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

Thursday, March 25, 2010

Really great links - Textbook models and extra reserves - Calibrating the quantitative easing - China bubble - Krugman vs. Krugman

Donald Kohn - Textbook models and extra reserves - "A second issue involves the effect of the large volume of reserves created as we buy assets. The Federal Reserve has funded its purchases by crediting the accounts that banks hold with us. Those deposits are called "reserve balances" and are part of bank reserves. In our explanations of our actions, we have concentrated, as I have just done, on the effects on the prices of the assets we have been purchasing and the spillover to the prices of related assets. The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. Other central banks and some of my colleagues on the Federal Open Market Committee (FOMC) have emphasized this channel in their discussions of the effect of policy at the zero lower bound. According to these types of theories, extra reserves should induce banks to diversify into additional lending and purchases of securities, reducing the cost of borrowing for households and businesses, and so should spark an increase in the money supply and spending. To date, that channel does not seem to have been effective; interest rates on bank loans relative to the usual benchmarks have continued to rise, the quantity of bank loans is still falling rapidly, and money supply growth has been subdued. Banks' behavior appears more consistent with the standard Keynesian model of the liquidity trap, in which demand for reserves becomes perfectly elastic when short-term interest rates approach zero. But portfolio behavior of banks will shift as the economy and confidence recover, and we will need to watch and study this channel carefully."

Donald Kohn - Quantifying the quantitative easing - "However, the economic effects of purchasing large volumes of longer-term assets, and the accompanying expansion of the reserve base in the banking system, are much less well understood. So my second homework assignment for monetary policymakers and other interested economists is to study the effects of such balance sheet expansion; better understanding will help our successors if, unfortunately, they should find themselves in a similar position, and it will help us as we unwind the unusual actions we took.
One question involves the direct effects of the large-scale asset purchases themselves. The theory behind the Federal Reserve's actions was fairly clear: Arbitrage between short- and long-term markets is not perfect even when markets are functioning smoothly; and arbitrage is especially impaired during panics when investors are putting an unusually large premium on the liquidity and safety of short-term instruments. In these circumstances, reducing the supply of long-term debt pushes up the prices of the securities, lowering their yields.
But by how much? Uncertainty about the likely effect complicated our calibration of the purchases, and the symmetrical uncertainty about the effects of unwinding the actions--of reducing our portfolio--will be a factor in our decisions about the timing and sequencing of steps to return the portfolio to a more normal level and composition. Good studies of these sorts of actions are sparse. Currently, we are relying in large part on studies that examine how much interest rates dropped when purchases were announced in the United States or abroad. But such event studies may not be an ideal means to predict the consequences of reducing our portfolio, in part because the economic and financial environment will be very different, and also because event studies do not measure effects that develop or reverse over time. We are also uncertain about how, exactly, the purchases put downward pressure on interest rates. My presumption has been that the effect comes mainly from the total amount we purchase relative to the total stock of debt outstanding. However, others have argued that the market effect derives importantly from the flow of our purchases relative to the amount of new issuance in the market. Some evidence for the primacy of the stock channel has accumulated recently, as the prices of mortgage-backed securities appear to have changed little as the flow of our purchases has trended down."

Willem Buiter - "A bubble is a manifestation of out-of-control or over-the-top economic success; you find bubbles in countries with strong fundamentals. In no major country are the fundamentals stronger, the structural change more dazzling or the policy authorities less experienced at managing a market economy than in China. We recognize that experience and familiarity with the modus operandi of a financial market economy are no guarantor of good policy. Even highly experienced monetary policymakers and financial regulators, heading institutions with a track record of decades, like the current and previous Federal Reserve Chairmen, failed to identify and prevent excessive credit growth and asset bubbles, and may indeed have contributed through their regulatory and monetary policy actions (or inaction) to the financial boom, bubble and bust that severely damaged the financial system of the US. Even so, the fact that those in charge of monetary, financial and credit management in China are operating in terra incognita increases the risk of policy errors."

Greg Mankiw - Krugman vs. Krugman - "In my view, a default on U.S. government debt is less likely than another scenario, suggested by Paul Krugman:
How will the train wreck play itself out?...my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar. It won't happen right away....But unless we slide into Japanese-style deflation, there are much higher interest rates in our future.
I think that the main thing keeping long-term interest rates low right now is cognitive dissonance. Even though the business community is starting to get scared — the ultra-establishment Committee for Economic Development now warns that "a fiscal crisis threatens our future standard of living" — investors still can't believe that the leaders of the United States are acting like the rulers of a banana republic. But I've done the math, and reached my own conclusions.
Actually, Paul wrote that in 2003, and we know now that his prediction of higher inflation did not come to pass"

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