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September 2008
September 29, 2008
Today in Financial History
The TED Spread:
Housing Prices:
Stock Market:
Unemployment:
From Calculated Risk:
Calculated Risk: MONDAY, SEPTEMBER 29, 2008
Cliff Diving by Calculated Risk
Dow off 6%.
S&P 500 off 7%.
NASDAQ off 7%.
With the failure of the bailout in the House, the question is now what? There is the possibility of some arm twisting and another vote tomorrow. Another possibility is that the bill will be revised in some way to garner a few more votes....
Bailout Plan Fails in House by Calculated Risk
Yes 205 No 228 ... Dow off 500 points. The vote failed....
House Vote Nears on Bailout Plan by Calculated Risk
Here is the debate on C-SPAN. Voting now ... will take about 15 minutes (so about 1:45 PM ET)....
Fed to significantly expand "the capacity to provide U.S. dollar liquidity" by Calculated Risk
From the Fed:
In response to continued strains in short-term funding markets, central banks today are announcing further coordinated actions to expand significantly the capacity to provide U.S. dollar liquidity. Central banks will continue to work together closely and are prepared to take appropriate steps as needed to address funding pressures.
Meanwhile the TED Spread from Bloomberg is at a record 3.48! Ouch....
Conventional open-market operations work on the liquidity premium--they either relax a cash-in-advance constraint keeping aggregate demand low, or relax a relatively-safe-investments-look-unprofitable animal spirits constraint keeing investment and thus aggregate demand low. For the past year the problem has not been that safe interest rates have been low--far from it. The problem has been that risky asset values have been low (partly because a lot of risky assets are backed by investments that weren't fundamentally very profitable, and partly because risk premia are high because the supply of risky assets is great and the mobilized risk-bearing capacity of the private market is not that large).
So the natural answer appears to be open-market operations working not on the liquidity premium but on the risk premium--Operation Twist on a Pan-Galactic scale.
Paul Krugman has thoughts:
The humbling of the Fed: Not a day has gone by since this crisis began that I haven’t been thankful that Ben Bernanke is the chairman of the Fed; had events gone a bit differently (thank you Harriet Meiers!) the post might well have gone to some unqualified Bush loyalist.
That said, the Fed’s experience in this crisis has been humbling; getting traction has proved harder than BB himself suggested in his pre-crisis writings. Here are my thoughts on why....
[T]he Fed... is a very big player, but not that big compared with the market as a whole — the Fed has roughly $800 billion each of assets and liabilities in a $50 trillion credit market. And conventional monetary policy consists, basically, of enlarging or contracting the Fed’s balance sheet. Why does the size of a financial player constituting less than 2 percent of the credit market matter? The answer is that the Fed’s liabilities are special: nobody else has the right to create monetary base, which can in turn be used either as currency or as bank reserves. When the Fed expands the money supply, the key thing isn’t that it’s buying Treasury bills, it’s the fact that it’s doing so by expanding the monetary base.... But in March, and again this week, interest rates on T-bills fell close to zero — liquidity trap territory. What does that do to the Fed’s role?... [O]nce T-bills have a near-zero interest rate... the two sides of the Fed’s balance sheet become perfect substitutes.... [T]he liquidity trap makes conventional monetary policy impotent.
But why not purchase stuff other than T-bills? This can be thought of as changing the composition of the Fed’s balance sheet, rather than enlarging it; and Ben Bernanke, in happier days, thought that might be an effective policy in a liquidity trap. There are, however, three reasons to be doubtful about this stuff:
1. The Fed is now trying to move a much bigger rock: it is, in effect, trying to raise the price of financial assets other than T-bills by selling T-bills and buying other stuff. There’s only (yes, “only”) $800 billion of monetary base....
2. T-bills and other assets, such as long-term bonds, are probably much better substitutes for each other than T-bills are for monetary base — money is unique as a medium of exchange....
3. The reason T-bills are an imperfect substitute for, say, corporate bonds — to the extent they are — is risk. Therefore, the reason changing the composition of the Fed’s balance sheet can move prices, to the extent it can, is because the Fed is taking on risk. This isn’t a role the central bank is meant to play; you’re sliding over into fiscal policy.
Nonetheless, I guess the Fed had to try the “Bernanke twist.” And it did — the old Fed balance sheet, in which T-bills were the vast bulk of assets, is no more. But the effects have been disappointing, especially weighed against the risk, which I know is making Fed officials very nervous.... So Ben Bernanke came into his current position believing that central banks have the power, all on their own, to fight Japan-type problems. It seems that he was wrong.
Krugman's (2) seems to be wrong, for the reason he gives in his (3): T-Bills are not close substitutes for mortgage-backed securities. If they were close substitutes, we wouldn't have a problem. It's the huge risk premium that makes them fail to be close substitutes--if the risk premium fell, things would be very different.
But I am not sure that (3) is right: taking on risk doesn't seem to me to be well-described as fiscal policy any more than as conventional open-market operation monetary policy. It is something else. I'm calling it open-market operations on the risk premium, but that is not a very good name.
As I have said before, I find it helpful to group all the things the Fed and Treasury have done, are doing, and might do into three baskets, each corresponding to a different stage of the seriousness of the financial crisis and the soundness of the financial system.
Stage I policies: dealing with a liquidity panic These are the "Bagehot rule" policies: the central bank acts to keep the economy at the "good equilibrium" in a panic when multiple equilibria--a good "confidence" equilibrium and a bad "panic" equilibrium--are possible. It does so lending freely to solvent but illiquid institutions at a penalty rate on collateral that would be good in normal timrs. Emergency discount window operations are of this kind. The conventions that the discount rate should be higher than the bank-to-bank federal funds market rate and that borrowing from the discount window should create a stigma and a presumption of a higher degree of future regulatory and counterpary scrutiny are part of the "penalty rate" charged for asking for such help from the central bank. The idea is that institutions that have gotten themselves short of reserves and need emergency liquidity should feel some pain as a result of the systemic risk they caused.
Stage II policies: These the are conventional consensus monetary policies--the central bank as central planner making the price in the short-term money market an administered price in the interest of maintaining full employment and price stability. It raises and lowers the market rate of interest to keep it near the Wicksellian natural rate of interest. It uses open-market operations to buy Treasury securities for cash to flood or drain the market with liquidity, and so push down or up real borrowing costs (thus encouraging or discouraging investment) and push up or down the cash values of all kinds of debt. In the case of a financial crisis, if there was worry about the liquidity or solvency of the system before, the hope is that stage II policy open-market purchases will drive such worry away by boosting the asset values and reducing the debt carrying costs of "banks"--that is, any financial intermediary that lends long and promises liquidity by borrowing short. The idea behind these policies is to keep the good equilibrium at the right place as far as employment and price stabilization is concerned--and, in an emergency, to do what it can to make sure that the good near full-employment equilibrium exists.
Stage III policies: These come after stage I policies aimed at curing a temporary inability to turn assets into cash at any but fire-sale prices have failed to repair matters have been exhausted. These come after the stage II policies of using normal tools of monetary stabilization to lower interest rates across the entire spectrum--flooding the system with liquidity--have failed to ease worries that one's counterparties are still insolvent or still at risk of becoming illiquid at an awkward moment.
The purpose of stage III policies is to boost demand relative to supply for risky assets, and thus to operate on the margin that is the spread in prices and yields between safe assets like Treasury securities and the risky assets whose falling prices are threatening the stability of the financial system and the macroeconomic flow of investment. It is not enough for the central bank to turn the short-term safe interest rate into an administered price, and set it at a low value (stage II). It is not enough to provide unlimited liquidity at a penalty rate (stage I). Instead, the Fed or the Treasury or both must make the price of risk or the quantity of risky assets or both an administered price. Just as for more than half a century there has been a consensus that the level of the short-term interest rate is too important a price to be left to a market full of easily spooked and not very rational financiers, so stage III leads us to the conclusion that the price of risk is also too important a price to be left to the market.
How are we to model these three stages?
Start with a version of Bernanke-Gertler: financial intermediaries can operate in one of two modes: well-capitalized or poorly-capitalized. When financial intermediaries are well-capitalized, they themselves have little problem borrowing on a large scale and serving as conduits for the flow of funds between savers and investors. Thus market demand for risky financial assets is relatively high:
And, given the (fixed in the short run) supply of risky financial assets like mortgages and private-sector bonds, the prices of such financial assets are relatively high as well--which gives businesses an incentive to expand their capital stocks and thus put people to work in the investment-goods industries:
But there is another mode of operation: if financial intermediaries are poorly-capitalized they themselves will have great problems borrowing--savers will fear the moral hazard problems that arise when those who manage their money don't themselves have a large stake in the game, and a financial intermediary without a large equity cushion leads savers to ask the American question "if you're so smart, why aren't you rich?" and shy away. So if financial intermediaries are poorly-capitalized, supply and demand looks very different:
with low demand for financial assets, a low equilibrium price of financial assets--and no incentive for businesses to expand their capital stocks, and mass unemployment, and depression.
The kicker is that large declines in the prices of financial assets--a panic--can switch financial markets from one mode to the other, because their is a large range over which declining prices do sufficient damage to financial intermediaries' capital and reputation to cause the demand curve to slope the wrong way--in what I was taught to call the "Krugman Backwards-S" demand curve:
which produces two stable equilibrium--a good, high-price, high-investment, full-employment one, and a bad, low-price, low investment depression one. The task of central banking is to keep the financial markets and the economy at the good equilibrium, and keep it from jumping to the bad one. These are crisis stage I policies--the good equilibrium is where it should be; monetary policy is appropriate; the problem is that some shock has destroyed confidence and the economy is threatening to jump to the bad, low-value, high-unemployment equilibrium. The correct response is "Bagehot rule" policies: lend freely to financial institutions that are caught short of cash so they don't have to liquidate good assets at fire-sale prices, but lend at a penalty rate so they do feel the pain appropriate to the amount of systemic risk that we have had.
Now let's jump back in time to 2001-2002. It is the aftermath of the collapse of the tech boom and of 911. The Federal Reserve has lowered interest rates to try to forestall deflation and keep the economy near full employment. By lowering interest rates it made safe assets less attractive, and thus pushed demand for risky assets outward--raising the prices of (which is the same thing as lowering the interest rates of) risky financial assets:
The outward push became larger because of two additional factors: Asia's policy of low-currency valuation and thus of providing interest-rate subsidies to America's borrowers, and relaxed lending standards coupled with real estate exuberance. In an environment in which any newly-created financial asset could be sold for a high price, construction companies undertook to build lots more houses--and thus pushed the supply of financial assets out to the right between 2002 and 2006 as all of these new houses--5 million more than trend construction--needed mortgages:
Now comes 2007: an end to irrational exuberance and a little bit of bad macroeconomic news pushes demand for financial assets back to the left. At first--last summer--the Federal Reserve thinks that its job is simply to maintain confidence, to keep the economy at the good equilibrium by making everybody understand that the Fed was not going to let the economy get to the bad, depression equilibrium. But over the fall it became clear that such "Panic Stage I" policy wasn't going to be enough:
Providing liquidity to the market in order to maintain confidence--following Bagehot's rule of lending freely at a penalty rate to organizations that could offer collateral that would be acceptable in normal times--wasn't going to be enough to avoid a depression because it was no longer a matter of maintaining confidence that banks and other financial intermediaries were and would remain well-capitalized. Why wasn't it enough? Because they weren't well capitalized. The good equilibrium was in the wrong place--had too low a price of financial assets and thus too low a level of economic activity and too high a level of unemployment. And perhaps the good equilibrium did not exist at all.
So over the winter the Federal Reserve moved on to "Panic Stage II" policy: fight the possibility of deflation and de
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