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February 28, 2009

Economist's View - 4 new articles

DeLong: The Stimulus Ostriches

Does the Media Deserve Liberal Defenders?

Should Democrats "ratchet down their hostility to newspapers and begin crusading on behalf of these imperiled organizations"?:

MSM, RIP, The Editors, The New Republic: ...Thirty-six percent of Americans now say that the press "hurts" democracy. Many others wouldn't express their feelings in ... such ... terms but share the basic disrespectful sentiment. Put another way, the crisis in journalism is even deeper than the crisis in its business model. It is suffering a crisis of legitimacy.

We all know the long list of scandals that has bloodied the profession--from Jayson Blair to Judith Miller to Dan Rather. But to focus only on these wrecks both misses the point and blames the victim. Just as the press has been slammed by the tides of technology, it has been hit hard by the political culture. The master narratives of both the right and the left have come to include the same villain: the hypocritical, biased elite media. And their combined grouching has helped foment the anti-media backlash.

On the right, the history of press-bashing is venerable... But during the Bush years, and thanks to Fox News, the critique of the liberal media was canonized...

A mirror version of this ... emerged on the left. In this telling, it was the timid, lazy press corps that failed to rigorously challenge the president's core (mendacious) claims about his tax cuts and rationale for heading to war. Very valid criticisms. But these specific objections morphed into populist broadsides against what the left came to describe as "the mainstream media"--avatars of establishmentarian groupthink who bend to the latest conventional wisdom emerging from D.C. cocktail parties and neurotically fret that they might be just as biased as their conservative critics allege. On The Huffington Post and its ilk, you would find rants about how "Beltway media really makes no effort to do anything other than parrot totally out-of-touch conventional wisdom--no matter how inane, stupid and ridiculous it is."

This rhetoric creates a poisonous atmosphere. By assaulting the credibility of the press, it destroys its authority in the culture, giving cover to politicians who would rather avoid dealing with reporters in the first place. ... When the administration needed to make its case, it took to the local press or Fox News, where it had no fear of probing questions.

At times, Obama has hinted that he will borrow from the Bush playbook and deal with the press only as he pleases, using new technology to vault over the old arbiters. Fortunately, that hasn't been his methodology in recent weeks... This is fortunate, because Obama is presiding over a turning-point moment in media history.

Obama can help set a tone for liberals, convincing them to ratchet down their hostility to newspapers and begin crusading on behalf of these imperiled organizations. The media deserves liberal critics, who hold it accountable. But it also deserves liberal defenders because a press working toward the ideal of objectivity is often the only means of blunting government or business run amok... Even the press's fiercest critics have been forced to acknowledge and fear its findings--an authority that will never exist in a world consisting entirely of partisan outlets. ...

Many venerable newspapers and magazines will close in the coming weeks and months; the ones that remain will be attenuated. But the old ideals embodied in these institutions must not be permitted to join the carnage.

When the press does its job well, it deserves defenders, and when it does a lousy job, it deserves being taken to task. The complaint seems to be that the criticism is without foundation, and there's some of that, but the fundamental problem is not, in my view, the people doing the criticizing, it's the media companies themselves. The argument also seems to treat "media" as something other than Fox News. I agree that the term journalism conjures up another image, as it should, but presently Fox News isn't clearly separate from other media outlets, far from it, and the commingling of all of these sources of information in the minds of the public is part of the problem. If journalists in the mainstream media want respect, they need to differentiate themselves from the "partisan outlets," including calling foul loudly and in no uncertain terms when Fox or whomever crosses the line, and they also need to do a better job themselves of establishing and maintaining their credibility through solid reporting.

'Discussion of "Oil and the Macroeconomy: Lessons for Monetary Policy"'

Janet Yellen discusses a report on "the macroeconomic implications of oil price movements":

Discussion of "Oil and the Macroeconomy: Lessons for Monetary Policy" by Janet Yellen, President, FRB SF1: It's a pleasure to discuss this thoughtful and comprehensive report on the macroeconomic implications of oil price movements.[2] Even though we are no longer faced with sky-high oil prices, the issues discussed here remain important and policy relevant. It is hard to believe that oil prices will not go up again sometime in the future, so it is vital that we learn from the last episode, both about how the economy is likely to be affected and how monetary policy should respond.

Perhaps not surprisingly, most of my discussion relates to the latter topic, namely the Fed's policy response to the swings in oil prices over the last seven years.

But I would like to start by commenting on the paper's discussion of the relationship between the market price of oil and the value of oil in the ground. Thinking of this relationship in terms of Tobin's q is an elegant and insightful contribution. As the authors point out, oil in the ground is like any other irreproducible asset, which should be described by Hotelling's theory that the price of such an asset minus marginal cost increases at a rate equal to the prevailing interest rate. But oil above the ground has distinct characteristics. And a number of factors can cause its price to depart—for some time—from the value implied by Hotelling's model. Thus, q—the ratio of the market price of oil to its value in the ground—can and does deviate from unity. The authors provide an important and informative example of such a departure, which uses data on mergers and acquisitions to calculate the value of the oil in the ground and compare it to the market price of oil over the last few years. This exercise, together with one based on the stock prices of large oil companies, suggests that the market price of oil was temporarily high in 2007, and that the jump in the first part of 2008 represented a further departure from the long-term value. I will return to this topic later.

Let me now turn to the paper's discussion of oil prices and monetary policy, a topic that has sparked much debate among academic economists and policymakers during my two stints as a Fed policymaker. The authors have accurately summarized the main issues involved in the debate that took place during 2002–2008, both inside and outside the Fed. As is well known, an oil price shock typically poses a dilemma for policymakers: Higher oil prices depress output and raise inflation. While the reduction in output provides a reason for policy to ease, the uptick in inflation pushes policy in the opposite direction. It is rarely obvious which element deserves greater weight in policy decisions, and that leads to debate about the appropriate response. The oil shocks of the past several years were no exception.

I agree with the authors' assessment that the Fed focused primarily on core rather than headline inflation to gauge the extent of underlying inflationary pressures during this period. This strategy, as the authors note, can be justified on theoretical grounds. Since core inflation rose only slightly, the Fed's main inflation gauge did not signal a need to tighten policy dramatically. But as energy costs soared, the economy did experience an uncomfortable increase in headline inflation. The authors argue that the Fed should have paid more attention to the acceleration in headline inflation and raised interest rates by more than it did from 2004 to 2006.

Their argument is buttressed by two exercises, one of which examines some data on expected inflation while the other is based on model simulations. I will comment on each of these, in turn. Using a small vector autoregression model—where the price of oil is assumed to be exogenous—the authors show that changes in the price of oil help predict (or, more specifically, Granger cause) the Michigan survey's measure of expected inflation and also one of two expectations measures based on Treasury yields. This result suggests to the authors that the Fed may have lost, or been on the verge of losing, at least some of its inflation-fighting credibility. Such a loss of credibility would obviously be problematic. For one thing, it would increase the amount by which the Fed would have to increase rates to offset any given inflationary shock.[3]

It's not clear to me, however, that the Fed's credibility was actually under such serious threat. Even taking the results at face value, the increase in expected inflation was small. Figure 5.3 in the paper reveals, in particular, that for three of their four measures, expected inflation in 2008 was only about one-tenth of a percentage point higher than what it would have been in the absence of any increase in the price of oil over this period.

But I think there are good reasons not to take these results at face value. Consider, first, the authors' choice of survey measures. They argue that an increase in readings from the Michigan survey—following years of stability—reflects increasing inflation expectations. But they discount the stability of inflation expectations in the Survey of Professional Forecasters (SPF), arguing that it indicates "…forecast inertia rather than a super-credible central bank." I find the authors' preference for consumer surveys over those of professional forecasters surprising since it is usually argued that households pay less attention to the latest data than do the professionals who are paid to make these forecasts. Moreover, households probably update their forecasts of inflation less frequently than professionals. It's also worth pointing out that the lack of responsiveness of professional forecasts to relative price shocks appears to be a recent phenomenon, likely due, in my view, to increased Fed credibility and not some newly acquired inertia on the part of the forecasters. Research by my staff shows that while the SPF forecasts were sensitive to headline inflation data in the past, these forecasts have responded in recent years to core rather than headline inflation data.[4] This finding suggests that professional forecasters no longer expect relative price changes to have a persistent effect on inflation.

I would also take issue with the authors' assumption that oil prices are exogenous. For one thing, this assumption is at odds with the paper's extended discussion about how the price of oil is determined by economic developments in the U.S. and other countries. Moreover, the assumption is probably not innocuous: previous research has shown that treating oil as endogenous in such models can greatly reduce the estimated effects of oil shocks.[5]

Last, and certainly not least, I would question the authors' conclusion that inflation expectations have become unanchored based on their finding that oil prices help predict the Michigan survey measures of expected inflation. This finding does imply that a jump in the price of oil causes expected inflation to increase for a time. But it does not prove that the increase is permanent rather than transitory. A permanent response of expected inflation to a change in oil prices requires either that the expectations process be nonstationary or that oil prices be expected to continue rising forever. In other words, the authors' finding of a link between oil prices and survey measures of expected inflation is perfectly consistent with a temporary impact of oil price shocks on both inflation and inflation expectations. Importantly, these are precisely the responses that are consistent with well-anchored expectations—except, of course, if consumers believe that the Fed would absorb the hit of an oil shock entirely in the form of reduced output.

Let me turn now to the second exercise in the paper, which involves simulating a new Keynesian model to examine the effects of oil shocks. As the authors point out, their specification reproduces a standard feature of such models, which is that it is better for monetary policy to target core inflation than headline inflation. But the authors then proceed to conduct an unusual simulation. To mimic the pattern of oil price increases from 2002 to 2008, they subject the model to a sequence of 26 quarterly shocks in which the average increase in the price of oil is about 7½ percent. While they present results for several different parameter combinations, the typical outcome entails a core inflation rate that is about 2 to 4 percentage points higher than the assumed inflation target of around 1¾ percent. The authors argue that such a sequence of oil price and inflation increases could cause inflation expectations to become unanchored. The implication is that the Fed should have tightened policy more than it did to keep expectations from being cast adrift.

A key element of their simulation is the assumption of a long period of increasing oil prices. Was it reasonable to expect such an outcome on a priori grounds? We can use the authors' elegant framework to answer this question. The first factor that is relevant in forecasting oil prices in that framework is the price of oil in the ground, as determined by the Hotelling model. However, the authors do not argue that this price changed substantially over the last five years or so. The second relevant factor is the behavior of q. In the authors' framework, q should be expected to converge toward unity in the medium to long term. Thus, the theory of the oil market presented in the paper suggests that forecasters during the 2002–2008 period should have expected oil prices to gradually revert to more "normal" levels over time, once q exceeded one. Of course, the model does not pin down precisely what might happen to the market price of oil for the next four, six or even eight quarters. Oil prices are notoriously hard to predict at these (and indeed at all) horizons, and there is plenty of room to argue about the role played by fundamentals, special factors, speculation, etc. But throughout most of this period, futures prices were predicting, even as oil prices rose, that oil prices would not rise further—and certainly not for six years running. And these were the most important real-time indicators of market expectations available to the Fed. Of course, futures-market forecasts proved wrong, ex post. But it seems to me now, as it did at the time, that there were neither strong empirical nor theoretical reasons to forecast that oil prices would continue rising for six years.

Since the improbable did in fact come to pass and the Fed tightened less than the authors consider optimal, it seems entirely appropriate to consider the costs of the Fed's policy judgment. The authors note that the onset of the recession makes it all but impossible to get an unambiguous answer, and I agree. But I still think we can form some judgments based on the behavior of inflation during the more-than-five-year period, ending in mid-2008, during which oil prices kept moving higher. In 2001—the year before oil prices began to rise—core PCE price inflation was 1.9 percent. It averaged 2.2 percent over 2005–2007 and registered 2.2 percent during the first half of 2008. So, core inflation did rise somewhat. We can debate just how much of that increase should be attributed to oil shocks, rising capacity utilization levels, and the wearing-off of the unusual sequence of productivity shocks of the late 1990s, which had helped to push inflation to an unusually low level for a time. The important point, though, is that the actual increase in core inflation fell far short of the increase predicted by the model simulations presented in the paper.

During the period of rising oil prices and high headline inflation, policymakers paid close attention to the behavior of wages for possible signs that higher inflationary expectations might be spilling over into wage bargains. Reassuringly, there was little evidence of any increase in the rate of wage growth, a linkage that I consider necessary for a sustained increase in the inflation rate. For instance, after increasing at a 4.3 percent pace in 2001—the year before oil prices began their sustained increase—the Employment Cost Index rose by an average of a little over 3.2 percent per year over 2005–2007 and at an annual rate of 2.8 percent in the first half of 2008. Other compensation measures also reveal relatively steady wage growth during this period.[6] So, data on wages, like those on core inflation, reveal little evidence of any impact resulting from the long sequence of large oil price shocks.

The authors attribute the lack of any sizable run-up in core inflation to other shocks that may have hit the economy at the same time. But it is important to emphasize that a significant body of recent research instead suggests that the measured effect of oil price shocks has diminished over the last several decades. Over a decade ago, Hooker (1996) showed that the effect of oil price shocks had diminished since the early 1980s and subsequent research has verified this finding. In fact, this influential research has shifted the academic debate concerning oil shocks, with some authors now questioning whether such shocks were ever actually as important as was believed in the 1970s (Barsky and Kilian, 2004, Bernanke, Gertler, Watson, 1997) and others investigating what structural changes in the economy may have diminished the impact of such shocks (Blanchard and Gali, 2007).

It seems to me that a change in the conduct of monetary policy following the experience of the 1970s has probably caused inflation expectations to become better anchored, explaining why recent oil shocks have inflicted relatively little damage on the economy. This hypothesis could at least partly explain why the huge run-up in energy prices through the middle of last year was not accompanied by rising wage demands. That in turn enabled the Fed to follow an easier monetary policy that gave greater weight to the output effect of rising oil prices than would have otherwise been possible.

Since mid-2008, oil prices have, of course, plummeted. But the extraordinary weakness in the economy means that the usual trade-offs associated with such supply shocks are absent right now. Any boost to spending from falling oil prices will be more than welcome in the current circumstances. And with inflation now below desirable levels, a decline in inflationary expectations that could push core inflation down over time would be most unwelcome. I argued earlier that the Fed's inflation credibility helped over a number of years to keep inflationary expectations anchored in the face of rising oil prices and high headline inflation. My hope is that inflationary expectations will remain similarly well-anchored now, serving to stabilize core inflation. The FOMC's recently released longer-run inflation projections should be useful in this regard, helping to reinforce inflation expectations of around 2 percent.

To conclude, let me emphasize that I enjoyed reading the paper and found the discussion of recent developments quite informative. But, the arguments in this paper did not persuade me to change my opinion of recent Fed policy. As I noted, during the period of rising oil prices, there was little evidence that policy was inappropriate: labor compensation growth remained well contained and inflation persistence appeared to be low, most likely because of increased Fed credibility. The Fed must always be vigilant in guarding its inflation credibility. But I did not think then, and I do not think now with the benefit of hindsight, that expectations became or were close to becoming unanchored at any point. Nor do I think that the Fed should have taken out substantial insurance against the possible consequences of a highly unlikely sequence of shocks, especially when a growing body of research suggested that the impact of oil shocks had declined substantially since the 1970s.

End Notes 1. I would like to thank Bharat Trehan, John Fernald, John Judd, John Williams, and Sam Zuckerman for assistance in preparing these remarks.

2. Harris, Kasman, Shapiro, and West (2009)

3. See, for example, Orphanides and Williams (2004, 2007).

4. Trehan (2009).

5. See Trehan (1986) and Barsky and Kilian (2004) for discussions of this issue.

6. Other wage and compensation measures reveal the same general behavior. Total compensation per hour in the nonfarm business sector rose by 4.1 percent in 2001, an average of 4 percent over 2005–2007, and by 2.4 percent at an annual rate in the first half of 2008. Average hourly earnings rose by 3.8 percent in 2001, an average of 3.6 percent per year over 2005–2007, and at a 3.8 percent rate in the first half of 2008.


Barsky, Robert B., and Lutz Kilian. 2004. "Oil and the Macroeconomy Since the 1970s." Journal of Economic Perspectives 18(4), pp. 115–134.

Bernanke, Ben S., Mark Gertler, and Mark Watson. 1997. "Systematic Monetary Policy and the Effects of Oil Price Shocks." Working Paper 97-25, C.V. Starr Center for Applied Economics, New York University.

Blanchard, Olivier, and Jordi Gali. 2007. "The Macroeconomic Effects of Oil Shocks: Why Are the 2000s So Different from the 1970s?" NBER Working Paper 13368.

Harris, Ethan, Bruce Kasman, Matthew D. Shapiro, and Kenneth D. West. 2009. "Oil and the Macroeconomy: Lessons for Monetary Policy." Unpublished manuscript, February 11.

Hooker, Mark. 1996. "What Happened to the Oil Price-Macroeconomy Relationship?" Journal of Monetary Economics 38(2), pp. 195–213.

Orphanides, Athanasios, and John C. Williams. 2004. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy." In Inflation Targeting, edited by Ben Bernanke and Michael Woodford. Chicago: University of Chicago Press, pp. 201–234.

Orphanides, Athanasios, and John C. Williams. 2007. "Robust Monetary Policy with Imperfect Knowledge." Journal of Monetary Economics 54(5), pp. 1406–1435.

Trehan, Bharat. 1986. "Oil Prices, Exchange Rates, and the U.S. Economy: An Empirical Investigation." Federal Reserve Bank of San Francisco Economic Review, Fall.

Trehan, Bharat. 2009. "Survey Measures of Expected Inflation and the Inflation Process." Unpublished manuscript.

links for 2009-02-28

February 27, 2009

Economist's View - 7 new articles

Christina Romer Answers Criticisms from Robert Barro and "the Best Man at My Wedding, Greg Mankiw"

Christina Romer's speech at the Chicago Booth forum at the University of Chicago:

The Case for Fiscal Stimulus: The Likely Effects of the American Recovery and Reinvestment Act: There are many thrills to my new job:

  • Three gates have to open to allow me to park each morning.
  • I get to speak frequently with the leader of the free world.
  • And, as a courtesy I get to see the Federal Reserve's Greenbook forecast in real time rather than with a five-year delay.

Actually, the biggest thrill of all is that after more than two decades of studying macroeconomic policy, I had the privilege of helping to craft what is without question the boldest countercyclical fiscal action in American history. ...

Over the past several months, there has been much discussion about whether the act will do enough to get the country back on track. I am extremely optimistic that it will, and thought it would be useful to spend my time today explaining why. In the process, I will explain why I disagree with some arguments that have been made against the recovery plan. ... I will strive to do my CEA best to give a balanced, dispassionate assessment.

The first issue is what it would mean for the policy to work. The President gave a very concrete metric: he wanted a program that would raise employment relative to what it would be in the absence of stimulus by 3 to 4 million by the end of 2010. Some on the blogosphere (such as the best man at my wedding, Greg Mankiw) call this metric meaningless: they complain that because we never observe the outcome under the no stimulus baseline, it isn't verifiable. But it is, in fact, the intellectually sound and appropriate metric to use. Exactly what any macroeconomist would ask of a policy is what are its effects, holding constant all the other forces affecting the economy. I feel the strongest evidence that the President's metric is a good one is that it has focused the debate on the right issue. Numerous forecasters, from Mark Zandi to Macroeconomic Advisers to CBO to the Federal Reserve, have looked at what they expect the Act to do. Rather than fighting over the differences in the no-stimulus baselines, which are substantial and largely outside the control of policymakers, the debate has centered on what the policy would accomplish.

Of course, one can also debate the baseline and the question of whether creating or saving 3 to 4 million jobs will be enough to fully heal the economy. But, it is important to acknowledge that creating or saving that many jobs would be a tremendous accomplishment.

This discussion of what the bill is intended to do leads naturally to the more important question of whether it will actually accomplish the President's goal. This involves two issues. One concerns the effects of a typical fiscal change. What will a quintessential increase in government spending or cut in taxes do to output and employment? The other concerns the particular fiscal changes in this bill. Are there aspects of its structure or timing, or of the economic environment in which it is taking place that would lead us to expect the effects to be different from usual?

Let me start with the issue of the effects of fiscal policy in general. If we cut taxes by 1% of GDP or increase spending by a similar amount, what will that typically do to the economy? I will be the first to point out that estimating these multipliers is difficult and that there is surely substantial uncertainty around any estimate. But, I feel quite confident that conventional multipliers are far more likely to be too small than too large. David Romer and I have argued that omitted variable bias is a rampant problem in estimating the effects of fiscal policy. One good way to illustrate this is to discuss Robert Barro's approach to estimating multipliers. Barro has argued that a reasonable way to estimate the effects of increases in government spending is to look at the behavior of spending and output in wartime. But, consider one of his key observations – the Korean War. If he were using just this observation, Barro would basically divide the increase in output relative to normal by the increase in government purchases relative to normal during this episode. When one does this, one gets a number less than one. From this Barro would conclude that the multiplier for government spending is less than one. But, other things were going on at this time that also affected output. Most importantly, taxes were raised dramatically; indeed, the Korean War was largely fought out of current revenues. The fact that output nevertheless rose substantially is in fact evidence that the effects of increases in government spending are very large.

To address the problem of omitted variables, David and I used narrative evidence to isolate tax changes uncorrelated with other factors affecting output. We read Congressional reports, Presidential speeches, the Economic Reports of the President, and other documents to identify relatively exogenous tax changes. We found that the estimated effect of these changes is very large. A tax cut of 1% of GDP raises GDP by between 2 and 3% over the next three years.

Unfortunately, doing the same kind of narrative analysis for government spending would be very difficult: there are vastly more spending changes than tax changes, and the motivations for them are less easily classified. But, the same issue of omitted variables is surely present. As the war example illustrates, spending changes are often taken at the same time as tax changes that push output in the opposite direction. Also, spending increases are often taken in recessions, where other factors are clearly reducing output. As a result, it is likely that conventional estimates of spending multipliers are also biased downward.

In estimating the effects of the recovery package, Jared Bernstein and I used tax and spending multipliers from very conventional macroeconomic models. We used simulations based on the realistic assumption that monetary policy would remain loose, and on the assumption that people would treat the individual tax cut as permanent. This last assumption is justified by the fact that the President ran on a permanent middle class tax cut and just included it in his budget. In these models, a tax cut has a multiplier of roughly 1.0 after about a year and a half, and spending has a multiplier of about 1.6. As I have suggested, it is very hard to claim that those are excessively large. Indeed, if you want to know why I am more optimistic than some, it is probably because I believe my own research. I think that both the change in taxes and the change in spending may pack more bang than the official Administration estimates assume. Before leaving multipliers, one issue that has come up is the interaction with the financial crisis. A common argument is that fiscal stimulus will have less effect because financial markets are operating poorly and lending is not flowing. I want to offer a different view. I think it is possible that fiscal policy will have even more oomph in this situation. When households and businesses are liquidity-constrained by reduced lending, any money put in their pockets is more likely to be spent.

More fundamentally, there is strong reason to believe that a recovery in the real economy is salutary to the financial sector. When people are employed and buying things, loan defaults fall and asset prices are likely to rise. Both of these developments would surely be helpful to stressed financial institutions. This is, I believe, a key lesson of the Great Depression. In the Depression, the end of deflation, renewed optimism, and increased employment and output were as crucial to the recovery of the financial system as the more direct actions taken to stabilize banks. Thus, real and financial recovery reinforced each other. So, fiscal policy to raise employment may help to restart lending and in that way generate a more durable recovery.

So much for the generic effects of fiscal policy. What about the particular actions called for in the Recovery Act? ...[...entire speech...]

-6.2% and 36%

The fourth quarter GDP figures have been revised:

In Revision, G.D.P. Shrank at 6.2% Rate at the End of 2008, by Catherein Rampell, New York Times: The economy at the end of last year contracted at a far faster rate than initially estimated... With the exception of government spending, every major component of the economy shrank. ...

Output fell 6.2 percent at an annualized rate in the fourth quarter of 2008, revised downward from a previous estimate of a 3.8 percent decline. ...

The economy took the biggest hits in exports, retail sales, equipment and software, and residential fixed investment.

The downward revisions, though, came primarily because of a larger-than-anticipated contraction in inventories of unsold goods. ... Some hail the decline in inventories as potentially good news.

"The only plus to take out of this is that inventories weren't as high, and that implies you don't have to cut as much this quarter to get them back under control," Mr. Gault said. He added that inventories were still too high, and he expected companies to further scale back their production, especially in response to the dismal consumer spending numbers. ...

Households also saved much more of their paychecks than initially estimated. ...


Minus 6.2%: Yikes.

And if the data on new unemployment claims are any indication (which they are), the economy is continuing to plunge at least as fast.

As Brad DeLong says, I think we're going to need a bigger stimulus.

Also, the US is taking a larger state in Citibase:

[T]he government will increase its stake in the company to 36 percent from 8 percent.
Under the deal, Citibank said that it would offer to exchange common stock for up to $27.5 billion of its existing preferred securities and trust preferred securities at a conversion price of $3.25 a share, a 32 percent premium over Thursday's closing price.

Paul Krugman: Climate of Change

Paul Krugman finds lots to like in Obama's proposed budget:

Climate of Change, by Paul Krugman: Elections have consequences. President Obama's new budget represents a huge break, not just with the policies of the past eight years, but with policy trends over the past 30 years. If he can get anything like the plan he announced on Thursday through Congress, he will set America on a fundamentally new course.

The budget will, among other things, come as a huge relief to Democrats who were starting to feel a bit of postpartisan depression...: fears that Mr. Obama would sacrifice progressive priorities in his budget plans ... have now been banished.

For this budget allocates $634 billion over the next decade for health reform. That's not enough to pay for universal coverage, but it's an impressive start. And Mr. Obama plans to pay for health reform, not just with higher taxes on the affluent, but by putting a halt to the creeping privatization of Medicare, eliminating overpayments to insurance companies.

On another front, it's also heartening to see that the budget projects $645 billion in revenues from the sale of emission allowances. After years of denial and delay by its predecessor, the Obama administration is signaling that it's ready to take on climate change. ...

Many will ask whether Mr. Obama can actually pull off the deficit reduction he promises. Can he actually reduce the red ink from $1.75 trillion this year to less than a third as much in 2013? Yes, he can.

Right now the deficit is huge thanks to temporary factors (at least we hope they're temporary)... But if and when the crisis passes, the budget picture should improve dramatically. ... So if Mr. Obama gets us out of Iraq (without bogging us down in an equally expensive Afghan quagmire) and manages to engineer a solid economic recovery — two big ifs, to be sure — getting the deficit down to around $500 billion by 2013 shouldn't be at all difficult. ...

So we have good priorities and plausible projections. What's not to like about this budget? Basically, the long run outlook remains worrying.

According to the Obama administration's budget projections, the ratio of federal debt to GDP. ...  will soar over the next few years, then more or less stabilize ... at a debt-to-GDP. ratio of around 60 percent. ...  [S]ooner or later we're going to have to come to grips with the forces driving up long-run spending — above all, the ever-rising cost of health care.

And even if fundamental health care reform brings costs under control, I at least find it hard to see how the federal government can meet its long-term obligations without some tax increases on the middle class. Whatever politicians may say now, there's probably a value-added tax in our future.

But I don't blame Mr. Obama for leaving some big questions unanswered in this budget. There's only so much long-run thinking the political system can handle in the midst of a severe crisis; he has probably taken on all he can, for now. And this budget looks very, very good.

More on the budget:

"Inferring How Smart People are from a Distance"

There must be a Facebook joke here somewhere:

Can we tell from pols' faces if they're competent?, by Jordan Lite, 60-Second Science Blog: We really do judge a book by its cover — and, it seems, the competence of politicians by their faces. What's more, adults and kids see the same competence — or, as the case may be, ineptitude — in a person's visage, which helps explain why children can accurately predict presidential elections, according to new research published today in Science.

Swiss adults unfamiliar with French politics were shown 57 pairs of photos of opponents from an old French parliamentary election and asked to pick which ones looked most competent. In a separate experiment, Swiss kids ages 5 to 13 played a computer game that enacted Odysseus' trip from Troy to Ithaca. Then, using the same pairs of photos, researchers asked the kids which candidate they'd choose to captain their ship. In both experiments, the adults and children tended to pick the winners of the election.

"Adults and children infer competence in precisely the same way, whether that [person] is six or seven — or 67. That is the shocking finding here," study co-author John Antonakis, a professor of organizational behavior at the University of Lausanne, tells "This stereotype is already formed in young childhood, which leads us to suggest this mechanism is innate or develops very, very rapidly at a young age."

The study didn't examine what, exactly, led people to see competence in one face more than another. ...

None of this is to say that the truism "don't judge a book by its cover" is obsolete. While our judgments about competence tend to translate into election results, they're not so great at predicting true leadership. What does correlate with a president's performance is his estimated IQ — not his face, according to a 2006 study in Political Psychology.

"If people were good at inferring how smart people are from a distance," Antonakis says,  "all the politicians we elected would be very clever."

Kansas City Blogging and Barbecue

Tyler Cowen:

Battle of the Barbecues, Kansas City: The Kaufmann Foundation brought together many bloggers and many servings of Kansas City barbecue.  (Isn't America a great country?  I met Mark Thoma for the first time and tomorrow we talk about blogging and the future of the world.)  Then we voted, using Borda Point Count.  Tim Kane tells me:

Oklahoma Joe's wins handily.  Arthur Bryant's loses handily.  Others are close.  (Hmmm ... looks like a normal).

It's been fun to meet the people behind the posts. [Update: more here.]

"The Case for and against Bank Nationalisation"

This column argues that bank nationalisation is the best hope we have for avoiding a "lost decade like Japan":

The case for and against bank nationalisation, by Matthew Richardson, Vox EU: Treasury Secretary Timothy Geithner's financial plan calls for stress tests at the large complex financial institutions (LCFIs). These tests are due to start this week. They will involve estimates on the eventual losses due to default on a wide variety of assets.

Economic analysts have already performed such a test at the aggregate level. The results were not pretty. For example, Goldman Sachs looked at the US banking sector's holdings of the current "toxic" pool of assets, such as option ARM residential mortgages, subprime residential mortgages, Alt-A residential mortgages, credit card debt, second liens/home equity loans, consumer auto loans, and commercial real estate. Expected losses come in at around $900 billion. These losses give the banking sector very little wiggle room. Therefore, there is the real possibility that some LCFIs are bankrupt – the face value of their liabilities exceeds the current value of their assets.

Insolvent financial institutions

If a bank is insolvent, there are three general ways to attack the problem.

The first is unbridled free-market capitalism. I am sympathetic to this view. I wish we somehow could figure out a way to let the market work and let these institutions fend for themselves. Shareholders, creditors and counterparties knew the risks they were getting into. After all, why is some debt secured, why do we have collateralised lending, why do riskier assets deserve larger haircuts, etc? But when Lehman Brothers went down, we looked into the abyss. This would be the equivalent of nuclear armageddon for the financial system.

The second option is to provide government aid to the insolvent bank – to in effect throw good money after bad. This is sanctioning private profit-taking with socialised risk. Since October of this past year, the government has followed this strategy. Let the banks plod along, throwing money here and there to keep them afloat, at usually way below-market prices at a high cost to taxpayers.

It is not a totally crazy solution. There may well be a positive externality to spending taxpayer money to save a few so we can save the entire system. For economists specialising in the field of banking, however, this approach has a familiar ring to it. In Japan's lost decade of the 1990s, its banks kept loaning funds to bankrupt firms so as not to writedown their own losses, which resulted in the government supporting zombie banks supporting zombie firms.

As an example, consider the poster child for the "freebie" programmes, the Temporary Liquidity Guarantee Program, started in late November of 2008. For a cost of 0.75%, it allows banks to issue bonds backed by the government, essentially risk-free. The banks have accessed this market 97 times for $190 billion!

The biggest pig at the trough was Bank of America, which accessed it 11 times for $35.5 billion. Close behind were JP Morgan ($30 billion), GE Capital ($27 billion), Citigroup ($24 billion), Morgan Stanley ($19 billion), Goldman Sachs ($19 billion) and Wells Fargo ($6 billion). A not so surprising correlation with their respective writedowns (including merged entities): Bank of America $96 billion, JP Morgan $75 billion, Citigroup $88 billion, Morgan Stanley $22 billion, Goldman Sachs $7, billion and Wells Fargo $115 billion.

In terms of helping us exit the financial crisis, this programme has many problems. It charges each institution the same amount, so it hardly separates the solvent from the insolvent institutions. It charges a fee that is grossly below what these institutions could issue in the marketplace given their current balance sheets, distorting the system. Wasn't that the Fannie Mae and Freddie Mac problem? And it is unlikely to cleanse the system of toxic assets, because it allows banks to continue business while out of money and hope that toxic asset prices increase. In effect, the access to this capital allows them to continue to make their original bets.

The final way of addressing insolvency is nationalisation. Over the past week, there has been debate about whether nationalisation is the right word. According to a standard dictionary definition, nationalisation is the act of transferring ownership from the private sector to the public sector. Although this is literally what we are discussing for certain banks, almost everyone agrees that the type of nationalisation that would take place would be a temporary one. Thus, if everything went as planned, a better analogy would be of the government acting as a trustee in a receivership of the bank.

That said, I do think a term like nationalisation is the appropriate description. It is a misnomer to think, as a number of pundits have suggested, that we have experience at nationalising banks through the FDIC. For example, the latest bank (and 39th of the current crisis) to be closed by regulators is the Silver Falls Bank of Silverton, Oregon. It has three branches and assets of approximately $131 million.

Silver Falls Bank is no Citigroup or Bank of America. The complexity, size and systemic nature of these institutions deserve deep analysis.

The basic argument for nationalisation is that we need an organisation to simultaneously facilitate the reorganisation of the large complex financial institutions and be a trustworthy counterparty to all current and ongoing transactions. The only one with the balance sheet right now is Uncle Sam. But make no mistake about it. With nationalisation of a LCFI, the government is the owner and the ultimate residual claimant. Once we take down the LCFI, we have crossed the Rubicon. The die is cast and there is no turning back.
It is therefore important to do it right. Nationalisation has its pros and cons.

The good bank, bad bank model

In order to have a healthy economy, we need a healthy financial system, and a healthy financial system requires that we cleanse the system of bad assets. Otherwise, creditworthy firms and institutions will not have access to needed capital, prolonging the economic downturn.

Such cleansing would be the primary benefit of nationalising some financial institutions. In receivership, it is much easier to separate a bank's good assets and bad assets – to divest the firm from its toxic assets and troubled loans. This is because insolvent institutions will never take this action. If they did, it would by construction force them under.

How would it work? The healthy assets and most of the bank's operations would go to the good bank, as would the deposits. Some of these deposits are insured; others (e.g., businesses and foreign holdings) are not. But the good bank would likely be so well capitalised that there would be no threat of a bank run. The net equity, i.e., assets minus deposits, would be a claim held by the other existing creditors of the bank, namely shareholders, preferred shareholders, short-term debtholders, and long-term debtholders.
The goal would be to reprivatise the good bank as soon as possible. After all, the point of the exercise is to create healthy financial institutions that can start lending again to creditworthy institutions. In almost every successful resolution of financial crises in other countries, this was the path.

Of course, the tricky part of nationalisation is the handling of the bad assets. The bad assets would be broken into two types – those that need to be managed, such as defaulted loans in which the bank would own the underlying asset, and those that could be held, such as the AAA- and subordinated tranches of asset-backed securities. With respect to the former, the government could hire outside distressed investors or create partnerships with outside investors as was done with the Resolution Trust Corporation in the 1980s savings and loan crisis.

Along with the equity of the good bank, these assets would be owned by the existing creditors. The proceeds over time would accrue to the various creditors according to the priority of the claims. Most likely, the existing equity and preferred shares would be wiped out, and the debt would effectively have been swapped into equity in the new structure. Under this scenario, it is quite possible, even likely, that taxpayers would end up paying nothing. This is because, for the large complex financial institutions, these creditors cover well over half the liabilities.

Does such a solution risk systemic bank runs?

The problem with the above solution is that it shifts all the risk of the insolvent institution onto the creditors of the LCFI. While this is fair to the extent the creditors were accruing the profits in normal times, it may lead to the "Lehman Brothers problem" – it risks runs throughout the system.

Why did Lehman Brothers cause systemic risk?

Was it the counterparty risk, e.g., fear of being on the other side of interest rate swap, credit default swap, or repo transactions? This fear was well founded. Ask any hedge fund whose hypothecated securities disappeared in Lehman's UK prime brokerage operations. It is pretty clear that the government would have to stand behind any counterparty transaction and publicly commit to this rule. Since most of these are margined and collateralised, however, many of the assets would show up in the good bank.

Or was it the short-term debt? The run on money market funds was directly attributable to the Reserve Primary Fund's holdings of a large amount of short-term Lehman commercial paper. One would presume the same thing would happen here as the short-term debt of all questionable LCFIs would come under pressure. It is highly likely that the government might have to step in.

Compared to the standard large complex financial institution, Lehman had very little long-term debt. To understand whether a collapse in the institution's long-term debt value is systemic, one would have to analyse the concentration of this debt throughout the system. If it is widely held, it is unlikely to have systemic consequences. Of course, it would have profound effects on future financing of these firms.

If the government has to cover the creditors, or at least some of them, what has been gained?

On the positive side, the system will have cleansed itself of the assets.

Moreover, to minimise the cost to taxpayers, it is not clear that the government will have to step in. If the government is completely transparent to the market who is solvent and who isn't, and the reasons why this is, then the type of uncertainty that surrounded Lehman's failure may be mitigated. The runs on the equity and debt of banks in September and October 2008 may have occurred because there was no clear message from the regulator.

That said, actions speak louder than words, and, in a dynamic setting where conditions change rapidly, solvent firms can become insolvent very quickly. While the government needs to do a thorough stress analysis, consistent across all the major banks, to find out the trouble spots, the only definitive way it can prevent a bank run on solvent institutions is to backstop all the creditors of these institutions. Maybe the government can provide a haircut, guaranteeing X% of the debt. In any event, in this case, the creditors of the insolvent institutions would not have to be protected.

Advantage: Nationalisation solves the toxic asset problem

It has been argued that trying to implement nationalisation will be near impossible because we won't be able to price the hard-to-value "toxic" assets. It is actually the opposite. The current problem is that banks don't want to sell the assets at the price the market is willing to pay for them. If we were banks, we wouldn't want to sell them either. As long as the government is providing free money, why not continue to hold out? Hope is eternal.

But let's be real. The banks bought illiquid assets with credit risk using borrowed short-term liquid funds. For taking these types of risk, the banks earned a hefty spread. And, in normal times, they raked it in. But there is no free lunch in capital markets. In rare bad times, illiquid, defaultable assets are going to be greatly impaired. There is no mulligan here. It will be easier to resolve this within a receivership.

To make the point using a real economy analogy, this past Christmas, Saks Fifth Avenue sold their designer lines at a 70% discount. Designer labels and boutique shops on Madison Avenue were up in arms. How could they sell $500 Manolo Blahnik shoes for $150? In this economy, they are $150 shoes.
Moreover, receivership allows one to separate out the assets without having to price them.

Disadvantage: How to manage a nationalised bank?

Does the government have the ability to run a large complex financial institution? In a recent conversation, Myron Scholes told me he was also in favour of nationalisation – as long as it lasts just 10 minutes.

These institutions have literally tens of thousands of transactions on their books –, who is going to manage a LCFI while it is a government institution, good bank or bad bank? Certainly, no one envisions Barney Frank or Christopher Dodd as the Chief Investment Officers of these firms, but there are many concerns. The government can go and hire professionals as they have done with Fannie Mae, Freddie Mac, and AIG. But much of the value of a Wall Street firm is in its vast array of intangible, human capital. This labour is incentive-driven. How much franchise value will be lost during the nationalisation process?

Let's assume this gets sorted out and the government mirrors employment practices at other firms. But then, with the government's protection in receivership, what is to prevent the LCFI from making too many, risky loans? They will have a competitive advantage over solvent, albeit less-supported banks. This issue has recently come up with other government-supported institutions. Indeed, the argument has been made that AIG and Northern Rock, to name just two institutions, have undercut their competition by offering overly cheap insurance and mortgages, respectively.

Advantage: Nationalisation addresses the moral hazard problem

There is something unseemly about managed funds buying up the debt of financial institutions under the assumption that these firms are "too big to fail". In theory, these funds should be the ones imposing market discipline on the behaviour of financial firms, not pushing them to becoming bigger and more unwieldy.

It has been said by many that this is not the time for thinking about moral hazard. I disagree. If we bailout the creditors, then effectively we have guaranteed the debt of all future financial institutions. We have implicitly socialised our private financial system.

It is certainly true that we can institute future regulatory reform to try to quell the behaviour of large complex financial institutions. But this will be complex and difficult to implement against the implicit guarantee of "too big to fail".

Thus, nationalisation resolves the biggest regulatory issue down the road, namely the "too big to fail" problem of banks that are systemically important. In one fell swoop, because the senior unsecured debtholders of a bank will lose when it is nationalised, market discipline comes back to the whole financial sector.

So the large solvent banks will have to change their behaviour as well, leading, most likely, to their own privately and more efficiently run spin-offs and deconsolidation. The reform of systemic risk in the financial system may be easier than we think.

Concluding remark

We are definitely caught between a rock and a hard place. But the question is – what can we do if a major bank is insolvent? Sometimes the best way to repair a severely dilapidated house is to knock it down and rebuild it. Ironically, the best hope of maintaining a private banking system may be to nationalise some of its banks. Yes, it is risky. It could go wrong. But it is the surest path to avoid a "lost decade" like Japan.

Epilogue: Sweden[1]

Sweden has been cited frequently as a model of "nationalisation". While this is probably an exaggeration, the Swedish approach is in many ways a model in terms of the principles it puts forth to handle a financial crisis. Putting aside the obvious fact that Sweden's economy is much smaller and its financial institutions much less complex, it is a useful exercise to describe some basic facts.

The distribution of assets within the Swedish and US banking system were similar. For example, while Sweden had 500 or so banks, 90% of the assets were concentrated in just six. In the US, while there are over 7,500 institutions, and the majority of assets are concentrated in the top 15 or so.

Sweden's credit and real estate boom in the late 1980s closely mirrors the recent US boom prior to the crisis. There was even a similar shadow banking system that developed during these periods – in Sweden, unregulated companies financed their operations via commercial paper; in the US, unregulated special purpose vehicles used asset-backed commercial paper. When the bubbles began to burst, there were also sudden collapses in these markets as a few of these companies and special purpose vehicles began to fail.2 Ultimately, the funding came back to the banks, causing them to have large exposure to the real estate market.

As conditions eroded in 1991, the Swedish government forced banks to writedown their losses and required them to raise more capital or to be restructured by the government. Of the six largest banks, three – Forsta Sparbanken, Nordbanken and Gota Bank – failed the test. One received funding and the other two, Nordbanken and Gota bank, ended up being nationalised.

These latter two banks had their assets separated into good banks and bad banks. The good banks ended up merging a year later and were sold off to the private sector. The poorly performing loans were placed in the bad banks, respectively named Securum and Retrieva. These banks were managed by asset management companies who were hired to divest the assets of these banks in an orderly manner. (It took around four years.)

The main lessons from Sweden for the current crisis are:

  1. Decisive action in terms of evaluating the solvency of the financial institutions.
  2. Some form of "nationalisation" of the insolvent firms.
  3. Separation of these insolvent firms into good and bad ones with the idea of reprivatising them.
  4. The management of the process was delegated to professionals, as opposed to government regulators.

While complexity may affect the application of these principles to the current crisis, it does not nullify them.


1 Many of the facts here are taken from Tanju Yorulmazer's "Lessons from the Resolution of the Swedish Financial Crisis."
2 In Sweden, in September 1990, a finance company called Nyckeln went bankrupt, while in the current crisis, in early August 2007, three ABCP funds run by BNP Paribas halted redemptions, leading to a run on the system.

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February 26, 2009

Economist's View - 5 new articles

"The Long and Short of It"

Travel day today, but here's something:

The Long and Short of It, by Mark Thoma, CIF, UK Guardian: President Barack Obama's State of the Union-style speech on Tuesday night presented a mixture of economic policies. Some, such as "extended unemployment benefits and continued healthcare coverage to help ... weather this storm", are devoted to short-run issues related to the economic downturn. Others, such as polices to "address the crushing cost of healthcare" and investments in "technologies like wind power and solar power, advanced biofuels, clean coal and more efficient cars and trucks", are devoted to longer-run structural issues that we need to resolve. [...continue reading...]

Paul Collier: I Don't Buy Economists' Case for Fighting Climate Change

Paul Collier rejects the utilitarian basis for reducing carbon emissions and replaces it with "a rights-based notion of ethics":

I don't buy economists' case for fighting climate change, Paul Collier, Commentary, The Guardian: ...In his Review on the Economics of Climate Change - widely regarded as the most important and comprehensive analysis of global warming to date - Lord Stern argued that in cold cost-benefit terms, it made sense for the present generation to make sacrifices because the benefits to future generations would be so substantial. ...

Necessarily, this approach ... depends .... upon a degree of ethical decency: if we thought only of ourselves, then our cost-benefit calculus would tell us to let the future fry. Stern's analysis rests upon a utilitarian calculus that is standard in applied economics: each person, whether alive or yet to be born, counts as equal, except that giving the same benefit to someone who is rich counts as less valuable than giving it to someone who is poor.

Prior to the publication of the Stern review, the main battleground was scientific: is climate change a reality...? Post-Stern, that battleground has now shifted to ethics. ...[T]he challenges have come from two ethical positions that ... cannot be readily dismissed.

One challenge is the elitism ... in overriding democracy: according to the utilitarian calculus the government should value the interests of the future far more highly than most voters would do. Indeed, if we are guilty of radically undervaluing the future, then this neglect applies not just to carbon emissions, but to all the other ways in which we could help the world of the future. The government should force us to save far more than we do... Are we radically neglecting the future by not saving enough? ...

The other ethical challenge questions the transfer from the poor to the rich that would be implicit in reducing carbon emissions: we, the current generation, are the poor who are to make sacrifices for future generations, who are likely to be much wealthier than we are... And so, on the utilitarian calculus, radical egalitarians should be opposed to curbs on carbon: let the rich fry.

Personally, I doubt whether the utilitarian calculus is the right ethical framework ... to think about global warming... Take the valuation of the future: are we radically undervaluing the interests of future people?

Of course, we cannot tell how the future will feel, but one simple test is to ask ourselves how we feel about the past - are we angry that our great-grandparents did not live more frugally so that we would now be richer? ...

Is there an ethical basis for being concerned about global warming that does not depend upon the notion that quite generally we are radically negligent about future people? I think that there is, but this concern depends upon a rights-based notion of ethics rather than on utilitarianism. Most professional economists will at this point stop reading because they will think that rights are a quagmire. But here goes.

Natural assets such as biodiversity, and natural liabilities, such as carbon, are not owned by the current generation, because we did not create them. We have them because previous generations passed them on to us, and we are obliged to do the same. If we deplete natural assets, or run up natural liabilities, we have an obligation to compensate future generations...

It is fairly obvious that adequately compensating the future for letting it fry is likely to be a more expensive undertaking than curbing our carbon emissions. Remember that future people are likely to be much richer than we are, and so what they would regard as fair compensation would be prodigious. ...

Ultimately, in a democracy our policy decision rules must rest on ethical principles that are widely shared by citizens. I suspect that most people feel that they should reduce carbon emissions, but the key issue is why? Is their motivation better captured by the utilitarian calculus used by economists, or by a sense of custodial obligation towards our natural legacy, of which carbon is but one instance?

Fed Watch: Lowering the Bar

One more from Tim:

Lowering the Bar, by Tim Duy: From the terms of the Capital Assistance Program:

As part of the application process, banks must submit a plan for how they intend to use this capital to preserve and strengthen their lending capacity – specifically, to increase lending above levels relative to what would have been possible without government support. The Treasury Department will make these plans public when the bank receives the capital under the CAP. (italics added.)

This is refreshing; unlike the initial TARP program, Treasury is not giving the impression that banks will increase lending - only that lending will contract by less than otherwise expected, all else equal.  Avoidance of a absolute collapse seems to be a reasonable goal.  I would prefer that we moved to avoidance of the Japanese scenario as well, but perhaps I just need to learn to be happy with small steps.

Of course, I can't see that it would be hard for the recipient bank to pick a safe baseline for lending in the absence of Treasury support (like zero).  Nor will it be easy to explain to the taxpayer that they should continue to expect lending to contract.  But at least we can say we were warned. 

Fed Watch: Will TALF Do The Job?

Tim Duy has doubts about how effective TALF will be:

Will TALF Do The Job?, by Tim Duy: The Administration is putting high hopes on TALF, especially now that the program will reach as high as $1 trillion (remember when $1 trillion was a lot of money?).  It has always seemed to me that TALF would fall short of the mark.  The key constraint:

Eligible collateral includes U.S. dollar-denominated cash ABS that are backed by auto loans, credit card loans, student loans, or small business loans that are fully guaranteed by the SBA, and that have a credit rating in the highest investment-grade rating category from two or more nationally recognized statistical rating agencies and do not have a credit rating below the highest investment grade rating category from a major rating agency.

The expansion of TALF to CBMS also requires AAA-ratings.  I suspected that limiting the program to investment grade securities would severely curtail the effectiveness of the program for one simple reason - that, relative to expectations of officials, investment grade borrowers are relatively few, and they have maintained that status by not accumulating excessive debt, so already they are not inclined to borrow.  The spending bubble was not driven by high grade debt; it was driven by low grade debt disguised as high grade debt.  Focusing on high grade debt as the solution will thus prove insufficient to give the economy much traction. 

Two recent stories tend to support this point.  First, from the Wall Street Journal:

The government's $200 billion program to revive the market for securities backed by consumer loans may end up providing little help to the very industry that needs it most: U.S. auto makers.

As the Federal Reserve hashes out final terms of its Term Asset-Backed Securities Loan Facility, or TALF, it is becoming clear that securities that help finance auto dealers mightn't meet some criteria. That would block a form of funding that auto companies had hoped would provide immediate relief as they fight for survival.

The problem came to a head because of credit ratings. The Fed has insisted that any deal it helps finance be given a triple-A rating from Moody's Investors Service, Standard & Poor's or Fitch Ratings. Bankers said this kicks out deals backed by loans to auto dealers because S&P and Moody's, in particular, have cut the ratings on such securities over the past several weeks as the industry grapples with potential bankruptcy filings and weaker demand for U.S. cars.

The second is from Bloomberg:

The Fed, through the TALF, could reduce the cost of financing commercial real estate by taking as collateral CMBS already traded in the secondary market rather just new bonds, said RBS analyst Lisa Pendergast in Greenwich, Connecticut.

Accepting bonds from the secondary market would be a "big deal" for reviving credit, said Jan Sternin, a senior vice president at the Mortgage Bankers Association in Washington.

The central bank also should make loans with at least a five-year term against CMBS, Pendergast said. The TALF is now geared to make loans of no more than three years against collateral, a misalignment with the typical five- or 10-year term of commercial mortgages.

"Nobody would buy a 10-year asset with a three-year loan," she said.

The Fed initially proposed a one-year term for TALF loans it will make before revising to a three-year period in December.

Without TALF support, borrowers would have a tougher time refinancing maturing debt and avoiding delinquency or foreclosure, said Chip Rodgers, senior vice president at the Real Estate Roundtable, a trade group in Washington.

The Fed has said it will only accept newly issued AAA-rated CMBS collateral.  Presumably, newly issued CMBS could be used to refinance maturing debt, assuming the refinanced debt could be rated AAA.  And, I suspect, therein lies the heart of the industry's conundrum.  Given the deterioration in credit quality, we can presume that much of the maturing debt is rated at something less than AAA.  Much less.  Consequently, the TALF would do little to help refinance maturing commercial mortgage debt, at least directly (I would not count on the indirect effect of building confidence in dodgy assets via liquidity programs).  They know it - the article contains a telling quote:

Atlanta Fed President Dennis Lockhart said today that commercial real estate is "the one domestic factor that keeps me up at night."

"Many banks are pretty heavily exposed to commercial real estate," he said in Orlando, Florida.

Lockhart must sleep well compared to me; I have a laundry list of economic issues that keeps me up at night. 

If the maturing debt cannot be refinanced at reasonable interest rates, then rising defaults and additional asset markdowns will play further havoc on the banking industry.  The Fed cannot fix this if they limit their loan programs to AAA-rated ABS as the problem debt by definition has a lower rating.   This appears to be the signal the industry is sending, so holders of CBMS want the next best thing - the Fed to absorb the risk of the existing AAA-ABS:

Top-rated commercial mortgage bonds are currently trading at about 10.82 percentage points more than benchmark interest rates, compared with 2.32 percentage points a year ago, Bank of America Corp. data show. In January 2007, the debt traded at 0.22 percentage point.

Seems those "top-rated" bonds are riskier than expected.  Better to sell them off to the Fed (and eat the haircut) while they are still AAA rated.  Of course, it may already be too late; ratings are dropping fast:

Moody's Investors Services downgraded an additional $23.89 billion of commercial mortgage-backed securities amid concerns that losses would grow from increased leverage, reduced reserves to pay debt and loan losses.

The move follows the ratings firm's announcement last week that it would review the ratings of some $300 billion of bonds backed by commercial-real-estate loans. More than a quarter of those securities are vulnerable to multiple-notch credit downgrades.

Last Thursday, Moody's said it will apply new assumptions about falling property cash flows and stressed capitalization rates, which are the ratio of net income to its value, when considering the rating of the bonds. The review is slated to be completed within 60 days.

Including the latest round of downgrades, $62.09 billion of CMBS has been downgraded by Moody's the past week.

The commercial real-estate market had held up better than the residential real-estate market, but it began to deteriorate quickly at the end of 2008 as the recession deepened.

The ratings firm had expected cumulative losses of 2% on commercial bonds issued between 2006 and 2008, but it has increased that to 5%.

Moody's, which on Tuesday downgraded 124 classes and affirmed 69, expects a significant decline in future property cash flows on higher tenant defaults, bankruptcies and a sharp decline in lease-renewal rates. Those cut include 47 tranches valued at $6.6 billion from Wachovia Corp., which was acquired by Wells Fargo Co. five weeks ago, 11 classes valued at $3.8 billion at J.P. Morgan Chase & Co. and 10 classes valued at $2.8 billion at UBS AG.

Existing CMBS might not be rated AAA for long.

Bottom Line:  TALF limitations provide protection for the taxpayer, but curtail the program's effectiveness.  This is not meant to imply that efforts should not be made to support the normal functioning of credit markets; simply to keep expectations about effectiveness in check.

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