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September 3, 2010

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Paul Krugman: The Real Story

Posted: 03 Sep 2010 12:24 AM PDT

When Obama announces his new measures to boost the economy next week, will he learn from the mistakes he made the first time?:

The Real Story, by Paul Krugman, Commentary, NY Times: Next week, President Obama is scheduled to propose new measures to boost the economy. I hope they're bold and substantive, since the Republicans will oppose him regardless — if he came out for motherhood, the G.O.P. would declare motherhood un-American. So he should put them on the spot for standing in the way of real action.
But let's put politics aside and talk about what we've actually learned about economic policy over the past 20 months.
When Mr. Obama first proposed $800 billion in fiscal stimulus, there were two groups of critics. Both argued that unemployment would stay high — but for very different reasons.
One group — the group that got almost all the attention — declared that the stimulus was much too large, and would lead to disaster..., skyrocketing interest rates and soaring inflation.
The other group, which included yours truly, warned that the plan was much too small given the economic forecasts then available...; an $800 billion program, partly consisting of tax cuts that would have happened anyway, just wasn't up to the task...
Critics in the second camp were particularly worried about what would happen this year, since the stimulus would ... gradually fade out. Last year, many of us were already warning that the economy might stall in the second half of 2010.
So what actually happened? ... Start with interest rates. Those who said the stimulus was too big predicted sharply rising rates. When rates rose in early 2009, The Wall Street Journal ... declared that it was all about fear of deficits, and concluded, "When in doubt, bet on the markets."
But those who said the stimulus was too small argued that temporary deficits weren't a problem as long as the economy remained depressed; we were awash in savings with nowhere to go. Interest rates, we said, would fluctuate with optimism or pessimism about future growth, not with government borrowing.
When in doubt, bet on the markets. The 10-year bond rate was over 3.7 percent when The Journal published that editorial; it's under 2.7 percent now.
What about inflation? Amid the inflation hysteria of early 2009, the inadequate-stimulus critics pointed out that inflation always falls during sustained periods of high unemployment... Sure enough, key measures of inflation have fallen ... to 1 percent or less..., and Japanese-style deflation is looking like a real possibility.
Meanwhile, the timing of recent economic growth strongly supports the notion that stimulus does, indeed, boost the economy: growth accelerated last year, as the stimulus reached its predicted peak impact, but has fallen off — just as some of us feared — as the stimulus has faded. ...
The actual lessons of 2009-2010, then, are that scare stories about stimulus are wrong, and that stimulus works when it is applied. But it wasn't applied on a sufficient scale. And we need another round.
I know that getting that round is unlikely... And if, as expected, the G.O.P. wins big in November, this will be widely regarded as a vindication of the anti-stimulus position. Mr. Obama, we'll be told, moved too far to the left, and his Keynesian economic doctrine was proved wrong.
But politics determines who has the power, not who has the truth. The economic theory behind the Obama stimulus has passed the test of recent events with flying colors; unfortunately, Mr. Obama, for whatever reason — yes, I'm aware that there were political constraints — initially offered a plan that was much too cautious given the scale of the economy's problems.
So, as I said, here's hoping that Mr. Obama goes big next week. If he does, he'll have the facts on his side.

"What Role Did the Fed Play In the Housing Bubble?"

Posted: 03 Sep 2010 12:09 AM PDT

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David Beckworth pushes back against some posts that have appeared here and elsewhere recently (my view is that low interest rates played a role, as did regulatory failures, but these were not the only causes of the crisis):

What Role Did the Fed Play In the Housing Bubble?, by David Beckworth: I really did not want to revisit this question since I have already covered it here many times before. Folks, however, are talking about it again given its coverage at the Fed's Jackson Hole conference. Mark Thoma, for example, has posted several pieces on it in the past few days. Most of this renewed discussion has taken a less critical view of the Fed's role during the housing boom, specifically the role played by the Fed's low interest rate policy. I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor--far from it--but it does appear to be one of the more important ones. Here is my list of reasons why:

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period. It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative. Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential). There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007). Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa. This figure shows that monetary policy was unusually accommodative during this time. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate.

(2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way--via financial innovation, lax governance (both private and public), and misaligned incentives--into the housing market. Housing market activity was further reinforced by "the search for yield" created by the Fed's low interest rates. The low interest rates at the time encouraged investors to take on riskier investments than they otherwise would have. Some of those riskier investments end up being tied to housing. Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.

(3) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom. The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s. Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s. Let me close by directing you to Barry Ritholtz who gives more details on how the Fed's policy distorted incentives in financial markets.

links for 2010-09-02

Posted: 02 Sep 2010 11:01 PM PDT

Measuring the Output Responses to Fiscal Policy

Posted: 02 Sep 2010 05:43 PM PDT

Using a model that allows multipliers to vary over the business cycle, Alan Auerbach and  Yuriy Gorodnichenko find that the fiscal stimulus multiplier is greater than one in recessions:

The return from a fiscal stimulus – the fiscal multiplier – remains one of the most controversial topics in economics today. This column considers the influence of expectations, of variation in recessions and expansions, and of different components of government spending. It finds that the size of the multiplier varies considerably over the business cycle: between 0 and 0.5 in expansions and between 1 and 1.5 in recessions.

"Companies Already Lobbying Fed on Financial Rules"

Posted: 02 Sep 2010 03:20 PM PDT

I don't like to steal other people's catch phrases (just their posts), but, well, quelle surprise!:

Companies Already Lobbying Fed on Financial Rules, by Michael Crittenden, WSJ: U.S. firms eager to shape newly-passed financial laws have wasted no time in lobbying the Federal Reserve and other agencies, according to new details released Thursday by the central bank.
Summaries of 11 meetings involving Fed staff and outside corporations and advocacy groups highlight the high-stakes rulemaking that will occur as U.S. regulators seek to implement the wide-ranging financial overhaul legislation. The meeting log shows representatives from Visa Inc. met with Fed staff just two days after President Barack Obama signed the Dodd-Frank bill into law on July 21.
The topics of conversation at that meeting: debit cards and interchange rates charged to merchants. ... The records show Bank of America Corp., J.P. Morgan Chase & Co. and American Express Co. have all met with Fed staff at least once since mid-July to discuss the interchange issue.
Firms such as Goldman Sachs Group Inc. and Citigroup Inc. have also discussed tough new rules for derivatives with Fed officials, among others. ...
It isn't just financial firms seeking to discuss the potential changes. The Fed on Aug. 20 hosted a discussion with a group representing firms that use derivatives to hedge risks, so-called "end users". Those present included executives from Safeway Inc. and Boeing Co., as well as representatives from the American Petroleum Institute and U.S. Chamber of Commerce. ...
Notice any interest that aren't being represented here?

The phrase "If they're too big to fail, they're too big to exist" has been heard a lot recently, but I'd add that: "If they're too big for Congress and the Fed to say no to, they're too big to exist."

It appears to me that many firms lobbying Congress and the Fed are, in fact, this big, and the question is whether we will do anything about it. I'm not optimistic that those with the ability to change things will do so as it would involve going against the interests of major campaign contributors. I would love to write a post entitled "Quell Surprise" about how wrong I am about this, I just don't think it's going to happen.

"Too Much “Too Big to Fail”?"

Posted: 02 Sep 2010 12:00 PM PDT

Adair Turner, Chairman of Britain's Financial Services Authority, on the too big to fail problem:

Too Much "Too Big to Fail"?, by Adair Turner, Commentary, Project Syndicate: Obviously, the global financial crisis of 2008-2009 was partly one of specific, systemically important banks and other financial institutions such as AIG. In response, there is an intense debate about the problems caused when such institutions are said to be "too big to fail."
Politically, that debate focuses on the costs of bailouts and on tax schemes designed to "get our money back." For economists, the debate focuses on the moral hazard created by ex ante expectations of a bailout, which reduce market discipline on excessive risk-taking – as well as on the unfair advantage that such implicit guarantees give to large players over their small-enough-to-fail competitors.
Numerous policy options to deal with this problem are now being debated. These include higher capital ratios for systemically important banks, stricter supervision, limits on trading activity, pre-designated resolution and recovery plans, and taxes aimed not at "getting our money back," but at internalizing externalities – that is, making those at fault pay the social costs of their behavior – and creating better incentives.
I am convinced that finding answers to the too-big-to-fail problem is necessary... But we must not confuse "necessary" with "sufficient"; there is a danger that an exclusive focus on institutions that are too big to fail could divert us from more fundamental issues.
In the public's eyes, the focus on such institutions appears justified by the huge costs of financial rescue. But when we look back on this crisis in, say, ten years, what may be striking is how small the direct costs of rescue will appear. Many government funding guarantees will turn out to have been costless...
All of this implies that the crucial problem is not the fiscal cost of rescue, but the macroeconomic volatility induced by precarious credit supply – first provided too easily and at too low a price, and then severely restricted. And it is possible – indeed, I suspect likely – that such credit-supply problems would exist even if the too-big-to-fail problem were effectively addressed. ...
There is therefore a danger that excessive focus on "too big to fail" could become a new form of the belief that if only we could identify and correct some crucial market failure, we would, at last, achieve a stable and self-equilibrating system. Many of the problems that led to the crisis – and that could give rise to future crises if left unaddressed – originated elsewhere.

I mostly oppose large banks due to the political power that they have, the market power that comes with size, the unfair advantage the implicit guarantee of a bailout gives large banks over small banks (since the large banks are perceived as less risky due to the guarantee, they can get funds at a lower cost), and the fact that the implicit guarantee induces large banks to take on too much risk. There's also a worry that size and connectedness amplifies the effects of a crisis. However, I don't think systemic risk falls much by simply breaking the banks into smaller pieces, so this isn't a major part of the reason why I think we should limit bank size. There are plenty of examples of crises involving smaller banks in the U.S. and elsewhere, so breaking banks up does not provide an impermeable defense against systemic issues.

The most frustrating part, though, is the implicit assumption in most of these discussions that big banks are inevitable. I have yet to see an analysis that convinces me that large banks provide a boost to efficiency that more than compensates for the problems their size brings about. I realize we are reluctant to impose per se rules against size for good reason, and that the fact that they may not increase efficiency is not sufficient justification to break them up, but the political power, the excessive risk taking, the economic power that come with size, etc. are. Maybe the problems aren't as large or worrisome as I believe, but it would be nice to have the sense that regulators are at least asking these questions. Instead they seem to be resigned to the fact that large banks are inevitable.

I hope to do more with this speech later -- we'll see if time permits that -- but here's Ben Bernanke talking about this issue earlier today: Notice the assumption in the background that large banks will exist:

"Too Big to Fail"
Many of the vulnerabilities that amplified the crisis are linked with the problem of so-called too-big-to-fail firms. A too-big-to-fail firm is one whose size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences. Governments provide support to too-big-to-fail firms in a crisis not out of favoritism or particular concern for the management, owners, or creditors of the firm, but because they recognize that the consequences for the broader economy of allowing a disorderly failure greatly outweigh the costs of avoiding the failure in some way. ...
In the midst of the crisis, providing support to a too-big-to-fail firm usually represents the best of bad alternatives; without such support there could be substantial damage to the economy. However, the existence of too-big-to-fail firms creates several problems in the long run.
First, too-big-to-fail generates a severe moral hazard. If creditors believe that an institution will not be allowed to fail, they will not demand as much compensation for risks as they otherwise would, thus weakening market discipline; nor will they invest as many resources in monitoring the firm's risk-taking. As a result, too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if their bets go bad. Where they have the necessary authority, regulators will try to limit that risk-taking, but without the help of market discipline they will find it difficult to do so... There is little doubt that excessive risk-taking by too-big-to-fail firms significantly contributed to the crisis...
A second cost of too-big-to-fail is that it creates an uneven playing field between big and small firms. This unfair competition, together with the incentive to grow that too-big-to-fail provides, increases risk and artificially raises the market share of too-big-to-fail firms, to the detriment of economic efficiency as well as financial stability.
Third, as we saw in 2008 and 2009, too-big-to-fail firms can themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools. ... The failures of smaller, less interconnected firms, though certainly of significant concern, have not had substantial effects on the stability of the financial system as a whole.
If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved. Simple declarations that the government will not assist firms in the future, or restrictions that make providing assistance more difficult, will not be credible on their own. Few governments will accept devastating economic costs if a rescue can be conducted at a lesser cost; even if one Administration refrained from rescuing a large, complex firm, market participants would believe that others might not refrain in the future. Thus, a promise not to intervene in and of itself will not solve the problem.
The new financial reform law and current negotiations on new Basel capital and liquidity regulations have together set into motion a three-part strategy to address too-big-to-fail. First, the propensity for excessive risk-taking by large, complex, interconnected firms must be greatly reduced. Among the tools that will be used to achieve this goal are more-rigorous capital and liquidity requirements, including higher standards for systemically critical firms; tougher regulation and supervision of the largest firms, including restrictions on activities and on the structure of compensation packages; and measures to increase transparency and market discipline. Oversight of the largest firms must take into account not only their own safety and soundness, but also the systemic risks they pose.
Second, as I already discussed, a resolution regime is being implemented that allows the government to resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation while imposing losses on creditors and shareholders. Ensuring that that new regime is workable and credible will be a critical challenge for regulators.

Finally, the more resilient the financial system, the less the cost of a failure of a large firm, and thus the less incentive the government has to prevent that failure. Examples of policies to increase resiliency include the requirements in the recent bill to force more derivatives settlement into clearinghouses and to strengthen the prudential oversight of key financial market utilities such as clearinghouses and exchanges. ... In addition, prudential regulators should take actions to reduce systemic risks. Examples include requiring firms to have less-complex corporate structures that make effective resolution of a failing firm easier, and requiring clearing and settlement procedures that reduce vulnerable interconnections among firms.

I asked Bernanke if large banks are necessary. Here's what he said:

B. Mark Thoma, University of Oregon and blogger: ...The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk?
...Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as "too big to fail." Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy.
Some observers have suggested that existing large firms should be split up into smaller, not-too big- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.

So the only benefit of size he lists is "large firms may be better able to meet the needs of global customers." I can't say I find this argument very convincing.

In addition, I am not at all convinced that the procedures to "resolve a distressed, systemically important financial firm in a fashion that avoids disorderly liquidation" can be made credible. The first time regulators start to use this in a big crisis and markets begin to tank over worries about whether it will work or not, will the administration in power be willing to risk creating a big meltdown? Or will they resort to procedures used in the past that were problematic for all the reasons cited above, but do seem to prevent the most catastrophic outcome? 

Until someone convinces me that there are significant advantages to having mega-banks that cannot be duplicated with banks that are not, by themselves, too big to fail, I will continue to call for them to be broken up. Again, I don't think it makes a big difference in terms of systemic risk, though if Bernanke's right it will reduce the magnitude of the crisis, and that reduction in risk is important to recognize. But I do think breaking them up could make a big difference in terms of addressing all the other problems that size (and connectedness) brings about.

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