How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

5. Confusion of insolvency and illiquidity

Although monetary easing likely offset some part of the economic effects of the financial turmoil, that offset has been incomplete, as widening credit spreads and more restrictive lending standards have contributed to tight overall financial conditions. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Consequently, the second component of the Federal Reserve's strategy has been to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector--that is, by lending cash or its equivalent secured with relatively illiquid assets.

Ben Bernanke, speech to the Greater Austin Chamber of Commerce, Dec. 1, 2008.

The Fed has made loans in various ways, Bernanke said, “to ensure that adequate liquidity is available, consistent with the central bank’s role as the liquidity provider of last resort.” This misrepresentation of insolvency for illiquidity has pulled the Fed into a policy that, in fact, violates traditional central banking. The two tasks of central banks have been the protection of the value of currency in the long-run and support of the payments system in the short run. The Fed has failed dismally in the first (after nearly equal price levels in 1789 and 1913, the purchasing power of the dollar has fallen 95% under the Fed) but it has been attentive to the latter. The central bank’s role as supporter of the payments system has been understood to include the responsibility to serve as lender of last resort.

A financial panic, or crisis, is a rush for cash, when “the rate of interest rises to a panic figure.” This normally comes at the end of an upward price movement, Irving Fisher (1922, p. 65) wrote, when those who have borrowed heavily are unable to renew their loans. They “must have currency to liquidate their obligations.” Runs on banks, even solvent banks, occur, and the central bank must come to their aid.

Liquidity is the proportion of an asset’s fundamental value that can be realized in cash quickly following the decision to sell. This is an individual concept, and differentiates assets in normal times. Market liquidity, on the other hand, refers to the general availability of cash. All assets except cash are illiquid during panics (Palgrave 1896; Wood and Wood 1985, pp. 163-66))

A traditional problem of the lender of last resort in maintaining the system’s liquidity has been to assist sound banks without bailing out the insolvent. The solution, Walter Bagehot advised in the classic Lombard Street (1873, pp. 187-88), has been to lend “freely and vigorously … at a very high rate of interest … on [the security of] good banking securities.”

None of this describes the Fed. The problem is clearly not one of liquidity, as the low interest rates on safe investments tell us. Even the safest securities, even Treasuries, are subject to panic interest rates during rushes for cash. This in seen in Frederic Mishkin’s (1991) account of seven financial crises from 1857 to 1907 (but not 1929 or 1987, when the Fed came to the aid of the money markets). Furthermore, despite the talk of the capital markets “freezing up” (simultaneously with a ”meltdown,” apparently) , bank credit was maintained and mortgages were available at traditionally low interest rates for good borrowers.

“For good borrowers” is key. The loan curtailments, except at high interest rates, of which some firms complained, and which, supported by the Fed, they called illiquidity, was due to the market’s assessment of their risk of insolvency. John Taylor and John Williams (2009) present data (see the figure) which indicate that the abrupt increase in the 3-month Libor rate relative to the overnight federal funds rate beginning August 2007 (after the failure of large banks heavily involved in mortgage-backed securities; it jumped again upon the failure of Lehman Brothers in September 2008) was due to risk rather than illiquidity. “As long as lenders who are not constrained by liquidity concerns exist, banks that seek to hoard liquidity can borrow from these lenders in the CD market…. Competition will lead to the equalization of borrowing rates across instruments for borrowers of the same credit quality. That CD rates have tracked Libor closely during the crisis …suggests that liquidity concerns at banks are not a significant factor separate from counterparty risk driving term lending rates.” Credit default swaps tell the same story, and regressions suggest that injections of Term Auction Swaps by the Fed have not affected what are clearly risk premia.

Recent Fed and Treasury actions have not been concerned with liquidity or the integrity of the payments system, which was not threatened, but rather with the salvage of particular managements (not firms, which would have continued with restructuring). Government purchases, and potential purchases, of bad assets have retarded the resolution of the crisis by preventing purchases of those assets by the many solvent firms who were able and might have been willing.

References:

Walter Bagehot, Lombard Street. 1873. (new ed. edited by H. Withers. J. Murray, 1920).

Irving Fisher. The Purchasing Power of Money, 2d ed. Macmillan, 1922.

Frederic Mishkin. “Asymmetric information and financial crises: A historical perspective,” in R. Hubbard, Financial Markets and Financial Crises. University of Chicago Press, 1991.

Palgrave, R.H.I. Dictionary of Political Economy(1896),new ed., H. Higgs, ed. Macmillan, 1923.

John Taylor and John Williams. “A black swan in the money market,” American Economic J. of Macroeconomics, Jan. 2009.

John Wood and Norma Wood. Financial Markets. Harcourt Brace Jovanovich, 1985.

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How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

4. Excess reserves again

The unprecedented increase in excess reserves during past year is shown in the figure. They are due to the increase in the Federal Reserve credit. Concerns have been expressed for their inflationary potential when loan demand turns up, but Chairman Bernanke says not to fear. He has an exit strategy.

… at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize…. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy….

A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Ben Bernanke, Stamp Lecture, London School of Economics, Jan. 13, 2009.

Easier said than done. There is no reason to believe that the Fed will do any less damage than when it “shrunk” excess reserves in 1936-37. The monetary base grew 49% between May 1933 and May 1936, almost entirely due to inflows and the revaluation of gold. M2 rose 42% but half the increase in bank reserves was held as excess, which rose (in millions) from $319 to $2800, compared with the increase in requirements from $1806 to $2838. The rising ratio may be seen in the figure. The FOMC saw the large excess reserves as a threat to monetary stability that needed to be “mopped up.” It adopted the following resolution in October 1935:

It was the unanimous opinion of the Committee that the primary objective of the System at the present time is still to lend its efforts towards the furtherance of recovery…. But the Committee cannot fail to recognize that the rapid growth of bank deposits and bank reserves in the past year and a half is building up a credit base which may be very difficult to control if undue credit expansion should become evident.

The Banking Act of 1935 had given the Fed the power to raise reserve requirements up to twice the levels then existing, and that power was used to its full extent, in three steps, between August 1936 and May 1937. The resulting fall in excess reserves is shown in the figure. Although the Fed claimed that the excess reserves thus eliminated had been superfluous, it was soon revealed that banks thought otherwise. Having come through the great downturn of 1929-33, with massive runs and record failures, banks were cautious. Their cut-back in loans to restore their excess reserves contributed to the severe 1937-38 recession.

The figure indicates that the task is much greater today. As we learned (or should have), “excess” is a legal term that tells us nothing of desires. A policy of shrinking slowly, as Bernanke suggests, may not be an improvement. It may not be possible. If banks want these excess reserves, and they apparently do, they will restrict lending in anticipation of reserve losses. Things can seldom be done “on schedule” in the financial markets, which are characterized by arbitrage across time. We do not know what will happen. The problem is unnecessary and may come back to haunt us.

It is made more complex by the recent decision to pay interest on reserves, another example of the tendency of policymakers to enforce gratuitous changes in the environment that increase the uncertainty of their policies.

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References

Milton Friedman and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton Univ. Press, 1963, pp. 520-32.

Clay J. Anderson. A Half-Century of Federal Reserve Policymaking, 1914-64. Federal Reserve Bank of Philadelphia, 1965, pp. 77-82.

OPERATION TWIST AGAIN

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

This should have been my second critique of government reactions to the economic downturn.

2. Operation twist again

After its March 18 meeting, the FOMC stated that it had decided to purchase “up to $300 billion of longer-term Treasury securities over the next six months.” This decision followed a speech by Chairman Bernanke on Dec. 1, 2008, indicating that “the Fed could purchase longer-term Treasury securities … in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.”

DanielThornton, The effect of the Fed’s purchase of long-term securities on the yield curve,” Federal Reserve Bank of St. Louis Economic Synopses, May 18, 2009.

There was a brief decline in long rates, but the yield curve soon regained, and surpassed, the steep slope of mid-March. The Fed’s failure to alter relations between yields on these highly substitutable securities has a long history. In 1961, President Kennedy indicated the importance of “increasing the flow of credit into the capital markets at declining long-term rates of interest to promote domestic recovery” while “checking declines in the short-term rates that directly affect the balance of payments” (Economic Report of the President, 1962, p. 50). The Federal Reserve was directed to twist the yield curve by buying long-term securities to lower long rates while selling short-term securities to raise short rates.

This policy flew in the face of the expectations theory of the term structure, according to which investors maximize expected returns. In a linear approximation of the simple case of default-free U.S. securities, investors are indifferent between 1- and n-year securities if

Long rates are averages of current and expected short rates, where prescripts denote expected 1-year rates i = 1, 2, … periods in the future. Relations between current long and short rates depend on expectations. Given expectations, a fall in Y_n while Y₁ rises must be reversed as investors shift to the suddenly more profitable shorts. Operation twist could have worked only if expectations of future rates were simultaneously lowered, contradicting the announced policy of higher short rates. Uncertainty interferes with perfect substitutability, but the policy was inconsistent and impossible.

The administration indicated its satisfaction with the yield curve’s twist (Economic Report of the President, 1966, p. 86), but the figure shows that it behaved normally (or twisted a little less than usual) during the 1961-65 economic expansion. The tendency of yield curves to flatten during expansions (because long rates are less variable than short rates) has continued in recent years.

An example of the lengths to which the Fed must go if it is determined to influence the yield curve contrary to expectations was given by the interest-rate peg of World War II. The Fed stood ready to buy and sell 3-month and long-term governments for 0.375% and 2%, respectively. At the peg’s end, the Fed held no long-terms and virtually all the short-terms. Official efforts to manipulate relative prices are futile, and destroy markets if pursued vigorously.

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References

John Wood and Norma Wood. Financial Markets. Harcourt Brace Jovanovich, 1985.

Elmus Wicker. “The World War II policy of fixing a pattern of interest rates,” J. Finance, June 1969.

Capital replenishments and requirements

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

3. Capital replenishments and requirements

I consider two mistaken policies: (A) The recent emergency infusions of capital and (B) the use of capital as a regulatory guide in general.

A.

Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

Paul Krugman, “Cash for trash,” New York Times, Sept. 22, 2008.

Isn’t it shameful that financial institutions receive capital infusions from the government, and instead of lending it out, they hoard it? I hear this complaint a lot.

Jack Guttentag, “Why banks ‘hoarding’ bailout funds is good,” Washington Post,

Jan. 24, 2009.

The government’s capital infusions to financial institutions were rationalized as help to home-buyers.However, distressed institutions avoided further risky investments. This was desirable as well as understandable, Guttentag wrote: “The justification for the capital infusions is [or ought to be] that they will increase capital, not loans [as critics in and out of Congress complained]. The goal is to avoid future shocks from the failure of undercapitalized firms. The fundamental purpose is to prevent the crisis from getting worse. Other measures are needed to cure it.”

B.

Obviously, the U.S. financial sector’s condition today is excellent. Capital ratios stand at levels we have not seen in sixty years, credit quality has been strong, and innovative financial instruments can spread risks more broadly than ever before…. Supervisory reforms also deserve substantial credit, particularly those aimed at raising bank equity ratios.

Mark Flannery, “Supervising bank safety and soundness,” Federal Reserve Bank of Atlanta Economic Rev., 1^st and 2^nd quarters, 2007.

It sounds reasonable that, since a bank’s Assets = Liabilities (mostly deposits) + Capital (equity or new worth), large capital relative to assets protects depositors against falls in the value of assets.This simple observation is the foundation of most bank regulation, including the international capital requirements agreed at Basel, Switzerland. There are several problems with the capital approach to bank regulation: (i) The capital measures used by regulators are of doubtful meaning; (ii) however measured, capital has not been a good predictor of bank failure; and (iii) capital cannot be imposed independently of the overall portfolio choice.

Regarding the first, regulators look mainly at book (accounting) rather than market values. This misses the information contained in market prices but is simple because capital requirements are preserved from stock-price fluctuations.

A primary reason for the second problem is that assets are sensitive to economic conditions and can deteriorate quickly. This was evidenced in the recent decline in house prices, as in the falls of agricultural and oil prices in the 1980s and the deflations of 1920-21 and 1929-33. Regulators try to adjust capital needs by the riskiness of assets, but this is difficult for at least two reasons: regulators are not competent to judge risks at any given time except in the most egregious cases, and conditions can change rapidly and substantially.

Third, large capital might be more a consequence of risk that a guarantee of safety. Credibly low-risk operations need little capital to satisfy creditors. U.S. bank capital ratios were high, and so was the rate of bank failures, in the volatile 19^th century. Whether increased capital requirements (even if properly measured) reduce risk-taking depends on bankers’ preferences. For a bank that maximizes expected profit subject to a given probability of failure, more capital leaves that probability unchanged as it is directed to risky assets.

The most common message of the Basel Committee on Bank Supervision is that its measures of bank risk have failed – but they’re working on the problem. Never discussed is evidence for the usefulness of the approach even if it could be done.

When Sam Peltzman found that deposit insurance had induced banks to take on more risk, he observed:

Bank examiners devote the greater part of their efforts to a determination of the “riskiness” of a bank’s assets, on the one hand, and the “adequacy” of its capital, on the other…. However, the preponderant emphasis is placed on regulating bank capital rather than the details of the asset portfolio. While there is no specific reason for this emphasis on capital adequacy, it can be explained on institutional grounds. It is surely difficult for a bank examiner to judge accurately the riskiness of the many different asset items he comes across, since they reflect a great variety of [changing] local [and national] market conditions, bank management judgments, and special circumstances. Instead of attempting an independent assessment of these details, a much easier course of action is to accept bank management judgment while substituting for this acquiescence a strong insistence that depositors be protected with adequate capital against the consequences of mistakes.

“Capital investment in commercial banking and its relationship to portfolio regulation,”

J. Political Economy, Jan-Feb 1970.

Nothing has changed. Rules at variance with preferences can still be satisfied without achieving regulators’ objectives (such as reducing risk). The only potentially effective regulation of complex operations must be aimed at results, with penalties for defaulters. Public policies that bail them out do the opposite.

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