Wednesday, July 14, 2010

Another Excuse: Shadow Banks

“One important reason” for the magnitude of the recent crisis, Federal Reserve Chairman Ben Bernanke told a Dallas audience on April 7, was “that the subprime mortgage market was closely linked to a broader framework for credit provision that came to be known as the shadow banking system…. The innovation underlying the shadow banking system was that it helped provide a wide range of borrowers indirect access to global credit markets” (my italics).

On May 6, Treasury Secretary Timothy Geithner told a commission investigating causes of the crisis that “Failure to give regulators enough legal power and the growth of a shadow banking system were behind the eruption of the financial crisis…. [L]oosely-regulated non-bank financial firms had grown to a size nearly equal to the traditional banking system.”

Who are these shadowy lenders outside the control of regulators and therefore able to bring the system down? So far as I can tell from the discussions of Bernanke, Geithner, and others, they are simply the nonbank financial intermediaries that have always been with us, and, as in other developing economies, have tended to grow faster than commercial banks. The figure shows the percentage of commercial bank assets relative to those of all financial intermediaries (including banks, savings and loans, credit unions, and insurance) in the U.S. since 1900, based on data in the references below (Goldsmith, Boyd and Gertler, and Mishkin). Geithner’s belated recognition of the “problem” is an understatement. Textbooks on “money and banking” have long considered, and often been titled, “money, banking, and financial markets,” with extensive treatments of nonbank financial intermediaries (NFIs). An example, is, Ritter and Silber, dating from the 1970s and now in its 12th edition.

So if the shadow banking system (NFIs) is not new, what’s their point? It’s apparent that they are using shadow banks as an excuse for policy failure – not for the first time. In the 1960s and 1970s, NFIs were cited as a reason for the impotence of monetary policy, inspired by Goldsmith’s data (see the figure) that showed the considerable relative decline of commercial banks since 1900. If most of the credit system is outside the Fed’s control, monetary policy must be irrelevant, argued proponents of the New View of banking and credit, who also denied the special characteristics of commercial banks. “The distinction between commercial banks and other financial intermediaries has been too sharply drawn,” James Tobin (1963) wrote. “The differences are of degree, not of kind [and] have little intrinsically to do with the monetary nature of bank liabilities.”

That leaves fiscal policy the Keynesians said. Keynes’s (1936) definition of money had been loose, applying to short-term assets in general rather than to the medium of exchange, and therefore, his followers alleged, could not be controlled. Anyway, they said, prices were due to the wage- and cost-push of unions and monopolists rather than money. These views coincided with the Great Inflation that lasted from the effective end of the gold standard in the early 1930s to the early 1980s, during which the U.S. price level rose eightfold.

The turnaround of monetary policy in the 1980s followed the rejection of Keynesianism, including the New View. Critics of the New View pointed out that the monetary nature of their liabilities gave banks unique leverage over total credit since all transactions, including financial transactions, are carried on through money (Guttentag and Lindsay 1968; Wood 1970). Money is important, Milton Friedman and Anna Schwartz (1963) argued. That inflation is a monetary phenomenon, which the Fed can control, was accepted in the 1980s and successfully applied throughout the developed world. It was again agreed that price and financial stability follow from stable monetary policy.

NBIs are not unimportant, but the vital roles of money and commercial banks have not changed. And neither has the principal cause of financial crises – bad bank loans.


John Boyd and Mark Gertler. “Are banks dead or are the reports greatly exaggerated?” Federal Reserve Bank of Minneapolis Quarterly Rev., Summer 1994.

Milton Friedman and Anna Schwartz. A History of Monetary Policy in the U.S., 1867-1960. Univ. of Princeton Press. 1963.

Raymond Goldsmith. Financial Intermediaries in the American Economy since 1900. Princeton Univ. Press. 1958.

Jack Guttentag and Robert Lindsay. “The uniqueness of commercial banks,” J. Political Economy, Oct. 1968.

J.M. Keynes. The General Theory of Employment, Interest and Money. Macmillan. 1936.

Frederic Mishkin. The Economics of Money, Banking, and Financial Markets. 7th ed. update. Pearson Addison Wesley. 2006.

Lawrence Ritter, William Silber, and Gregory Udell. Principles of Money, Banking, and Financial Markets, 12th ed. Prentice Hall. 2009.

James Tobin. “Commercial banks as creators of ‘money’,” in D. Carson, ed., Banking and Monetary Studies. Irwin. 1963.

John Wood. “Two notes on the uniqueness of commercial banks,” J. Finance, March 1970.


Saturday, June 26, 2010

It's Nothing to Do With Us

It’s Nothing to Do with Us

1. “Global saving intentions … chronically exceeded global intentions to invest…. In short, geo-political events ultimately led to a fall in long-term mortgage events.”

2. “I define a bubble as a protracted period of falling risk aversion that translates into falling capitalization rates that decline measurably below their long-term trendless averages.”

3. “We have chosen capital standards that … cannot protect against all potential adverse outcomes…. Hundred-year floods come only once every hundred years.”

4. “The global house price bubble was a consequence of lower interest rates, but it was long term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seeming conventional wisdom…. The 30-year mortgage rate had clearly delinked from the fed funds rate in the early part of this decade.”

5. “Could the breakdown that so devastated global financial markets have been prevented? Given inappropriately low financial intermediary capital and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.”

Alan Greenspan, The Crisis, March 2010.

These are some of the Federal Reserve’s excuses for the recent crisis. Its disclaimers of responsibility have become famous. We are not sure that they are without merit, but they are not well-reasoned. Most of the evasive statements of Federal Reserve officials have been unsupported assertions of innocence, untroubled by the careful explanations that we are entitled to expect from the “experts” that we have raised to “responsible” public positions. Their actions and calls for action are justified by hysterical claims that if we don’t do something, the world’s financial system will melt down. We won’t have an economy tomorrow. We are looking at an abyss (see the 9/14/09 blog). The transparency so often promised is not forthcoming, although we don’t know whether this is because the Federal Reserve is secretive or because it doesn’t know what it’s doing.

Once in a while, however, one of them provides pieces of an account of events – such as former Fed Chairman Alan Greenspan’s explanation of The Crisis, excerpts from which are listed above. It was not well-received (e.g., The Economist, March 20, 2010), but it might provide an inkling of the economics behind the policies that have baffled students of the Fed. I consider the stated elements of what might be his model in the order listed.

1. They made us do it. Greenspan has an unusual view of how interest rates are determined (we will see more of this below), which in standard economic theory depends on the supply (thrift) and demand (investment) for savings, that is, on the competition for funds. Saving is a fairly steady proportion of income, so that the demand for capital goods drives interest rates and growth. That is why investment, interest rates, and income are procyclical. Greenspan, however, sees no effect of investment on interest rates (ignoring a blade of the scissors that Alfred Marshall used to illustrate the determination of price by the intersection of supply and demand) and attributes low real interest rates to the global saving that accompanied rising income. Funds were so abundant that savers could not be careful about the risks of their lending. It was a borrowers’ market.

Not only is Greenspan’s explanation wanting because it ignores demand during the global boom of the early part of the decade, so is his observation. The figure shows that real long-term interest rates (LTR – p) were not low by historical standards.

2. Changed people or changed incentives? The penchant of each generation to be convinced of declines in morals and the work ethic is not new. Greenspan has joined the crowd in blaming the bubble on a rise in greed (a fall in risk aversion), and neglects the possibility that the boom was due to a change in incentives.

The title of his book, “The Age of Turbulence,” like Kenneth Galbraith’s “The Age of Uncertainty,” reveal his lack of historical perspective. The Tulip Craze of 1630, the South Sea Bubble of 1720, the Panic of 1873, and the 1929 Crash might as well never have happened. Instead of considering the opening lines of Dickens’ “Tale of Two Cities,” Greenspan treats each event as unique and without precedent, and therefore not susceptible to analysis.

He fails to account for the implied government guarantees behind the government-sponsored subprime mortgage creators (Fannie Mae and Freddie Mac), the Too Big to Fail frame of mind of regulators, and the Greenspan put (bailout promise) on the risks perceived by lenders. An increased expectation of bailouts is a reduction in perceived risk rather than risk aversion. However much Greenspan likes the easy explanation, recent events suggest more continuity than change in human behavior.

3. The hundred-year flood metaphor is false. Snake-eyes occur on average once every thirty-six throws of a pair of fair dice. This changes if the dice are loaded. Similarly, although we might reasonably estimate a financial collapse once every hundred years in a given environment, the odds change if we alter the environment by increasing the incentives to take risks.

Capital has been a poor predictor of financial failures, as must be the case if we are not careful about the risks of assets. The capital sufficient to protect depositors against the dangers of high-risk loans exceeds that for low-risk loans. Capital regulation has never been successful (as was noted in my 9/29/09 blog), partly because capital ratios are determined by the same factors (such as the perceived risks discussed above and the seriousness of regulation) as assets. Regulation in general and capital regulation in particular are popular solutions for those unwilling to admit the effects of information or incentives on the behavior of financial (and other) institutions.

4. The claim that long rates were “delinked” from short rates denies economics and central banking. Long rates depend on expected short rates, and central banks have operated through short rates from their beginnings. A classic defense of “bills only” (short-term Treasuries) as its primary instrument was issued by the Fed in the 1950s. If short rates have no effects, one can only wonder what Greenspan thinks the Fed is doing.

5. It was inevitable. Booms have often been followed by busts, but central bankers have usually “leaned against the wind,” as Fed Chairman (1951-70) William McChesney Martin, Jr., put it. He also said: “It’s my job to take away the punch bowl just as the party gets going.” Martin and other central bankers have made plenty of mistakes, but they have usually accepted responsibility for moderating financial developments. Greenspan rejects this and other responsibilities, although his stated economic ideas suggest that he couldn’t have been effective anyway.


Tuesday, April 27, 2010

The FDIC's Call for Papers

In the 19th century, U.S. Supreme Court Justice Samuel Miller complained about the "united, vigorous, and selfish effort of the capitalists" to protect their interests. Their suits had "shaken my faith in human nature.… They engage in no commerce, no trade, no manufacturing, no agriculture. They produce nothing."

The Federal Deposit Insurance Corporation's Center for Financial Research and the Journal of Financial Services Research recently invited papers for their 10th Annual Fall Research Conference with the following theme:

Financial services are intermediate inputs that provide benefits to society when they contribute to economic growth and raise standards of living. As a share of GDP, financial services have grown from 2.5 percent in the 1940s to almost 8 percent today. During this period of growth, few questioned whether the finance sector created social benefits commensurate with its share of GDP. Following the crisis, many are re-examining the linkages between the financial sector and sustainable growth. Government policies, moreover, are likely to alter the existing balance between finance and the real sector. Many market failures have been identified as a source of skewed incentives that inflated a credit bubble.

Talk about standing history on its head! Middlemen of all types, including financial, have always been objects of a popular hatred that politicians and regulators have sought to exploit. The present is no exception. In his first Inaugural Address, Franklin Roosevelt said the Great Depression occurred

Primarily … because the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence…. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men…. Faced by failure of credit they have proposed only the lending of more money [we wish]…. They know only the rules of a generation of self-seekers.

The money changers have fled from their high seats in the temple of our civilization. We now restore that temple to the ancient truths. The measure of the restoration lies in the extent to which we apply social values more noble than mere monetary profit.

We know that the Great Depression was one of the greatest government failures of all time: wildly fluctuating monetary policies (inflation during and after World War I followed by severe deflations) of the Federal Reserve (a government agency created in 1913), which finally abandoned its responsibilities.

Overlooked by populists and politicians, as well as in the theme of the FDIC’s conference, is that intermediaries do produce things – particularly the transport of goods and money from suppliers (including lenders) to users (including borrowers), activities that include the production and use of information, which, contrary to the attitudes of regulators, is not free. We must remember that financial intermediaries exist because of transaction costs, including the costs of information, and that they compete for profits by producing and selling information and other transaction services – just as manufacturers pursue profits by buying inputs, transforming them into tangible products, and selling them. Economist Robert Clower wrote in his compelling fashion:

The trades that take place in a market economy ultimately are determined by the quantity and distribution of natural and human resources and by individual tastes. This is true regardless of the manner in which trade is organized. In the absence of market-making firms, however, … vast quantities of resources would be diverted away from directly want-satisfying production and consumption activities into tiresome and inefficient search and bargaining chores…. [T]he firms that make and operate our numerous retail, wholesale, manufacturing, and service markets are the visible fingers of the invisible hand -- the fingers that coordinate the countless activities of people in every modern society.

The conference call’s suggestion that the growth of intermediary services as a share of the economy is recent also flies in the face of history. Industrial and financial revolutions, old and new, have been inseparable (Goldsmith 1954; Carter 2006). The coiner of the term, Arnold Toynbee (1884), wrote:

The essence of the Industrial Revolution is the substitution of competition for the mediaeval regulations which had previously controlled the production and distribution of wealth.

The conference call’s reference to market failures is also misguided. Market failures may occur – although the tendency of economists to attribute failure to the latter when theory and practice do not conform is suspect – but the recent crisis was the result of the responses of households and firms to government-promoted adverse incentives – including the promotion of packages of subprime mortgages by Government Sponsored Enterprises, official endorsements of ratings, too-easy and then too-tight monetary policy, and dependence on prospective bailouts under the Greenspan put and Too Big To Fail – reminiscent of the mercantilist/pre-industrial era that Adam Smith (1776) criticized.

The U.S. financial sector has always been heavily regulated in the belief that financial intermediation is costless (and therefore useless), so that, for example, bank portfolios are as easily understood and even managed by remote, inexperienced, and part-time overseers without meaningful incentives, as by full-time professionals whose livelihoods are at risk. This attitude was responsible for the creation of the FDIC in the 1930s as part of an attempt to resolve bank problems resulting from (1) official restrictions on bank structure (mainly anti-branching laws) and (2) the erratic monetary problems of the Federal Reserve (referred to above) by means of what might be the classic adverse incentive – deposit insurance without independence of risk or risk-based premiums (which are even today inadequate).

Instead of seeking more regulations (and engines of government failure), the conference organizers should address the connections between finance and growth, including the development of financial services in an increasingly specialized economy, and the elimination of regulations and their institutions, including the FDIC. But then they would be out of a job.


George J. Benston and Clifford W. Smith, Jr. 1976. “A transactions costs approach to the theory of financial intermediation,” Journal of Finance, May.

Susan Carter,, eds. 2006. Historical Statistics of the U.S. Millennial Edition. Cambridge Univ. Press.

Robert W. Clower, 1994. “The fingers of the invisible hand,” Brock Univ. Review, April.

Raymond Goldsmith. 1954. The Share of Financial Intermediaries in National Wealth and National Assets, 1900-1949. National Bureau of Economic Research.

Carter H. Golembe. 1960. “The deposit insurance legislation of 1933: An examination of its antecedents and its purposes,” Political Science Quarterly, June.

Adam Smith. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. Strahan and Cadell.

Arnold Toynbee. 1884. The Industrial Revolution. Rivington’s.

John J. Wallis and Douglas C. North. 1986. “Measuring the transactions sector in the American economy, 1870-1970,” in S. Engerman and R. Gallman, eds. Long-Term Factors in American Economic Growth. Univ. of Chicago Press.

Robert H. Wiebe. 1967. The Search for Order, 1877-1920. Hill and Wang.


Friday, March 26, 2010

The Market Doesn't Believe the Fed

The Consumer Price Index for February was unchanged from January, and only 0.4% above August 2009, meaning inflation less than 1% at an annual rate the last six months. This is apparently not expected to continue, however, since the yield curve is steeply sloping and getting steeper.

A temporarily low inflation should not be the object of monetary policy. Recent price stability is due to weak demand that has nullified the massive increase in Federal Reserve credit, which is held mainly as excess reserves by banks.

In arguing against specific targets and their “false precision,” Chairman Greenspan said that the goal of “price stability is best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms” (2002). His successor, Ben Bernanke, reinforced this view in his first (2006) Monetary Policy Report to Congress.

Experience shows that low and stable inflation and inflation expectations [are] essential for strong and stable growth of output and employment.

Although he has said he has a plan to prevent the Fed's credit overhang from fueling future inflation, the market is skeptical. We do not see “stable inflation and inflation expectations.” The Fed announced a policy to reduce long rates (without changing its policy of low short rates), which was bound to be ineffective (see my blog of 10/4/09), but we have, not surprisingly, seen the opposite. The continued low short-rate policy (which the figure shows has become even more pronounced), and the Fed’s incredibility in general, has steepened the yield curve. This is abnormal for expansions, when short rates normally rise more than long rates.

The extent to which the Fed’s policy will retard recovery depends on expectations and realized inflation. If businesses and consumers are confident of future inflation, expected real long-term rates may be low and therefore encourage spending. In this case, expected inflation had better be realized or bankruptcies will result. The Fed will be pressured to produce expectations and possibly another bubble.

If high long rates are caused by uncertainty, current spending is reduced. We have no clue which way the Fed will jump. Its behavior the past few years has been unprecedented and gives no inkling of what’s in store.

“During the past two decades,” a monetary economist wrote earlier in the decade, “central bankers [have come to] agree that price stability is an important goal and that ‘credibility’ of policy and ‘transparency’ of its implementation are crucial to accomplishing that goal” (Green’s 2005 Review of Woodford 2005).

We wish. My April blog will discuss the Greenspan/Bernanke denial not only of personal responsibility but of the effects of monetary policy at all. Somehow, flying in the face of the history of central banks, which have nearly always operated through a short rate, monetary policy is no longer responsible for long rates, spending, or inflation.


Edward Green. 2005. “A Review of Interest and Prices by Michael Woodford,” J. Economic Literature, March.

Alan Greenspan, 2002. “Transparency in monetary policy,” Federal Reserve Bank of St. Louis Review, July/August.

Michael Woodford. 2003. Interest and Prices. Foundations of a Theory of Monetary Policy. Princeton Univ. Press.


Sunday, February 14, 2010

What Bernanke believes

Let me end my talk [in honor of Milton Friedman’s 90th birthday] by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna [Schwartz]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Ben Bernanke, University of Chicago, Nov. 8, 1992.

In fact the Federal Reserve has learned nothing, and is doing it again, it being the substitution of controls for monetary policy.

Whatever attention is being paid to Chairman Bernanke’s allusions to an exit strategy from under the massive reserves the Fed has dumped on the banking system – which is not much because observers realize that they merely repeat the musings of a year ago -- are misplaced because the chairman is not really interested in monetary policy. This may seem strange, but it is not the first time the Fed that has been uninterested in what one might have thought was its principal mission.

For example, the Fed allowed the money stock to collapse (falling 38% between 1929 and 1933) while the Hoover administration focused on bank reforms (deposit insurance and changes in banking structure and regulation, including the Glass-Steagall Act that separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation, which was expanded by the New Deal. Among other interventions, RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management. In their monumental Monetary History of the United States, Friedman and Schwartz contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the recovery of the money supply (as Christina Romer also pointed out in a 1992 paper in the Journal of Economic History).

We might have thought, in light of these experiences and the opening quotation, that Chairman Bernanke would eschew direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock. We would be wrong. He and his colleagues have done the opposite. The failed official strategy of the Great Depression has been repeated in the Fed’s lending to specific institutions, its focus on the risk and liquidity of particular markets, the Troubled Asset Relief Program, Asset Backed Commercial Paper, swap agreements, and numerous other market interventions, as well as lobbying for more regulations of financial institutions of which it would be the principal administrator.

What about monetary policy? The easy money (negative real rates) of 2002-2005, followed by the tightening of 2006-2007, is reminiscent of the run-up to the Great Depression. In 1928-29, the Fed focused on credit controls and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and to lower rates in recession – just as in mid-2008, when it suddenly became hawkish about inflation. The intensification of the recession began before the financial turmoil of September 2008. “In this recession, unlike the other recessions that followed the Depression [but like the Depression], commentators [like the Fed] have assigned causality to dysfunction in credit markets,” as Robert Hetzel pointed out in a recent paper in the Richmond Fed’s Economic Quarterly.

Perhaps the key to these similarities is found in Bernanke’s view of the financial markets. His fame as an academic economist rests on his 1983 paper that stressed the banking structure and the nature of capital flows as causes of the Great Depression. He argued that bank failures and falling bank loans – the interruption of credit arrangements – were significant contributors to the severity of the Great Depression that had been overlooked by Friedman and Schwartz. Although the latter’s message that recovery came with the turn-around in money (while bank loans remained weak) has been reinforced, Bernanke has not, despite the protestation quoted above, come around to the Friedman-Schwartz view of the importance of money or, just as significantly, free markets.

As fundamental as money to their monetarist philosophy is the freedom of markets, which necessarily includes their component institutions. The government should (1) let them alone while (2) pursuing a stable monetary policy. The Federal Reserve under Bernanke has done neither.

There is much talk of the Fed’s independence (of what or whom is not made clear). We should be more concerned about our independence of the Fed.