced into bonds and equities.
        Those with long memories would argue that the German authorities will spot where all this is heading and will do what is necessary to trample on growth. But Europe and Germany have changed. Sovereign power is not what it was. The German authorities no longer have control of their own policy. <..>
        Of course, Germany will be divided in its attitude to this boom and if it were down to the authorities, interest rates would rise and the currency strengthen. But they are going to be as unable to reach the brake pedal next year, as Ireland et al were unable to reach the accelerator this year."

Tyler Cowen - Paul Krugman's predictions from 1998

Matthew Yglesias - Money and Metaphysics

Dave Altig - Probability of deflation has fallen to the levels observed prior to the economy's summer soft patch

Arnold Kling - Equilibrium vs. institutional process - "As Boettke points out, the profession is split between economists who work out the properties of equilibrium and economists who focus on institutional processes. The latter are marginalized, although they include many Nobel Laureates, including Douglass North and Elinor Ostrom.
        The focus on properties of equilibrium attracts interventionists. You point out an undesirable property of an equilibrium, and then you propose a fix. For example, Stiglitz and Rothschild pointed out that a health insurance market could collapse because of adverse selection, so it follows that government should impose a mandate to purchase health insurance.
        The focus on institutional processes attracts libertarians. You see the benefits of the forces of competition and creative destruction. You see the adverse institutional properties of government."

Tim Duy - Curiously Weak Consumer Confidence - "Consumer confidence figures appear inconsistent with actual spending patterns. That inconsistency will be resolved by either confidence rising or falling spending growth, with more or less obvious policy implications. There will be a tendency to assume the resolution will come from decelerating spending growth. To be sure, the recent trend appears unsustainable. But I also think it is worth paying attention to the more positive household spending data."

David Andolfatto - Robert Shiller's bad idea of a tax-financed increase in government spending - "Its not that I'm against increasing (components of) G. Public works projects of the sort mentioned by Shiller (building highways and improving our schools) were advocated by sensible economists long before Keynes (as evidence of this, note that public works were implemented in the Depression well before publication of the General Theory). What I have a problem with is in using some silly theory to support the notion, for example, that taxes should be raised to finance a large public capital expenditure. Shiller has been rightly celebrated for his work in the theory of finance, and on asset price bubbles in particular. But is this not a rather odd stand to take for a professor of finance?
        Now, I'm no expert in finance myself, so maybe I should be careful in what I'm about to say. But it seems to me that a large capital expenditure should be financed with debt. The debt service could be supported by toll revenue (on bridges and roads) and user fees in general, backed by the Treasury, if needed. The use of tax finance advocated by Shiller in his balanced-budget exercise implicitly assumes (among other things) lump-sum taxes. For some thought experiments, the assumption of lump-sum taxes is innocuous enough. But this is not one of those cases. Taxes are distortionary and to the extent that they are needed to support public spending, they should be spread out over time. This is a standard principle of public finance (I think). "

Monday, December 27, 2010

Really good links - Nominal GDP targeting - Shadow banking - Milton Friedman's thermostat - Origins of the national debt - QE2 and market factors

David Beckworth - The case for nominal GDP targeting - "Mark Thoma wants to hear the case for nominal GDP targeting. This approach to monetary policy requires the Fed stabilize the growth path for total current dollar spending. As an advocate of nominal GDP level targeting, I am more than happy to respond to Mark's request. I will focus my response on what I see as its three most appealing aspects: (1) it provides a simple and intuitive approach to monetary policy, (2) it focuses monetary policy on that over which it has meaningful influence, and (3) its simplicity makes it easier to implement than other popular alternatives. "

Interview with Gary Gorton - Shadow Banking; The Rise of Repo; Growth of Securitization; Information Sensitivity; The Collapse of Repo; Regulatory Reform; Creating Collateral, not Insurance; Vulnerability to Panic

Nick Rowe - Milton Friedman's Thermostat

Brad DeLong - Alexander Hamilton and the Origins of the National Debt - "Back in the early 1790s, the national debt was close to 40% of annual GDP. It was close to 40% because the first Treasury Secretary, Alexander Hamilton, thought it was a good idea to make it close to 40%. <..>
        The most important reason, however, was that Alexander Hamilton was Secretary of the Treasury in a country where the rich were at best uneasy about the revolution and independence. Of America's upper class as it stood in 1775, full half of them were gone: had fled to Britain or Canada during the Revolutionary War. Those who remained remembered that back before 1775 the British monarch had protected property, that the British army and navy had protected them against deprivations of all kinds, that it was quite clear who the police worked for. Now you have a republic with a much broader electorate. Might politicians run on a platform of soaking the rich and redistributing wealth to the poor? Thus the rich people were nervous--and at least thinking about how maybe it would be good if the British came back and ruled again.
        This was where Alexander Hamilton had his good idea. Suppose, he thought, he could set things up so that the rich owned a lot of U.S. government bonds. Then if the British returned--well, the British were not going to pay off the Revolutionary War debt of the United States of America under any circumstances. Having a national debt was a way to bind the United States rich to the country--giving them a stake in the new republic's survival. And by large it worked: the national debt was a national blessing."

John Hussman - QE2 and market factor analysis - "The key event related to QE2 wasn't its formal announcement, but was instead the Op-Ed piece that Ben Bernanke published a few days later in the Washington Post, which essentially advanced the argument that the Fed was targeting a "wealth effect" in stocks and other risky assets, in hopes of getting people to consume off of that perceived wealth. At that moment, Bernanke unleashed a speculative bubble in risky assets, and a selloff in safe ones. This has rewarded risk-seeking and punished risk-aversion, but it has also unfortunately driven the markets into an overvalued, overbought, overbullish, rising-yields condition that has historically ended in steep and abrupt losses.
        Ned Davis Research tracks a set of "factor attribution" portfolios, which measure the performance between the top 10% of stocks ranked by a given factor, and the bottom 10% of stocks as ranked by that factor. The factors are things like market beta, dividend yield, 26-week momentum, and so forth. Essentially, the these factor portfolios track the return of hypothetical portfolios that are long the top 10% and short the bottom 10% of stocks based on any given variable.
        The performance of these 133 factor portfolios over the past 13 weeks offers tremendous insight into the extent to which the Federal Reserve has encouraged speculative risk. Investors are chasing stocks with the greatest exposure to market fluctuations, commodities, credit risk, small-cap risk and volatility. Conversely, securities demonstrating reasonable valuation, stability, quality, or payout have been virtually abandoned by investors. Here is a sampling:

Market Beta
Raw Materials Beta
Commodity Sensitivity
Credit Spread Beta
Macro Economic Sensitivity
Small vs. Large Beta
Style Sensitivity
Silver Beta
Commodity Sensitivity
Sigma Risk (Volatility)
Operating Cash Flow Yield
EPS Stability
Value vs. Growth Beta
Style Sensitivity
Return on Invested Capital
Dividend Yield
10-Year T-Note Beta
Macro Economic Sensitivity
High vs. Low Quality Beta
Style Sensitivity

Saturday, December 18, 2010

Monetary policy and Minsky cycles

1. It is impossible to understand the Great Recession without invoking Minsky's cycle theory.

2. Minsky cycle creates the least damage if Minsky recession takes place in the context of stable NGDP growth. Minsky crash creates collateral damage if there is a downward deviation from the NGDP trend.

3. We observe the asymmetry of Minsky booms and Minsky crashes. Traditional monetary policy is a very powerful AD fine-tuning tool during the Minsky boom, on the other hand, monetary policy is prone to crashes and mistakes during the Minsky bust.

4. Monetary authorities usually operate some kind of peg, this peg may crash or lose credibility when the Minsky moment arrives. During the Great Depression, the dollar gold peg lost credibility, and the AD was too low until the Roosevelt devaluation. These days the Fed is operating a crawling fed funds rate peg, this peg has crashed after the bankruptcy of Lehman, and the AD was too low during the crash. During the collapse of the fed funds rate peg, we had the flight to liquidity problem, not the flight to safety problem, so the root cause of low AD was monetary, not Minskyite. The fed funds rate peg was restored in late October 2008.

5. When the monetary peg is restored, it is important that it is restored at the levels where it promotes the speedy recovery. Roosevelt repegged the dollar at the level that generated a fast recovery, on the other hand, the federal funds rate was too high when the fed funds rate peg was restored in late October 2008. Scott Sumner's NGDP expectations peg is useful in this regard. If the NGDP expectations peg crashes, most likely it will be restored at the previous NGDP trend.

6. If the neutral short term risk free interest rate drops below zero during the Minsky bust, the risk of monetary policy mistakes increases. Monetary tools that bring the neutral interest rate back into the positive territory need to be aggressively employed. There are three such tools - higher inflation targets, quantitative easing, credit easing.

7. Higher inflation targets are undesirable, as credibility of monetary policy is diminished during normal times. NGDP path targeting removes the need to change the goals of the monetary policy during the Minsky cycle.

8. Quantitative easing is powerful only until the term risk premium is lowered to zero. After that, it loses the direct effect and only signalling effect remains. The power of quantitative easing is limited, so Bernanke did not use this tool until March 2009.

9. Credit easing is the most powerful non-traditional monetary tool. Bernanke started using it in 2007. However, the extensive use of credit easing increases the risk of Fed's insolvency, it also creates various legal, technical and political problems. Credit easing programs were not expanded to the extent needed to stabilize AD. Bernanke has indicated that additional fiscal stimulus is needed to increase AD.

10. Measures that increase the use of credit easing would be helpful. Larger Fed's capital base could reduce the risk of Fed's insolvency. Development of broad short term credit market indexes could help us design credit easing programs that are not discriminatory and thus more attractive politically.

11. NGDP path pegging is the policy that could prevent the collateral damage caused by the Minsky crash. NGDP path peg gives us a speedy recovery when monetary policy temporarily loses credibility. NGDP path provides a good focal point for the coordination of monetary and fiscal policies when the zero interest rate constraint is binding.

Thursday, December 16, 2010

Really good links - Optimism about US recovery - Bailout - What is money? - Mankiw is a New Keynesian

Nick Rowe - Optimism about US recovery - "What matters is the gap between what the market believes will happen and what the market believes the Fed believes will happen. I think we have just such a gap right now. The market believes the Fed is too pessimistic. That creates an upside cumulative process. That's what makes me optimistic."

Tyler Cowen - Bailout and inequality - "In short, there is an unholy dynamic of short-term trading and investing, backed up by bailouts and risk reduction from the government and the Federal Reserve. This is not good. “Going short on volatility” is a dangerous strategy from a social point of view. For one thing, in so-called normal times, the finance sector attracts a big chunk of the smartest, most hard-working and most talented individuals. That represents a huge human capital opportunity cost to society and the economy at large. But more immediate and more important, it means that banks take far too many risks and go way out on a limb, often in correlated fashion. When their bets turn sour, as they did in 2007–09, everyone else pays the price.
        And it’s not just the taxpayer cost of the bailout that stings. The financial disruption ends up throwing a lot of people out of work down the economic food chain, often for long periods. Furthermore, the Federal Reserve System has recapitalized major U.S. banks by paying interest on bank reserves and by keeping an unusually high interest rate spread, which allows banks to borrow short from Treasury at near-zero rates and invest in other higher-yielding assets and earn back lots of money rather quickly. In essence, we’re allowing banks to earn their way back by arbitraging interest rate spreads against the U.S. government. This is rarely called a bailout and it doesn’t count as a normal budget item, but it is a bailout nonetheless. This type of implicit bailout brings high social costs by slowing down economic recovery (the interest rate spreads require tight monetary policy) and by redistributing income from the Treasury to the major banks. <..>
        The upshot of all this for our purposes is that the “going short on volatility” strategy increases income inequality. In normal years the financial sector is flush with cash and high earnings. In implosion years a lot of the losses are borne by other sectors of society. In other words, financial crisis begets income inequality. Despite being conceptually distinct phenomena, the political economy of income inequality is, in part, the political economy of finance<..>
        Another root cause of growing inequality is that the modern world, by so limiting our downside risk, makes extreme risk-taking all too comfortable and easy. More risk-taking will mean more inequality, sooner or later, because winners always emerge from risk-taking. Yet bankers who take bad risks (provided those risks are legal) simply do not end up with bad outcomes in any absolute sense. They still have millions in the bank, lots of human capital and plenty of social status. We’re not going to bring back torture, trial by ordeal or debtors’ prisons, nor should we. Yet the threat of impoverishment and disgrace no longer looms the way it once did, so we no longer can constrain excess financial risk-taking. It’s too soft and cushy a world."

Paul Krugman - What is money? - "Surely we don’t mean to identify money with pieces of green paper bearing portraits of dead presidents. Even Milton Friedman rejected that, more than half a century ago. For one thing, a lot of those pieces of green paper are pretty much inert — sitting outside the United States, in the hoards of drug dealers and such. For another, checking accounts are clearly a close substitute for cash in hand.
        Friedman and Schwartz dealt with this by proposing broader aggregates –M1, which adds checking accounts, and M2, which adds a broader range of deposits. And circa 1960 you could argue that those aggregates were good enough.
        But now we have a large shadow banking system, in which things like repo serve much the same function as deposits; M3 used to capture some of that, but the Fed discontinued it, in part I think because it wasn’t clear which repo belonged there, and data on repo not involving primary dealers is scattered. Whatever.
        The truth is that these days — with credit cards, electronic money, repo, and more all serving the purpose of medium of exchange — it’s not clear that any single number deserves to be called “the” money supply. Intellectually, this isn’t a problem; nor is there necessarily a problem maintaining monetary policy even if there isn’t any single thing you’re willing to call money."

JTapp - Textbook politics - " I had been using the Mankiw Principles of Macro text for the 2 years I’d been at my current position and decided to adopt his Micro this year in order to bring some symmetry and take advantage of his Aplia sets, etc. But I share Micro with other professors who would also be required to adopt it. One lodged a complaint when a Google search revealed Mankiw is a “New Keynesian,” which immediately raised a flag b/c anything with “Keynes” in it is problematic. Nevermind that the department, including this professor, had been using other New Keynesians, including Mishkin, for years in other classes and I’d been using Mankiw’s macro for years and adopted Ball in the M&B class– Micro was a step to far.
        He had our department chair (a marketing professor) take it home to check for subversive material. One of Mankiw’s 10 Principles of Economics being “government can sometimes improve market outcomes” was a red flag. In the end we adopted it b/c they trusted my judgment. In higher education, EVERYTHING is political, maybe worse than proper academia. (I sent the story to Mankiw who found it amusing, he commented that just working at Harvard made him a socialist to many.)"

Wednesday, December 8, 2010

Really good links - Global AD - Austrian theory - Germany - A sentence to ponder

Bill Gross - Global aggregate demand - "The global economy is suffering from a lack of aggregate demand. In simple English that means that consumers are not buying enough things and that companies are not hiring enough people because of it. Growth slows down, especially in developed as opposed to developing countries, and the steel mills of Allentown, USA and Sheffield, England close down.
        This shortfall of global demand is a nearly impossible concept to grasp amongst politicians and their citizenry. Don’t people always want to buy more things and isn’t demand theoretically insatiable? They do, and it is. Yet economic growth is a delicate dance between production and finance and when a nation’s or a family’s credit card gets maxed out, then demand/spending slows measurably. We are witnessing these commonsensical repercussions across the entire continent of Europe today and to a lesser extent in the United States.
        Developing nations and their consumers want to buy things too. And while their economies are growing fast, their overall size is not yet sufficient to pull along the economies of Europe, Japan and the U.S. Their financial systems are still maturing and reminiscent of a spindly-legged baby giraffe, having lots of upward potential, but still striving for balance after a series of missteps, the most recent of which was the trio of the 1997–98 Asian crisis, the 1998 Russian default and the 2001 Argentine default. And so their policies are oriented towards export to debt-laden developed nations instead of internal consumption, leaving a gaping hole in global aggregate demand. China is a locomotive to be sure, but it cannot pull the global economy uphill on the basis of mercantilistic exports alone. It needs to develop many more of its own shopping malls and that will take years, if not decades."

Steve Randy Waldman - Austrian hangover theory - "Austrian-ish “hangover theory” claims, plausibly, that if for some reason the economy has been geared to production that was feasible and highly valued in previous periods, but which now is no longer feasible or highly valued, there will be a slump in production. It wisely asks us to consider not only the prosperity we measure today, but the sustainability of that prosperity going forward. I am not “Austrian”, and have no interest in defending specific claims regarding the roundaboutness of activity or the role of central banks in causing bursts of quasiprosperity. But as Brad DeLong wisely reminds us, it is good to be somewhat catholic in our evaluation of macroeconomic schools, and to take what is useful from each. I consider myself Keynesian at least as much as I am Austrian, but I recognize good and not-so-good offshoots of both schools. (Austrian and Keynesian ideas are more complementary than most people acknowledge. The Austrians focus on unsustainable arrangements of real capital, while the Keynesians focus on unsustainable arrangements with respect to money, debt, savings, and income. I think both approaches are fruitful.)<..>
        At an individual level the correlation between past consumption and recent unemployment is obviously negative. The people who have sinned are not by and large the people being punished. Some people overconsumed relative to their income, and some people invested poorly. Those who overconsumed have mostly faced consequences for their misbehavior — they are either deeply in debt, or they have endured foreclosure or bankruptcy. But the people who invested absurdly, especially “savers” who lent money but permitted themselves ignorance and indifference to how their wealth would be mismanaged, have not suffered the costs of their recklessness. Instead, they have been almost entirely bailed out. It is lenders and investors more than any other group who determine the patterns of our macroeconomy. There are always people willing to overconsume or gamble on foolish enterprises. We do and must rely upon those with resources to steward to ensure those resources are used wisely. They did not, and their recklessness has brought us to catastrophe. But rather than condemn them for negligence and permit their claims to be appropriately devalued, we applaud them for “prudence” and let government action be bound by commitments to sustain their destructive and ridiculous claims. You don’t counter that sort of villainy with technocratic arguments about liquidity traps. You point out that the motherfuckers who are calling themselves prudent, who are blocking both writedowns and government action that might risk inflation, are hypocrites and thieves. You state clearly that their claims are illegitimate and will be written down one way or another, unless we can generate sufficient growth to ratify them ex post, which would require claimants to behave less like indignant creditors and more like constructive equityholders. It is not technocratic economists who will win the day and pull us out of our cul-de-sac, but angry Irishmen and Spaniards who challenge, on moral terms, the right of German bankers to impose vast deadweight costs on current activity because they lent greedily into what might easily have been recognized as a property and credit bubble."

Daniel Pfaendler - German view - "What we should not forget though is that a) just as the peripheral countries were profiting from very low real yields during the past decade amid the German economic malaise, Germany suffered from too high real yields amid the periphery's boom which rendered its economic weakness even worse and most importantly b) if Germany would not have done the corporate restructuring/budget consolidation/structural reforms, the German economy would be in a much worse shape at present."

Michael - A sentence to ponder - "Most people are libertarian with regards to their own lives and people they like, statist with regards to people they don't know, and positively fascist about people they dislike, stereotype, or don't understand."

Payroll tax holiday and the credit channel

Bryan Caplan says Obama has botched the payroll tax holiday:

"If you cut a tax on employers, this reduces labor costs, increases the quantity of labor demanded, and reduces surplus labor. If you cut a tax on employees, in contrast, this increases worker compensation, increases the quantity of labor supplied, and increases surplus labor.

In both cases, admittedly, a tax cut might directly increase demand and, with nominal wage rigidity, increase employment. But when you cut taxes on employers, the incentive effect and the fiscal effect work in the same direction. When you cut taxes on employees, the incentive effect and the fiscal effect work in opposite directions.

That's why Obama's proposed payroll tax holiday botches an idea of truly Singaporean cleverness. Instead of giving the tax cut to employers, where it would do the maximum good, or splitting it evenly, where it would do intermediate good, he's giving all of it to employees, where it does the minimum good"

I have an alternative interpretation. It is true that if you cut a tax on employees, you do very little to directly correct the labor market imbalances. However, the poor functioning of the labor market was caused by the insufficiently stimulative monetary policy that is constrained by the zero bound on interest rates. The zero interest rate bound creates the most damage to those economic agents who have the weakest balance sheets. And these days the household balance sheets are the weakest. Weak household balance sheets are pushing the optimal fed funds rate down to the negative levels. If you cut a tax on employees, you relax the credit constraints on household balance sheets, and the day when the zero interest rate bound is no longer constraining Bernanke will arrive sooner.

In late 2008 - early 2009 balance sheets of non-financial corporations were very weak, so Bryan Caplan's logic would have worked then very well. But today Obama's payroll tax holiday is the solution that will have the most powerful effect.

Sunday, December 5, 2010

Ireland - Greece - Fiscal vs. monetary policy - Eurozone - Overconsumption and recessions

Barry Eichengreen - Ireland - "The Irish “program” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130 per cent of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan. After a couple of years, not just interest but also principal is supposed to begin to be repaid. Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.
        This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. A populist backlash is inevitable. <..>
        For internal devaluation to work, therefore, the value of debts, expressed in euros, has to be reduced. This would have been particularly easy in the Irish case. A bright red line could have been drawn between the third of the government debt that guarantees the obligations of the banks, on the one hand, and the rest of the government’s debt, on the other. The third representing the debts of the Irish banking system could have been restructured. Bondholders could have been offered 20 cents on the euro, assuming that the Irish banks still have some residual economic value."

John Dizard - Greece - "The Greeks and their advisers are already much further along in their thinking than euro-officialdom. They realise that reaching a “successful” conclusion of the three-year adjustment process agreed with the euro leaders would be a disaster for their balance sheet. As Greek bonds mature over that period, they are paid off in large part with new borrowings from Europe and the IMF, as well as with Greek banks’ discounting bond purchases with the ECB. That means Greece is exchanging outstanding debt that is legally and logistically easy to restructure on favourable terms with debt that is difficult or impossible to restructure. It’s as if they were borrowing from a Mafia loan shark to repay an advance from their grandmother."

Narayana Kocherlakota - Fiscal policy vs. Monetary policy - "I believe that QE is a move in the right direction. However, as I have discussed on earlier occasions, I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. That’s why I would have greatly preferred for the committee to have been able to cut its target rate rather than using QE. The problem is that its target rate is already essentially at zero, and so it was not possible to cut the target rate any further.
        Given this constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative. Their key insight is that there is a broad equivalence between monetary and fiscal policy. They argue that the essence of an FOMC interest rate cut is that it makes current consumption cheaper relative to future consumption. With that in mind, the fiscal authorities can use the time path of consumption taxes to accomplish this same change in relative prices.
        In the remainder of my remarks, I’ll illustrate this insight by describing one particular fiscal policy plan that is equivalent to a 100-basis-point cut by the Fed. The proposal has three parts. The first part is a permanent consumption tax of 100 basis points, instituted with a one-year delay. The second part is a permanent decrease in labor income taxes of 100 basis points, also instituted with a one-year delay. The third part is an investment tax credit undertaken in 2011. The Nicolini et al. results demonstrate that, in a wide class of economic models, the effects of this three-part plan would be equivalent to the effects of a 100-basis-point interest rate cut."

Tyler Cowen - Eurozone - "Fiscal union was, is, and will remain a fantasy. The best the eurozone could have done was to abolish national banking systems and have a truly European banking market. It's too late for even that, though."

Karl Smith - Overconsumption theory of recessions

Monday, November 29, 2010

Really good links - Uncertainty and AD - Cash is the king - Interest on reserves - Tea party

Brad DeLong - Uncertainty and aggregate demand - "The future is always uncertain--and how uncertain it is fluctuates. When the future is more than unusually uncertain, economic players want the security of extra financial asset holdings before they are willing to spend to put people to work. It is, then, the business of the government to make sure that they have the amount and the kinds of financial assets they need to sleep easily. That was one of the insights of John Maynard Keynes. That was one of the insights of Milton Friedman."

Jeremy Grantham - Cash is the king - "We've already started to sell [stocks]. We're not even— averagely weighted. We're modestly underweighted. And you must remember bonds are even worse than stocks on a seven-year forecast. So, you get caught in this paradox. It's very tempting— and this is what the Fed wants by the way.
        It wants us to go out there and buy stocks, which are overpriced because bonds they have manipulated into being even less attractive. So, we’re being forced to choose between two overpriced assets. That is not always a terrific choice to make because there is a third choice, and that is don't play the game and hold money in cash.
        And cash has a— a virtue that people don't appreciate fully. And that is its— its optionality. In other words, if anything crashes and burns in value— say the U.S. stock market, if you have no resources, it doesn't help you. If the bond market crashes, and you have no resources, it doesn't help you. And what cash is is an available resource. It buys you the right to buy the U.S. market if the S&P drops from 1,220 today to 900, which is what we think is fair value."

Mark Thoma - Interest on reserves - "There’s been a lot of talk lately about the Fed’s policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn’t paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all. <..>
The tool the Fed has for removing reserves from the system is open market operations (QEI and QEII are essentially traditional open market operations, but the Fed buys long-term rather than the more traditional short-term financial assets). So why do they need another tool — interest on reserves — to control reserves? Removing reserves too fast through open market operations could disrupt financial markets. Paying interest on reserves gives the Fed a way to remove reserves in a more leisurely fashion while still maintaining control over inflation."

Steve Landsburg - Cut agencies - "Like I said, cut agencies. And cut them in bunches, to dilute opposition. As I’ve said before on this blog, the department of commerce steals from workers and farmers to subsidize businesses; the department of agriculture steals from workers and businesses to subsidize farmers, and the department of labor steals from businesses and farmers to subsidize workers. Eliminate them all at once and every American will lose one friend and two enemies."

Saturday, November 27, 2010

Really good links - Case against the Fed - Fiscal democracy - IOR - Bernanke and Palin - EMU - Boom-bust-bailout

Tyler Cowen - The case against the Fed is weak - "To whatever extent we can do without a Fed, it's because there are so many Treasury securities, which should be a sobering thought to a market-oriented perspective. If the Fed were shut down, over time the new base money would not be gold, "Hayeks," or a commodity bundle. It would be T-Bills. We would have achieved the full integration of the monetary and fiscal authority but to what useful end? (Better not balance the budget!) The real question is whether the Treasury should be the Fed or whether the Fed should be the Fed, but you won't often see it framed that way."

John McDermott - Democracy as a solution for fiscal crisis - "Imagine that in country X, measure A receives 90 per cent support in parliament but measure B squeezes through with only 51 per cent. The bond issued to pay for measure A is given seniority. Its holders get paid before those with the bond behind measure B. (If measure C then receives 98 per cent support it would trump A, and so on.)
        [Hans Gerbach of the ETH says:] Vote-share government bonds align the strength of the political support for particular government activities with the pledge to repay debt. This is desirable in its own right, as voting for debt-financed government expenditures is connected to the willingness to repay. Accordingly, it may have a favourable effect on deliberation in democracy by linking debt-financing with repayment promises when political debates about new government expenditures take place."

Bill Woolsey - Interest on reserves and inflation - "Murphy does make an odd error when discussing the possible strategy of the Fed paying higher interest on reserves. He says that investors will figure out that an exponential increase in reserves will hardly allow the Fed to control inflation. Now, suppose the expected inflation rate does rise to 10 percent and that a 12 percent interest rate is needed so that the demand for reserves will be high enough so that the demand for base money remains $2.6 trillion. Murphy seems to imagine that since each reserve balance would increase by 12 percent each year, base money would rise at a 12 percent annual rate. No. The Fed would simply have to sell between $200 billion and $300 billion in assets each year to leave base money the same. Rather than having to sell off $1.8 trillion in assets post haste, they could sell much fewer assets and prevent any excess inflation."

Scott Sumner - Ben Bernanke and Sarah Palin - "The reason QE worked was not the operation itself (which I agree does little or nothing) but rather because it tells the market that the Fed is now more serious about boosting long term prices and NGDP. In other words they are now willing to leave that base money out there long enough to get closer to their implicit inflation target. The Fed was afraid to directly call for higher inflation (something Krugman thinks could work) so they spoke in code, hoping the markets would understand them but Sarah Palin would not. Unfortunately for Bernanke, Sarah Palin has advisers who know exactly what the Fed was up to. "

Ambrose Evans-Pritchard - Way out for EMU - "A reader asked me this week whether there is any graceful way to avoid this coming chain of disasters.
Yes, there are two options, neither entirely graceful. The European Central Bank can print money like a drunken sailor, flood the bond markets with €2 trillion, and tank the euro against China’s yuan for good measure.
        If the Germans refuse to accept this, they should abandon EMU at once, leaving France and southern Europe with the residual euro and the institutions of monetary union. Existing euro debt contracts would be upheld. Germany would revalue – alone or with Finns, Dutch, etc - so holders of Bunds would enjoy a windfall gain.
        France could revive the Latin Union of the late 19th Century, a more benign venture than the Máquina Infernal now asphyxiating Portugal, and deflating Spain.
        Any better ideas out there?"

Simon Johnson - Boom-Bust-Bailout - "In “The Quiet Coup,” published in Atlantic magazine in May 2009, I compared the U.S. economic boom-bust-bailout cycle to what has become typical in emerging middle-income countries such as Russia, Argentina or Indonesia. Just don’t think these problems are limited to emerging markets.
        There is a much more general or global phenomenon in which powerful people cooperate to build an economic model that provides growth based on a great deal of debt. When the crisis comes, those who control the state try to save their favorite oligarchs, but there aren’t enough resources to go around."

Thursday, November 25, 2010

Really good links - Sovereign default - Brad DeLong and Larry Summers - No Trade Theorem - Austrian zero bound - Billion prices - Interest elasticity

Simon Johnson and Peter Boone - Sovereign default - "The Germans should recall the last episode of widespread sovereign default – Latin America in the 1970’s. That experience showed that countries default when the costs are lower than the benefits. Recent German statements have pushed key European countries decisively closer to that point. <..>
        Bond-market participants naturally turn now to calculating “recovery values” – what creditors will get if countries default today. For example, Greece’s debt stock, including required bridge financing under the IMF program, should peak at around 150% of GNP in 2014; much of this debt is external. If a country can support debt totaling 80% of GNP (a rough but reasonable rule of thumb), then we need approximately 50% “haircuts” on this existing and forthcoming debt (reducing it to 75% of its nominal value).
        However, of this 150% of GNP, at least half is or will be official in some form. If it is fully protected, as seems likely (the IMF always gets paid in full), then the haircut on private debt rises to an eye-popping 90%. And this leaves out government spending that may be needed for further recapitalization of Greek banks."

Robert Waldman - Brad DeLong and Larry Summers - "You [DeLong] thought the problem was George Bush not Joe Cassano. You thought the fundamental problem with the US economy was the huge federal budget deficit. You thought the crisis would come when the People's Bank of China got tired of throwing good money after bad and let the dollar collapse and US long term interest rates shoot up.
        Why did you think this (aside from evidence and logic) ? Well you are much inclined to think that the Clinton economic team did a very good job. So you are much inclined to think that Bush did a terrible job. Also you can't stand him.
        The idea high deficits cause high real interest rates which are terrible for growth is very dear to you (not to mention overwhelmingly supported by massive evidence).
        I think this is also true of Larry Summers. He put Harvard's money where his mouth was. He bet on high interest rates on US Treasuries. That most definitely was not because he thought that Greenspan could control everything. That was because he was sure that Bush would cause a catastrophe not just by neglecting dangerous Wall Street developments but by undoing the great work of Clinton, Bentson, Rubin and Summers."

Alex Tabarrok - No Trade Theorem

Tweet of the day - Garrett Jones - "In Austrian term-structure-of-capital theory, the zero nominal bound would seem particularly perilous."

James Hamilton - Billion prices project

Jeremy Grantham - Interest elasticity of consumption - "And let me point out that the Fed's actions are taking money away from retirees.
        They're the guys, and near retirees, who want to part their money on something safe as they near retirement. And they're offered minus after-inflation adjustment. There's no return at all. And where does that money go? It goes to relate the banks so that they're well capitalized again. Even though they were the people who exacerbated our problems.
        And, hopefully, the redeeming feature in that infamous trade is that your corporations go out there, borrow money, build factories, hire people, which they're not doing because consumption is weak and because they were also terrified by the crunch. I— I think, therefore, under these conditions, low rates is actually hurting the economy. It's taking more money away from people who would have spent it —retirees — than are being spent by passing it on to financial enterprises and being distributed as bonuses to people who are rich and, therefore, save more."

Monday, November 22, 2010

Really good links - Deleveraging - Bernanke and tax cuts - Pain caucus - Causes of economic downturns - Critics of QE2 - Sustainability - Hugh Hendry video

Paul Krugman - Deleveraging - "The situation: over the past decade, households ran up what is almost universally regarded as an excessive amount of debt — shown here for the United States, but also in the UK, Spain, and elsewhere. They are now being forced to pay down that debt by cutting spending.
        The question is, what will replace their spending? We’re told that we can’t have fiscal expansion, because that’s Big Government. And now we’re being told that we can’t have monetary expansion, which might induce businesses and low-debt consumers to spend more, because that’s debasing the dollar. Oh, and while we’re on that, we can’t allow the dollar to fall, which might help exports."

Ben Bernanke (2002) - Tax cuts - "A pledge by the Fed to keep the Treasury's borrowing costs low, as would be the case under my preferred alternative of fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut taxes."

Scott Sumner - Open letter to fellow conservatives

Brad DeLong - What is wrong with American macroeconomics? - "What is wrong with American macroeconomics? In a nutshell, when 2007-9 came along every single macro textbook (including mine) and every single macro course (save possibly Perry Mehrling's) was of little or no use in helping people who had read or taken them to read publications like the FT as they chronicled the downturn or understand the policy debates hosted by the FT.
        At the very minimum, a macro course should teach people enough about the macroeconomy that they can then read the reporting of the FT. And it should teach people enough about the theoretical approaches that underpin policy advocacy that they can then understand and evaluate the policies proposed in contributions to the FT.
        What would such a macroeconomics course look like?
        It would, I think, teach the five still-live theories of the causes of economic downturns that underpin people's analyses. <..>
        All five of these theories are best taught sympathetically by being taught historically: as long traditions of thought that smart people have used to try to understand a changing and confused world. Thus Minskyism from its nineteenth century roots with Walter Bagehot or perhaps Adam Smith grappling with nineteenth-century financial crises, Keynesianism from its roots in Knut Wicksell's studies of disturbances to the flow-of-funds, monetarism from its roots in John Stuart Mill trying to understand the first industrial downturn in England in 1825, overinvestment theories from their roots in Karl Marx grappling with the crisis of 1848, high-real-wage from its roots in Nassau Senior's examinations of technological unemployment in the pre-1850 Midlands--all tussling with a set of problems first raised by Jean-Baptiste Say and Thomas Robert Malthus.
        That would be a macro course that would turn out graduates who could read the FT--and who would be of great value to all the employers who need people to process information from the FT."

Bill Woolsey - Why are many free market economists so critical of the Fed's proposed quantitative easing?

David D. Friedman - Sustainability - "Generalizing the point, "sustainability" becomes an argument against whatever policies one disapproves of, in favor of whatever policies one approves of, and adds nothing beyond a rhetorical club with which partisans can beat on those who disagree with them."

BBC Video - Fund manager Hugh Hendry vs. politicians and audience

Cartoon - QE2, Hayek and Scott Sumner

Thursday, November 18, 2010

Really good links - Too little money chasing too many goods - Credit Easing - Will the Fed Scale Up QE2? - Leverage as a positive good - Currency war - Fed - IOR

Bill Woolsey - Recession - "Recession is NOT too little money chasing too many goods.
        It is too little money chasing too few goods."

Ben Bernanke, please bring credit easing back! Here is what you said about it in 2002:
        "If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities."

Tim Duy - Will the Fed Scale Up QE2? - "But we shouldn't kid ourselves. Flooding the market with money is dangerous business. It risks distorting prices and capital allocations. We simply don't know where the money will wash up. I know that is in vogue to believe there is a nice, obvious story that links an increase in the money supply to an increase in nominal GDP, but that only works on paper. In the real world, the paths between money and output and prices are complicated. The ultimate composition of aggregate demand matters. It matters a lot - distortions have consequences. Warsh's risks amount to a laundry list of the possible distortions that might occur as the result of ongoing quantitative easing. And he clearly takes those risks seriously.
        It makes me think that I haven't been taking those risks seriously enough. But when monetary policy is the only game in town, what choice do you have? You do what you can up to a point…but then you throw it back to Congress and say "you take responsibility for the mess you created by abdicating your role in crafting long run, stabilizing macroeconomic policies." Warsh has set the stage for doing exactly that.
        Of course, seriously, if we really have to throw this back to Congress, we are absolutely done for. Cooked. Toast. Somebody remember to tell the last guy to turn off the lights on his way out. Better to take our chances with the next bubble.
        Bottom Line: One can tell a seemingly optimistic story - the threat of the double dip is behind us, setting the stage for a nice return to potential growth. But that story holds the dark side of persistent, pernicious low levels of labor utilization. Still, I think now the Federal Reserve would have chosen the optimistic narrative had it not been for the obvious slowdown midyear. Which suggests to me they are not eager to do more, especially if growth settles back in at trend. Reinforcing that belief is the Warsh speech, which makes a strong case that further monetary policy is increasingly ineffectual and very risky. But even more important, he makes clear a belief that only Congress and the Administration have the tools to restore growth. I imagine if that view is, or becomes, a widespread opinion among policymakers, we have seen the last gasp of quantitative easing. They have abated the financial crisis, serving as the lender of last resort, and flooded the economy with cash. They have done what they can. The rest is up to the fiscal authorities. "

Brad DeLong - Leverage as a positive good - "Once we had concluded that the Federal Reserve had the tools and the competence to absorb financial shocks, the jaws of the trap snap shut. Leverage then appears to be a positive good rather than a danger. Why? Because if the past two centuries of financial market history prove anything, it is that the markets are woefully short of patent capital willing to bear risks. The financial rich are overwhelmingly the patient risk-bearers. The financial poor are those who sought safety, or who were unwilling or unable to hold their positions and wait for fundamentals to reassert themselves. Leverage then becomes a way of taking the money of the risk-averse of whom the market has too many--for that is what low long-term returns on "safe" portfolios tell us--and putting it too work in the hands of the too-few who will use it to take the long-term risks that the market, historically, has always handsomely rewarded. And financial sophistication becomes a way of concentrating and amplifying the rewards of risk-bearing to call forth additional risk-bearing capital to bolster the numbers of the too-few."

Menzie Chinn - QE2 and currency war - "I have also been thinking about the anger with which the policymakers and economists in the rest-of-the-world (as well as certain US politicians) have greeted QE2 with. In some ways, the fact that they are angry speaks volumes about the effectiveness or ineffectiveness of QE2. (In other words, to criticize QE2 as having no effect, and then to be angry that it is being undertaken, are internally inconsistent views.)
        My view is that anger at the US position is currently being driven by an understanding that QE2 has been surprisingly effective at depreciating the dollar, and that the rest-of-the-world has limited scope in countering that depreciation."

Statsguy - Fed and the support of financial system - "Finally, the one CONSISTENT principle the Fed has pursued has been to support the financial system. Period. I would challenge you to name a single decision in the last 3 years that hasn’t favored the financial system. Even QEI was not unleashed until the Fed was absolutely sure the threat of rising interest rates had been crushed, and the risk of financial collapse through defaulting loans and asset depreciation had exceeded the risk of financial collapse through loss of bond valuations. AKA, liquidity crunch.
        The current QEII round has directed preferential liquidity through primary dealers, thereby supporting trading activity which has buttressed bank balance sheets (in other words, infused capital) to compensate for the bad loan book.
        You currently view Bernanke et. al.’s endorsement of QEII as an intellectual victory. Consider, for a moment, it simply reflects a closer alignment between the interests of large financial entities, and the broader economy."

Niklas Blanchard - Interest on reserves - "I think that Drum gets two things wrong in his analysis. The first is that interest on reserves is a very desirable policy that smooths out the Fed Funds rate fluctuations, reduces lending spreads, and reduces the opportunity costs of capital. Milton Friedman was the most famous proponent of interest on reserves, and Canada and Australia (if I’m not mistaken, working from memory) also pay interest on reserves.
        When Kevin says that the IOR should be zero, what he should be saying is that the Fed Funds rate should be zero, and should have been in Sept 2008 (currently 0-.25, at the time it was 2). "

Monday, November 15, 2010

Really good links - QE2 as a signal - Gold and monetary policy - QEII - EMH - Clearinhouse panic

Menzie Chinn - QE2 as a signal - "There is some mystery why the impact on the exchange rate has been so much more marked than that on long term rates. As several observers have observed, QE2 is fairly small in quantitative magnitude, and in terms of implied impact on duration adjusted interest rates. Theory suggests offsetting inflation and liquidity effects from open market operations, so the impact on observed nominal rates could in principle be small (and in either direction).
        I think a large chunk of the impact comes from the fact that QE2 signals additional information about the willingness of the monetary authorities to undertake actions to stimulate the economy, perhaps by future injections. I will also observe that the likelihood of a sensible fiscal policy declined after the mid-term elections (that is the US will more likely undertake contractionary fiscal policy by not offsetting state spending reductions), so that from a simple Mundell-Fleming model, we should expect dollar depreciation."

Gavyn Davies - The gold price is not a very useful signal - "In the graph, which is drawn on a log scale, the gold price has risen in a virtual straight line for the whole of the past decade. There have been some periods when the gold price has fallen, but these have not lasted very long.
        Over the same period, global price inflation has had periods of rising (before 2007) and falling (after 2007). Government debt ratios and budget deficits have similarly had periods of improvement and deterioration. The dollar has seen years in which its trend has been rising, and years where the reverse has been true. Global current account imbalances have widened, and then narrowed. The gold price has risen when measured in “inflationary” currencies like the dollar, and it has also risen (though by less) when measured in “deflationary” currencies like the yen. In other words, it is not at all clear what the rise in the price of gold has been warning us about.<..>
        Consequently, I am genuinely unsure about what the gold market is signalling which could be useful to policy makers, unless it is just a general message that “things are worrying, so get your house in order”. That may be true, but it does not tell us what to do next."

Tyler Cowen - QEII - "I'm not sure it will work, because it won't fix the housing market, may not restore the demands for wealth-elastic goods in a sustainable manner, may not restore the normal flow of credit to small businesses, may not lower subjective estimated risk premia, and may not fix the general disconnect between expectations and reality. The effects on long-term interest rates are murky. "

Brad DeLong - EMH - "He [Summers] (and I) never were believers in the efficient markets hypothesis. How could we be? Look around: there are idiots! The market's prices are the results of a wealth-weighted voting mechanism: the more money you have, the bigger is your weight in the market's average. People who have done well in the recent past thus have more weight than people who have done badly. But those who have done well me be irrational trend-chasers who have been lucky and those who have done badly may be sober-sided fundamentalists whose time has simply not yet come. The questions of the degree to which the limited amount of risk-averse smart money can leverage itself and profit from all this noise in the market by reducing it is a fascinating and subtle one. But nobody thinks that the answer is that the noise simply does not matter, is ironed out into insignificance."

Craig Pirrong - Clearing, voting and panics - "One other historical note that illuminates another important cost of heterogeneity. In Banking Panics of the Gilded Age, Elmus Wicker shows that with one notable exception (the Panic of 1873), the New York Clearinghouse was unsuccessful in dealing with financial panics and contagion. (NYCH was a bank clearinghouse, not a derivatives clearinghouse, but there are important similarities. Most importantly, NYCH had the ability to mutualize some risks.) Wicker argues that conflicts between heterogeneous members were the main impediment in dealing with panics. Although mutualization of risks would have mitigated panic (because the banks collectively were more likely to be solvent than any individual bank), mutualization transferred wealth from the stronger banks to the weaker ones. The inability to overcome this distributive conflict stymied the ability of the NYCH to respond to crises in an effective way. Thus, not only can heterogeneity increase the likelihood of a problem at a CCP (due to its effect on the severity of moral hazard problems), it can reduce the effectiveness of a CCP in dealing with a crisis situation."

Friday, November 12, 2010

Collapse of the Fed Funds Rate Peg and the Great Recession

The causes of the Great Repression are still a matter of active debate among economists, and Scott Sumner, in a post directed at me, says "the interest on reserve policy was a huge mistake, comparable to the 1936-37 decision to double reserve requirements in the midst of the Great Depression". Here I will attempt to show that the primary cause of the Great Recession was the collapse of fed funds rate peg after the bankruptcy of Lehman Brothers. The second most important cause of the Great Recession is related to the imperfections of interest rate targeting regime that was too closely associated with backward looking Taylor rules. And the interest on reserves program was not a cause of the Great Recession, it was one of the first "green shoots".

The collapse of fed funds rate peg is clearly visible in a chart below. This collapse was seen by markets as a regime change that led to deflationary expectations.

When the standard deviation of effective fed funds rate is so huge, volume weighted average of fed funds rate transactions is no longer a reliable indicator of fed funds rate. As October 2008 FOMC minutes put it, "In the overnight federal funds market, financial institutions became more selective about the counterparties with whom they were willing to trade." Fortunately, overnight LIBOR is an indicator of fed funds market that does not have a participation bias:

Breakdown of fed funds rate market has led to market expectations of elevated future cost of fed funds, and October 2008 FOMC minutes indicated that "the spread of term Libor rates over comparable-maturity overnight index swap (OIS) rates rose sharply from already-high levels". Here is a chart that compares three month Libor to fed funds rate target:

The inadvertent tightening of monetary policy that was caused by the breakdown of fed funds rate market was a matter of great concern for policymakers. On September 18 2008 a $180 billion monetary expansion was announced. The need for softer monetary conditions was communicated to President Bush, who understood the danger and said "If money isn't loosened up, this sucker could go down".

The key instrument that lowered the cost of fed funds was interest on reserves. Start of interest on reserves program led to the announcement of October 13, 2008, on that date the Fed promised to supply unlimited quantity of reserves until the policy objectives have been met. After the announcement overnight Libor and three month Libor rates started falling.

On October 22, overnight Libor finally fell to the rate consistent with the fed funds rate target, and on that date the Fed increased interest paid on reserves to prevent effective fed funds rate from falling further. This was a mistake for two reasons. First, the fed funds rate peg was not completely credible on that date according to three month Libor, and for this reason the expected future cost of reserves was higher than the target. Second, the fed funds rate target as set by the FOMC was too high at that time according to Svenssonian forward looking approach.

Related post: Should Fed stop paying interest on reserves?

Wednesday, November 10, 2010

Really good links - Kocherlakota: helping the victims of real estate bubble crash - Bad loans - What would Friedman say? - Gold - Bernanke put - McLean & Nocera

Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis - Government should recreate the distribution of wealth that existed before the housing bubble crashed - "Amore feasible option might be to allocate government funds so as to re-create the distribution of wealth that existed under the bubble. By doing so, the government can also re-create the higher levels of output that existed under the bubble. This distribution of funds can work in many ways. Consider a person A who has a mortgage from bank B with principal $200,000. A’s property was worth $300,000 at the peak of the bubble and is now worth $150,000. How should the government allocate the proceeds of its new debt issue between A and B? There are many ways to proceed, but my favorite is that the government pays B $150,000 to write down the value of the mortgage to $50,000. I like this approach because A keeps her property and again has $100,000 of equity in her property. In addition, B has a (presumably viable) debt worth $50,000 from A and has received $150,000 from the government."

John Kemp - Bad loans - "But while intervention may have averted the threat of widespread suspensions and failures, the losses from imprudent lending and borrowing to acquire unproductive and permanently impaired assets remain. Someone somewhere has to shoulder them.
        Like central banks around the world, the Federal Reserve has decided they should be borne by depositors, savers, pension funds and bond holders. Not in the form of suspensions, insolvencies and write-downs in the face value of accounts, but through the stealthy and gradual mechanism of negative real interest rates.
        Depositors, savers and bondholders may rail against the unfairness of having their wealth confiscated via inflation, and clamor for a return to more “normal” interest rates. But the reality is that they have put their funds in institutions which have lent and lost them. By making the delinquencies and asset impairments more apparent, normal interest rates would simply accelerate those losses and make them more visible.
        The money has gone. It is not only the banks and their shareholders that have lost money in the crisis. Through deposits and exposure to mortgage products, ordinary savers have lost money too. The only question is what form the losses take.
        Economists remain divided about whether it is better for losses to be recognized and written down, or hidden and gradually worked off over time. But policymakers have shown an overwhelming preference for the hidden, gradual approach."

David Beckworth - Last Word on What Milton Friedman Would Say - "The only reason why Milton Friedman would be critical of QE2 is its ad-hoc nature. While Friedman would be for restoring monetary equilibrium, he would want it to be done in a predictable, rule-like manner. So far that has not happened. It is likely he would have argued the Fed should adopt an explicit nominal target and commit to doing whatever is necessary to maintain it rather than the make-it-up-as-we-go-along approach behind the QEs so far. The economy needs more certainty now and an explicit nominal target would help immensely on this front. "

Martin Wolf - Could the world go back to the gold standard? - "So why choose gold? It is, after all, an impossibly inconvenient means of exchange. But gold has a lengthy history as a widely-accepted store of value. If one is looking to reinstate a pre-modern monetary, gold is the obvious place to start.
        After the experience of the last three decades the monetarism of Milton Friedman is no longer a credible alternative. It was abandoned for two simple reasons: first, it proved impossible for monetarists to agree on what money is; and, second, the relation between any given monetary aggregate and nominal income proved unstable.
        Again, recent experience suggests that we can no longer be so confident that delegation to independent central banks protects against severe monetary instability. That system permitted a gigantic increase in credit, relative to gross domestic product. It is equally clear that governments do not wish to see this edifice collapse, for understandable reasons. This being so, the ultimate solution may be to increase nominal incomes, via inflation. Indeed, several economists recommend this. If that did happen, it would support those who argue for abandonment of the modern experiment with fiat money.
        So would the gold standard be the answer? We would need to start by asking what a return to the “gold standard” might mean.
        The most limited reform would be for the central bank to adjust interest rates in light of the gold price. But that would just be a form of price-level targeting. I can see no reason why one would want to target the gold price, rather than the price of goods and services, in aggregate. <..>
        With these possibilities eliminated, the obvious form of a contemporary gold standard would be a direct link between base money and gold. Base money — the note issue, plus reserves of commercial banks at the central bank (if any such institution survives) — would be 100 per cent gold-backed. The central bank would then become a currency board in gold, with the unit of account (the dollar, say) defined in terms of a given weight of gold.
        In a less rigid version of such a system, the central bank might keep an excess gold reserve, which would allow it to act as lender of last resort to the financial system in times of crisis. That is how the Bank of England behaved during the 19th century, as explained by Walter Bagehot in his classic book, Lombard Street.
        So what would be the objections to such a system? There are three: difficulties with the transition; instability; and lack of credibility."

Izabella Kaminska - Bernanke put - "The Bernanke put — a.ka. that almost magical and metaphysical QE2 effect — appears to be having an impact on equity options skew already.<..>
As UBS comment:
"As we mentioned in our report out earlier this week, These Go to 11, many investors have interpreted a more engaged Fed as providing put protection under the equity market, decreasing the potential for adverse outcomes.
This dynamic can be observed most directly by looking at the option market’s implied volatility skew, which measures the difference between the cost of puts and calls. As illustrated below, this declined significantly following the Fed’s hint at additional QE on September 21. Why buy downside protection when the Fed has done it for you?"<..>
But there is another point that Curnutt makes, which is that the Fed may be unwittingly displacing all that volatility elsewhere:
"…it looks like there’s a divergence between currency and equity volatility. The Fed may be compressing equity volatility but it’s incentivising currency volatility in its place.""
Eric Falkenstein - Book review - All the Devil's are Here, by Bethany McLean and Joe Nocera

Sunday, November 7, 2010

Really good links - Kocherlakota and bubbles - Capping the climate change - Bernanke and stock market - Basel 3

Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis - Housing bubbles, credit bubbles and government bond bubbles - "Insufficiently stringent bank regulation may have relatively little impact on bank profits, but nonetheless lead scarce factors (finance talent, land) to be overvalued. <..>
        There has been a great deal of discussion about how monetary policy should respond to bubbles. I will have nothing to say on this issue. In the United States, monetary policy generally takes the form of open market operations. In an open market operation, the Federal Reserve exchanges some govenment liabilities (reserves) for other government liabilities (Treasuries or securities issued by govenment-sponsored enteprises) of equal market value. In this way, the Federal Reserve can influence the composition of outstanding government liabilities, but not the total value of outstanding government liabilities. (The latter is shaped by Congress.)
        As we will see, in the rational bubble framework, the time path of the total value of government liabilities matters a great deal for economic outcomes. However, the composition of those liabilities is, at a minimum, less essential. Hence, I abstract from the latter consideration entirely–and, in doing so, I abstract from monetary policy. <..>
        Because of the government’s ability to tax, public sector bubbles may be more stable than private sector bubbles."

Andrew Restuccia - Thomas Crocker - Newly released paper details origins of cap-and-trade - Inventor now believes it's the wrong approach to climate change - "Cap-and-trade, which Crocker said is not “inappropriate by any means” to reduce greenhouse gas emissions, works better for traditional pollutants like sulfur dioxide, because “incremental emissions of SO2 do a great deal of damage.”
        “Whereas with respect to greenhouse gases,” he continued, “the marginal damages of an additional bit of greenhouse gas is not going to do much harm.”
        Because each additional increment of SO2 that is emitted into the atmosphere is so detrimental to the environment, a proper policy must give certainty with respect to quantity, Crocker said. Cap-and-trade puts a hard cap on emissions and therefore controls emissions quantity. A carbon tax, on the other hand, provides certainty with respect to pricing — it imposes a certain cost on carbon — but does not set a limit on how much carbon can be emitted across the economy.
        Greenhouse gases, Crocker argued, are not as incrementally dangerous as SO2 and other pollutants. Therefore, price certainty, delivered through a carbon tax, is more important."

Scott Sumner - Dating game (Bernanke and stock market) - "If I had some literary talent, I’d try a dating analogy for the game that Bernanke and the stock market are playing. Bernanke sends out some sweet talk, the stock market responds with enthusiasm. That emboldens Bernanke (a rather shy guy) to send out a bit more sweet talk, with the confidence his ‘policy tools’ are not viewed as being impotent. I think you can see why I’ll stay away from literature, I couldn’t even write trashy romances. <..>
        The way the stock market responded to rather vague and unimpressive rumors of monetary ease, suggests to me that credibility is the last thing Bernanke needs to worry about. The stock market seems like a lonely girl who laps up anything she hears from a sweet-talking guy with a very big wallet in his back pocket. A cheap date.
        What do you guys think? Is Krugman right, or is it easy for the Fed to impress the markets? No need to even mention marriage (i.e. higher inflation targets), just give her a wink and a nod, and promise you’ll spend $600b on the date."

Pablo Triana - Basel III - "By keeping total capital requirements almost intact, demanding that the core equity component of those requirements be substantially raised, and insufficiently modifying the mechanisms through which asset risks are measured, the new Basel III regulatory regime still allows for the possibility of a banking blow-up while making it harder for banks to produce juicy returns.
        While banks can still sink abruptly, the journey enjoyed before that happens might be less glamorous than was the case previously (due to the lower return on earnings implied by the harsher equity demands). In fact, Basel III could well result in a perverse combination of higher risks and lower returns."

Nick Rowe - Monetary policy and Daylight Savings Time

Thursday, November 4, 2010

Really good links - QE2 - Scott Sumner - Milton Friedman - Voter turnout - Plain English FOMC

Brad DeLong - QE2 - "The five-year note carries an interest rate of 1.17% per year. The Federal Reserve is thus changing the supply of assets by taking onto its own balance sheet... wait for it... wait for it... duration risk that the market is currently willing to pay $7 billion a year to avoid.
        To take $7 billion a year of duration risk off of the private sector's books in a global economy that still has more than $60 trillion of financial assets is a change in "credit conditions" equivalent to what would be achieved in normal times by a coordinated one basis point reduction in short-term interest rates by the world's central bankers."

Scott Sumner - QE2 - Will it work? - "In the end, the market movements over the last few weeks seem to be telling us that QE2 is likely to provide a modest boost to the economy, and that a double dip recession is less likely than in August. But overall the future still looks bleak. The Fed’s action fell pitifully short of what was needed. At a minimum, I would have liked to have seen enough stimulus to raise 5 year TIPS spreads to 2.0%, instead they merely rose from 1.61% to 1.65%. We didn’t need more QE, but rather the three-pronged attack I suggested earlier (including lower IOR and level targeting.)
        Of course markets are often wrong, and the economy may do better than expected or worse than expected. But for those of us who favor a Svenssonian policy of targeting the forecast, the verdict is already in; the policy is better than nothing, but not nearly enough. My hunch is that unemployment will remain high for quite some time, and the Fed will be forced to do even more in 2011."

David Beckworth - A Reply to Those Who Claim We Misreprensented Milton Friedman - "The growth rates of the monetary aggregates have been anything but stable. In fact, M3 and MZM--arguably better measures of money during this crisis than M2--have had a recent run of negative growth. While M2 has had positive growth, it too appears below trend. All of them have seen plunges in their growth rates. Would Milton Friedman really look at this graph and conclude there has been monetary stability?
        With that said, one should note that in this 2003 WSJ article Milton Friedman appears to have moved beyond aiming to just stabilize the growth of the money supply. For in this piece he praises the Fed for adjusting M2 in response to a M2 "velocity bubble" in the 1990s. Friedman is endorsing the Fed's actions at this time to offset money demand shocks. Thus, in this article he is implicitly calling for the Fed to stabilize the MV part of the equation of exchange (i.e. MV=PY). "

David Myatt (via jeff) - Rational voter turnout - "If each voter is willing to participate in exchange for a 1-in-2,500 chance of influencing the outcome of the election, then turnout will exceed 50%. "

Update: FOMC statement in plain English

Monday, November 1, 2010

Really good links - Successful QE - What would Milton Friedman say? - QE for bankers - University macroeconomics

David Beckworth - Successful QE in 1934 - "QE has been done before in the United States and it worked incredibly well. It was initiated in early 1934 when FDR and his treasury officials decided to (1) devalue the value of the dollar relative to gold and (2) quit sterilizing gold inflows. <..>
        But that is exactly what was needed, a big permanent shock to inflation expectations that served to stop the deflationary spiral, end the liquidity trap, and allow a recovery in aggregate demand. Now this policy move was backed up with significant and permanent increases in the monetary base over time: it went from about $8 billion right before the policy change to about $24 billion by the end of the 1930s."

Bill Woolsey - What would Milton Friedman say? - "Friedman believed correctly that money expenditures (nominal income) depends entirely on monetary factors. In the long run, unemployment and ouput depend on suppply side factors. And so, monetary factors only determine money prices and wages in the long run. However, short run fluctuations in money expenditures lead to undesirable fluctuations in real output in the short run.
        He found that the conglomerations of assets that make up M2 was more or less proportional to money expeditures. In other M2 velocity is was pretty much constant. The implication was that if the Fed could vary the monetary base in such a way that the M2 combination of assets stated on a 3% growth path, then money expenditures would stay on that same growth path. The price level would be stable, wages and other incomes would grow about 3%, and fluctuations in supply side factors would result in fluctuations in output and also the price level and inflation as the price level moves.
        But it turned out that the M2 measure of the money supply stopped tracking money expenditures. M2 velocity changed.
        Before he died, Friedman noticed that like everyone else. There was never any reason why that combination of assets should necessarily track money expenditures. When they stopped, Friedman began to change his mind.
        However, he always maintained that money expenditures depend on monetary factors, that interest rates don't tell us much about those factors, and that stable growth in money expenditures are important in both the short run and long run."

Karl Smith - QE explained for bankers - "However, the Fed’s strategy can be summed up succinctly for bankers: get out of long dated nominal Treasuries. In the short run we are pushing down yields, so we are lowering the return you can lock in. In the long run yields are going to pop up so you are going to take capital losses.
        Ergo: find some other place to put your money."

Nick Rowe - University macroeconomics and Barro-Grossman supply-side multiplier - "The supply of seats is determined by the individual department. But the demand for seats is determined centrally, by Admissions. Admissions is ordered to bring in as many students as are needed to pay the profs' salaries. But each individual prof and department wants to reduce the number of bums on seats in his course and his department.
        The result is a classic case of chronic excess demand for seats. Just like in the old Soviet Union. Capitalist economies have chronic excess supply. Communist economies have chronic excess demand. My job as associate dean (because I made it my job) was to persuade, cajole, bribe, threaten, or bully departments into putting on enough seats for the bums that needed or wanted to sit in them. I was what the Russians used to call "the pusher". <..>
       You get hoarding. Students grab a seat in any course that's open, even if they think they will probably not want it, just in case they do want it and can't find a seat.
        What's worse is that you get Clowerian spillovers. Walras' Law is totally false. The sum of the excess demand for seats can add up to anything whatsoever, because the student who can't get a seat in course A, will try to get a seat in course B instead, and if he can't will try for course C,...then maybe try course A again, and so on. So the central planner (that was me) trying to find out how many extra seats in which courses are really needed, hasn't got any idea. A notional excess demand for one seat in one course can create an effective excess demand for hundreds of seats all over the university. I am one of the very few economists who has actually seen the Barro Grossman supply-side multiplier at work, in real time. Create a couple more seats in one course, and seats suddenly start appearing in other courses all over the university."

The Money Demand