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

8. Monetary Policy as Credit Control

Let me end my talk [in honor of Milton Friedman’s 90^th 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.

Friedman and Schwartz argued that the Federal Reserve caused the Great Depression by allowing the money stock to fall 38% between 1929 and 1933, while the Hoover administration focused on bank reform (deposit insurance and banking structure in the Glass-Steagall Act, which separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation. RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management (Butkiewicz 2002). Friedman and Schwartz (1963, pp. 325-30) contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the growth of the money supply (Romer 1992).

The following contemporary account of the RFC, which was expanded by the New Deal, is interesting:

The best banking walls of Wall Street did not fall down last week before the long trumpet-blasts of Jesse Jones [head of the RFC]. But most of them opened their postern gates and let Mr. Jones come in with the money he was determined to inject into them.

The National City was the only big bank last week to surrender completely. It the stockholders approve, it will let the RFC buy $50,000,000 of its preferred stock. Mr. Jones radiated assurance that the government would not make itself a nuisance at stockholders’ meetings. But the fact remained that the U.S. will become National City’s biggest stockholder – and if ever two preferred stock dividends should be omitted, the Government will have complete control.

Eight other New York banks were able to resist the RFC’s passion to become a stockholder because they were state institutions. They compromised by selling the RFC “capital notes.” Thus supersolvent Guaranty Trust, already vexed by having more money than it can profitably use, planned to let the Government lend it $20,000,000.

Having removed the curse of taking government aid, Mr. Jones could now proceed to make the Government a large, if not the largest stockholder … in perhaps one-quartet of all the country’s banks ….

National City planned to use its huge piece of government money to write down its common stock [and] surplus. “With the adoption of the plan,” Chairman Perkins informed his stockholders, “the assets of the bank will be carried at conservative values ….”

“Without disgrace,” Time, Dec. 18, 1933.

We might think that, given the opening quotation, Bernanke would have eschewed direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock. But 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 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 control and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and lower rates in recession – just as in mid-2008, when the Fed 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 (Hetzel 2009).

A key to this similarity may be found in Bernanke’s view of the financial markets (in which he, like the Fed of 1929-33, has found plenty of support in official circles). His fame as an economist rests on his 1983 paper that stressed capital flows and the banking structure as contributors to the severity of the Great Depression. In particular, bank failures and the fall in bank loans joined the money stock as significant causes of the downturn. The recovery came with the turn-around in money (while bank loans remained weak), but Bernanke has never, despite his protestations, been shared the Friedman- Schwartz view of money’s importance, or of the economy in general. A key element of Friedman’s monetarist philosophy, as important as money, is its reliance on free market institutions. The government should (1) let them alone while (2) pursuing a stable monetary policy. Bernanke and the present Fed have done neither.

References

Ben Bernanke. “Nonmonetary effects of the financial crisis in the propagation of the Great Depression,” American Economic Rev., June 1983.

James Butkiewicz. “Reconstruction Finance Corporation,” EH.Net Encyclopedia, ed. Robert Whaples, July 19, 2002

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

Robert Hetzel. “Monetary policy in the 2008-2009 recession,” Federal Reserve Bank of Richmond Economic Quarterly, Spring 2009.

Christina Romer. “What ended the Great Depression?” J. Economic History, Dec. 1992.

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Henny-Penny and friends, whose careers were ended abruptly.

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

7. We’ve got to do something

We need to compare the cost of this package against the cost of doing nothing. The cost of doing nothing would be catastrophic!

Wisconsin Congressman David Obey.

We can’t afford to wait. We have to act. Presidential spokesman Robert Gibbs.

“I do try to put a lot of weight on what people are saying,” Watt said, referring to the overwhelming opposition of his constituents. “But in this case, I think a lot of people don’t know exactly why a bailout is necessary… On this issue, we have heard the top two economic authorities in the world tell us we’re on the verge of a calamitous event.”

North Carolina Congressman Mel Watt.

Were the massive government responses to the economic downturn in the interests of the public, i.e., for recovery, or simply political, i.e., to assure voters that government was not unresponsive; there would not be a repeat of the do-nothing Hoover administration, as it has erroneously come down in history.

We know the futility of the former. A small part of the so-called stimulus packages was directed to the short term, and that part (such as temporary tax breaks) was known to be ineffective (see this blob for September 23 and 29). The best we can hope for is that they will do little harm, that they will, as George Selgin suggests, be like Granny’s cure for the common cold: work in a week to ten days (The Beverly Hillbillies). (It now looks like we’re out of the recession after 6 quarters – IV/2007 to II/2009 – with a fall in real GDP of 2.8%; compared with the most similar post-WWII recession of 3.2% in 5 quarters, IV/1973 to I/1975. Government either shortened or lengthened the recession, depending on your point of view.)

History suggests that the political motive is also futile. Polls, letters to Congress, and the Tea Parties on tax day (April 15) indicated that many, probably most, Americans opposed the government’s actions. More important to those who will run for reelection, votes have depended not on good intentions but on actual economic conditions (Fair 2009). As the lawyer played by James Mason in The Verdict said to his young assistant: “You’re not paid to do your best. You’re paid to win.” Government actions during recessions have varied from highly (e.g., Hoover) to not very (e.g., Carter and G.H.W. Bush) active (see Hoover 1940, 97-119; Wood 2005, 204-11; Carter 1995, 541; Keech 1995, 69-70). Much more constant, at least since Martin Van Buren, has been the failure of reelection attempts during recessions, whatever the efforts to forestall them, notably in the 20th century, Hoover, Carter, and G.H.W. Bush. The 1990-91 recession had officially ended, but unemployment continued. “It’s the economy, stupid,” was Clinton’s successful slogan in 1992.

The lesson is that mindless action is politically futile – at best: spending loses votes (Peltzman 1992).

References

Ray Fair. “Presidential and congressional vote-share equations, "American J. Political Science, Jan 2009.

Jimmy Carter. Keeping Faith. Memoirs of a President. Univ. of Arkansas Press, 1995.

Herbert Hoover. Memoirs: The Great Depression, 1929-41. Macmillan, 1952.

William Keech. Economic Politics. The Costs of Democracy. Cambridge Univ. Press, 1995.

Sam Peltzman. “Voters as fiscal conservatives,” Quarterly J. Economics, May 1992.

George Selgin. “Did Bernanke save us from another Great Depression?” Christian Science Monitor, Sept. 17, 2009.

John Wood. A History of Central Banking in Great Britain and the United States. Cambridge Univ. Press, 2005.

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

6. We need more regulation

Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets, [including] tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily….

House Financial Services Committee Chairman Barney Frank … said any changes would [also] have to discourage “excessive risk taking.”

Treasury Secretary Timothy Geithner said there would have to be “more focused accountability” and a “much stronger set of oversight over all financial institutions that could pose risk of damage to the system. He said core parts of the financial markets, such as markets for derivatives and other complex products, must “have a basic framework of oversight around them.” [T]here would be stiffer capital requirements to deter companies from becoming overleveraged “so that a mess like this never happens again.”

“Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking …, and be held to high capital and liquidity standards,” Mr. Bernanke said.

Damian Paletta, Wall Street Journal, March 11, 2009.

All this is empty or disingenuous bombast for two reasons.

A. Financial regulation as pursued in the United States is, if honestly intended to protect the public, is impossible. Financial intermediation is a full-time, complicated, skillful, and costly task. Part-time amateurs removed from the scenes of action cannot assess expected returns or risk. They have neither the means nor the incentives to do so. Those who expect otherwise deny the principles of economics. Economic analysis rests on incentives and information, which itself depends on incentives as well as experience. Official and often artificial portfolio rules are accommodated while their intentions are thwarted by substitutions or innovations. Capital requirements, deposit insurance, and leverage restrictions induce riskier investments. Interest ceilings broke down because of evasions. Ed Kane (1981) has described the process as the regulatory dialectic of interactions between political and economic pressures in regulated markets. Avoidance leads to more regulation which leads to more …. Normally changing conditions further reduce the effectiveness of regulation. Many of the derivatives and other instruments that government agencies hope to regulate did not exist a few years ago, and will be succeeded by new and imperfectly understood instruments, partly to avoid regulation and partly in the normal course of events. The capitalistic system that has made us rich -- as well as secure compared with earlier times – requires the taking of risks in a free environment. Effective regulation would be self-defeating, but we need not fear because it is impossible.

B. Nor is it honestly attempted.

As a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.

George Stigler, “The theory of economic regulation,” Bell J. of Economics and Management Science, Spring 1971.

The history of regulation is better described as one of protection. The Federal Reserve was created by and for the big banks, primarily to support bank loan markets, guarantee cheap credit (the Greenspan put dates from 1913), and help fix prices and procedures (Wood 2009, pp. 105-110). The FDIC was created to forestall legislation favoring competition after the bank failures of the Great Depression (Golembe 1960). The Securities and Exchange Commission has discouraged small firms by increasing the cost of capital, it has cut the number of exchanges and retarded price and service competition in the financial services industry, nominally in support of “standards” but actually in opposition to competition. Whatever new regulations and regulators are decided by Congress, they will not threaten the profits of the politically powerful.

So what to do? The most essential change (one we can believe in) required of governments is to behave -- to stop supplying incentives for risky and inefficient behavior. The degeneration of loan qualities caused by the push for home ownership by government-sponsored enterprises, the easy money (negative real interest-rate) policies of the Federal Reserve, and the government’s too-big-to-fail commitment were the three main causes of the crisis.

If the urge to regulate is irresistible, it should be directed to results rather than rules. If we wish to reduce a bank’s chance of failure, we could (1) require more capital, less leverage, and/or fewer mobile-home loans; or (2) confiscate the assets of and/or imprison management if failure occurs. Can there be any question which would be more effective? Can there be any question which will be adopted?

It should be noted that the recent discovery of “systemic risk” is manufactured. The reason for the greater regulation of banks, which is as old as the republic, has always been the tendency of banks to fail in groups together with the perception that bank failures are worse for the economy than those of other firms.

References:

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

Edward Kane. “Good intentions and unintended evil: the case against selective credit allocation,” J. Money, Credit and Banking, Feb. 1977.

John Wood. A History of Macroeconomic Policy in the U.S. Routledge, 2009.

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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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