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

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


  1. I haven't read the linked Kocherlakota pdf, but my immediate reaction to the bit you've quoted is that it's pretty dumb. It ignores the role of expectations. During the bubble, both person A and bank B were expecting house prices to keep rising forever, and that's why she was mortgaged to the hilt and was able to spend money like a Congressman. Paying off part of her mortgage for her is not going to restore those expectations.

  2. Anonymous, if I only quoted the smart bits my blog would be pretty boring, wouldn't it?

    Kocherlakota does not want to restore housing bubble expectations. He wants to create a new government bond bubble, and use the proceeds to compensate housing bubble victims.


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