October 25, 2009
Evaluating the new tools of monetary policy
Last week I participated in a conference hosted by the Federal Reserve Bank of Boston, at which I discussed the new lending programs and asset acquisitions pursued by the Federal Reserve over the last two years. Previously I shared with Econbrowser readers empirical evidence on the effects these targeted liquidity operations seem to have had. Below I reproduce my remarks from the conference on the underlying motivation for using such measures, in which I suggested that the critical question is what was the underlying cause of the financial stress to which the Fed was responding. I distinguished between two possible interpretations of how the financial crisis arose.
Perspective 1: Everybody just panicked
The first interpretation of what went wrong is that financial markets were pricing risk correctly in 2006 but began to overprice risk in 2007. Keister and McAndrews analyzed a situation in which banks out-of-the-blue stop lending to each other, while Gorton interpreted events in terms of a classic bank run, in which the liquidation value of entities is feared to have fallen below their short-run liabilities, creating an incentive for lenders to refuse to renew short-term credit. In the benign version of this theory, the troubled entities would in fact be solvent if it were not for the "fire-sale" prices at which distressed assets must be sold in such an environment. If allowed to proceed unchecked, these fears could prove self-fulfilling and result in a rapid collapse of credit.
In terms of appropriate policy responses to this problem, I would distinguish between actions that might have helped if implemented earlier in the decade and options that were available if we begin the analysis in the fall of 2007. If we are looking at what might have been done years earlier that could have helped, the obvious answer is to consider regulatory reforms that might have prevented financial markets from reaching a point at which the liquidation spiral could be set off in the first place. Bank panics are not an inevitable result of private financial intermediation. The key principle for avoiding them is to ensure that the liabilities of financial institutions consist not just of short-term borrowing, but also of equity contributed by the owners. As long as this equity cushion exceeds potential liquidation losses, there is no incentive for short-run creditors to rush to get their cash back, and no insolvency for the bank in the event that the bank does experience a run. It was a regulatory failure to allow an explosion of off-balance sheet entities that borrowed short and lent long but were immune from bank capital requirements.
On the other hand, if we ask what policy options were available after we had entered the fall of 2007, this particular policy prescription is of no help, as the horses were already out and the barn had no capital. Since there are profound negative externalities from simply watching asset prices and lending collapse, there would seem to be a clear case for the Fed to fulfill the function of lender of last resort, lending and buying assets where others won't until the panic subsides and rational valuations return, and trying to do so in such a way that otherwise solvent enterprises were shielded from a panic bankruptcy.
Perspective 2: The core problem in credit markets preceded the crisis
An alternative perspective is that risk was incorrectly priced in the years leading up to the crisis with rationality only returning in 2007-2008. During 2004-2006 there was $2.7 trillion in new subprime and alt-A mortgage debt generated; (Ashcraft and Schuermann). Much of this was extended without documentation of the borrowers' income, little or no money down, negative amortization, and called for huge increases in the borrowers' monthly payments a few years into the loan. Yet somehow through the magic of securitization, this debt was repackaged into tranches that overwhelmingly received AAA credit ratings.
Such massive capital flows only made sense if one believed that house prices would continue to expand rapidly. Because this process was funneling such huge sums into the U.S. housing market, for a while house prices did just that, more than doubling between 2000 and 2005 according to the Case-Shiller 20-city house price index. U.S. household mortgage debt tripled in a little over a decade. According to this second interpretation, when house prices inevitably came crashing down, they brought with them defaults not just on the hybrid subprime and alt-A mortgages, but also put many otherwise sound borrowers underwater.
If it is claimed that the run-up in house prices and mortgage debt were a horrible miscalculation, what were the market failures that produced it? There is a long list of contributing factors. The originate-to-distribute model left the loan originators and securitizers with profits and lesser-informed buyers with the losses, creating agency problems; (Ashcraft and Schuermann). Intra-firm compensation schemes left decision-makers personally with the upside and stockholders with the downside, inducing excessive risk-taking; (Diamond and Rajan; Bebchuk and Spamann). The public-private GSEs Fannie Mae and Freddie Mac were woefully undercapitalized, giving private players the upside and the taxpayers the downside, and perhaps emboldening private securitizers to take even bigger risks (Hamilton). Both the compensation and procedures of the ratings agencies may have contributed to inaccurate perception of the safety of MBS (Ashcraft and Schermann), as did the mistaken perception that entities like AIG had the ability to insure against aggregate default risk. Moral hazard problems induced from the (ex post correct) belief that the U.S. government would absorb the downside on such gambles may have been another factor inducing excessive risk-taking.
If this perspective is the correct one, we can again distinguish between policies that would have made sense earlier in the decade and policies that were realistic options once we entered the crisis phase in 2008. If the above list of contributing market failures is correct, obviously addressing these with regulatory reforms before we reached the crisis point would have been the first-best option. On the other hand, if we condition on previous policy mistakes and ask what could have been done with options available in the fall of 2008, I disagree with those who reason that the way to correct the moral hazard problem is to hang tough in this situation and simply watch the losers go down. There are huge macroeconomic externalities from the resulting collapse of credit, which is why the government claiming it will not bail out the gamblers is not a credible strategy. Instead, this perspective suggests that the key policy question once we find ourselves in the fall of 2008 is how to allocate the necessary capital losses among lenders, stockholders, and the taxpayers in a way that minimizes the disruptive externalities of a credit collapse. If this is the correct perspective, the primary effect of targeted liquidity measures is simply to allocate these potential losses to the Federal Reserve. It is far from clear that this is the appropriate way for a democratic society to answer the question of who should bear the losses.
Finding the middle ground
I laid out the two perspectives above as diametrically opposed views. I nevertheless believe that the correct interpretation of events would acknowledge that each account contains some truth. It is hard to deny that there was some degree of misallocation of capital in the explosion of house prices and mortgage debt or that the resulting real estate price collapse was a key cause of the devaluation of securities and loss of bank equity that precipitated the banking panic phase. The remarks I presented at the Jackson Hole conference in August 2007 laid out precisely this scenario. We might disagree on how much of that $2.7 trillion in new subprime and alt-A debt represented a malfunctioning capital market, and characterize the middle ground between the two views in terms of choice of a number between 0 and 2.7. If that number is big enough, it may be that no realistically feasible level of bank equity would have been sufficient to assure solvency in the face of a deterioration of confidence, and there is certainly the potential for fire-sale asset price deterioration and a necessary role for the Federal Reserve to fulfill its role of lender of last resort. But obviously from this hybrid perspective, the Fed is performing a combination of liquidity provision and residual loss absorption through these operations, and would want to undertake the latter only with extreme care and thoughtfulness.
Participants in this session were asked to address two basic questions. The first is whether the Fed's targeted liquidity operations were necessary and effective. My answer is probably yes, though I would have a hard time persuading someone if they were not already convinced of that. The second question is whether such operations should be considered an important part of central banks' arsenal of tools in the future. To that my answer is categorically no. From virtually any perspective of our current problems, it would have made far more sense to address these problems with proper regulatory supervision prior to the crisis instead of targeted liquidity operations after the crisis unfolds.
You can view my complete set of comments prepared for the conference here.
Posted by James Hamilton at October 25, 2009 06:03 AMdigg this | reddit
Would the money supply in the USA during the last decade have outmatched the GDP growth? (The same in Europe courtesy of the ECB)
But not only in the USA, worlwide ? Here again outmatching the world GDP growth?
The 10 yields curves have been on a downwards paths and never,ever feared inflationary threats ? (Its replica in Europe courtesy of the ECB)
FRED GS10 V: 2009-09-08 10-Year Treasury Constant Maturity Rate, Monthly, Percent
May we please know why such a large amount of interest swaps Graph 2/ 3 concentrated among so few ?
At every financial debacle the same conclusion a concentration of risks on specific assets,collateral being irrelevant as not only mispriced but not to be sold as they would increase the downwards pressure on collateral value.Banks would earmark assets at a given prices against security but would be unable to reach them through sales. The markets have evaporated as they usually try to sell at the same time.A recurrent phenomena in the financial world has this time been more damaging as it has been leveraged. Prior to the crisis the banks balance sheets were showing leverage,unsuffiscient capitalisation and risk concentration on the same assets.
Legislators may think well, execution is always the culprit.There are central banks where money supply and banks supervision are the vested powers. A reminder of the same in the business world,when asked to long trained lawyers where are the major causes of disasters in the financial arena. The answers are invariable the conditions precedent for the materialisation of the transactions are well thought, the transaction is balanced, but throughout the life of the deal they are no longer in compliance and more often at the time said to be the period of availaibility .
Posted by: ppcm at October 25, 2009 09:40 AM
I have nothing new to say on the philosophy, but it's worth pointing out that by mid-November we will have finally past the peak of monetary stimulus.
Not only is the Fed wrapping up its purchases of $300 billion of Treasures, which went straight into the general economy in the form of federal deficit spending, the Fed is redeeming the last $200 billion of Treasury "supplementary financing" bonds, which were used to sterilize the money-creating effect of Fed purchases before Congress allowed the Fed to pay interest on reserves. This was done by having the Treasury sell additional Treasuries beyond its financing needs and deposit the proceeds at the Fed. About $200 billion of that debt was one-year paper that started falling due in late September, creating an additional burst of monetary stimulus over the past several weeks as Treasury withdraws the cash from the Fed and pays off the debt.
The Fed plans to continue pumping some $20 billion of newly created money into the mortgge sector through the end of March.
Posted by: Tom at October 25, 2009 09:57 AM
"the key policy question"..."is how to allocate the necessary capital losses among lenders, stockholders, and the taxpayers in a way that minimizes the disruptive externalities of a credit collapse."
From my perspective, once you make the equivocation "minimizes the disruptive externalities", you can justify any action to keep the corrupt and incompetent incumbents in power. Indeed, that is precisely the defacto policy of the Federal Government for at least the last 40 years.
Where are the prosecutions for fraud? Where is the policy and legislation for OTC derivative regulation? Where is the claw-back from the deal makers who profited from sub-prime and adjustable rate mortgages? Where do you find proper pricing and appraisal of distressed mortgage securities? What changes have been made to the deck chairs controlling banking and finance policy in the Treasury, White House and Fed?
I'm not going to hold my breath waiting for the oligarchs to purge themselves. I've concluded that the only way we can get effective change, is to let over-leveraged and/or corrupt institutions collapse. I'm suprised, Dr. Hamilton, that you're still willing to continue to enable the same disfunctional system with massive increases in public debt.
Posted by: Anonymous at October 25, 2009 10:13 AM
Once again an entirely approachable, cogent and erudite post. Thank you.
Posted by: Rob at October 25, 2009 02:23 PM
"There are huge macroeconomic externalities from the resulting collapse of credit, which is why the government claiming it will not bail out the gamblers is not a credible strategy. Instead, this perspective suggests that the key policy question once we find ourselves in the fall of 2008 is how to allocate the necessary capital losses among lenders, stockholders, and the taxpayers in a way that minimizes the disruptive externalities of a credit collapse."
This is the central insight, I think. This brings us back to familiar turf for macroeconomics. It would be interesting to contemplate exactly what these externalities are, how they are to be measured, and how they might be allocated, at least in principle.
Posted by: Steven Kopits at October 25, 2009 05:18 PM
This weekend I was reviewing some of the economic declines in economic history and I was simply overwhelmed by how instrumental the government was in creating nearly everyone of them either through subsidy to crooks or by direct action. But even more overwhelming was how the press and economic community white-washed the guilty in government. The rule of thumb is that if your party is in power you get a free hand, if your party is out of power you get a tongue lashing, but usually keep your seat.
Connecting that with question of how could anyone allow a Hitler or Mussolini come to power and it is easily seen. And at this point Edmund Burke's quotation from his Thoughts on the Cause of Present Discontents (1770): "When bad men combine, the good must associate; else they will fall one by one, an unpitied sacrifice in a contemptible struggle" is most appropriate. Who will stand up against the evil that is infecting our monetary policy and our economy in general.
Your points are valid but your omissions scream for exposure. It is like a doctor discussing symptoms because he is afraid to tell his patient that he is about to die.
Posted by: RicardoZ at October 26, 2009 05:01 AM
"The second question is whether such operations should be considered an important part of central banks' arsenal of tools in the future. To that my answer is categorically no. From virtually any perspective of our current problems, it would have made far more sense to address these problems with proper regulatory supervision prior to the crisis instead of targeted liquidity operations after the crisis unfolds. "
Hooray! Let's abolish the "Greenspan Mop Up". We need the Fed to set it's goals higher than just being the "Janitor of Last Resort".
Posted by: Cedric Regula at October 26, 2009 08:00 AM
Participants in this session were asked to address two basic questions. The first is whether the Fed's targeted liquidity operations were necessary and effective. My answer is probably yes.... The second question is whether such operations should be considered an important part of central banks' arsenal of tools in the future. To that my answer is categorically no.
This makes no sense. If the operations were necessary and effective how can you say they now should not be one of the CBís tools? Isnít it foolish to take away any tool that is effective?
It makes sense to say that the operations were ineffective and more, contributed to the problems while creating additional problems making it more difficult for the FED to stabilize the currency. Then you could say it should not be one of the CBís tools.
Posted by: RicardoZ at October 26, 2009 11:52 AM
Congratulations on a light shedding simple summary of the issues.
I look on the episode as a classic banking panic including a housing lending /collateral bubble. But also brand new panic inducing, insovency producing abuses. Thats why your list is key. i would argue the two new drivers leading to your list are
1 Exotic products,including credit products with little credit assessment selling at overvalued prices, and abysmally bad accounting of them.
2 Abuse of insurance type products like Fannie and freddie guarantees and Credit default swaps.
Posted by: AWH at October 26, 2009 12:46 PM
What rating do you think the subprime/Alt-A loans from 01-07 would have received had they been originated in 1980? The answer is simple: 100% of those applications would have been rejected.
ALL of the non-bank mortgage lending was pure fraud. If you doubt, please start reading the works of Tanta over at Calculated Risk.
You really don't need a theory - the loans were fraud, there never was any ability to make payments, yet the nominal value of the debt remains.
The current economic malaise is simply the Panic of 1865 with the names of the players modernized for cable television.
Posted by: Unsympathetic at October 27, 2009 07:13 AM
Your comment that "the Fed is performing a combination of liquidity provision and residual loss absorption through these operations, and would want to undertake the latter only with extreme care and thoughtfulness. " is a good one. It is unfortunate that the Fed has failed regarding care and thougtfulness, thus far - to the point of violating the US Constitution.
Bloomberg News has reported that the NY Fed, under Geithner, refused to negotiate or segment AIG's payouts for CDSs, despite widespread practice to do so, and they refused to make the term sheets public despite it being public money. US taxpayers got stung for over $13 billion that unnecessarily went to large banks to bail them out of capital shortages. Since this was a back-door rescue, not authorized by either Congress or the Treasury, it is a violation of the Constitutional principle that disbursement of taxpayer funds starts in the House of Representatives. More details are on Bloomberg's site at http://www.bloomberg.com/apps/news?pid=20601109&sid=a7T5HaOgYHpE
Since the Fed has not acted legally, they do not deserve to be independent. They need closer supervision by a Congressional appointed group, and the Fed needs to make all transactions open and public. We can debate the schedule for openness, but after a few months (less than 3), all Fed transactions should be public. It is after all the public's money.
Posted by: Mike Laird at October 27, 2009 04:45 PM
Let's suppose that the country gets out of the current mess in relatively good shape. Once growth comes back and "market euphoria" sets in, what's going to prevent the same type of excess from happening, especially when executives in financial companies know for a fact that the "too big too fail" policy will kick in should they get in major trouble?
Posted by: Investing 101 at November 13, 2009 01:43 AM