I think it is probably a little bit of both, discounting the supply of new debt, but I detect...there is a pick up in confidence about the future

TO BE NOTED: From Reuters:

"Fed's Fisher says recovery will be very slow

Thu May 28, 2009 7:56pm EDT

By Alister Bull

WASHINGTON (Reuters) - The U.S. recession is fading but the economy will not recover in a "meaningful" way before the end of this year and deflation remains a risk in this climate, a top Federal Reserve official said on Thursday.

Dallas Federal Reserve Bank President Richard Fisher also said that official foreign holdings of U.S. government bonds had grown and appetite to hold the country's assets remained intact, despite expected record U.S. government deficits.

"There continues to be strong demand for longer duration Treasuries," Fisher told the Washington Association of Money Managers in a speech. A steep sell-off in the U.S. government bond market on Wednesday was blamed in some quarters by a decline in foreign demand for U.S. assets.

Fisher also said he had not detected any evidence that the Chinese wanted to significantly alter their U.S. Treasury holdings during a recent trip he had made to Beijing.

"They have no desire to inflict harm on the financial markets of the United States because they would inflict harm on themselves," he said.

The Fed has promised to buy $300 billion of longer-dated U.S. Treasuries and $1.45 trillion of agency mortgage debt and discussed increasing this program at its last policy meeting on April 28-29.

Fisher declined to say if he favored ramping up the purchases. The gap between 2- and 10-year government bond yields widened to a record 2.75 percent on Wednesday and some economists said this yield curve steepening might dampen the economic recovery and trigger more Fed asset buying.

But Fisher said it was not clear if the curve steepened on worries over upcoming Treasury supply to finance record U.S. fiscal deficits, or because of a brighter economic outlook.

"I think it is probably a little bit of both, discounting the supply of new debt, but I detect...there is a pick up in confidence about the future," Fisher told reporters after the speech. The distinction matters.

Economists say the Fed is much more likely to ramp up the asset purchasing program if it thought the yield curve had steepened due to an increase in the risk premium being charged by investors to buy U.S. assets, because this would make credit more expensive for businesses and households.

But if the yield curve steepened because investors thought the economic recovery was on track, and the Fed would at some point begin to raise its benchmark overnight funds rate from current levels of almost zero, this would be a healthy development that would not warrant more Fed asset buying.

Fisher, who is not a voting member of the Fed's policy-setting committee this year, said that inflation would stay "meek" amid a tepid economic recovery.

However, he also emphasized that the Fed was well aware its aggressive expansion of the central bank's balance sheet through the purchase of assets like Treasuries and mortgage backed securities had long-term inflation implications, and it was focused on getting its exit strategy right.

"Nobody I know on the (Fed's policy) committee wants to maintain our current posture for any longer and to any greater degree than is minimally necessary to restore the efficacy of the credit markets and buttress economic recovery without inflationary consequences," he said in the speech.

"Indeed, as I speak, we are studying ways to unwind our balance sheet in a timely way," Fisher added.

This did not sound like an immediate concern for Fisher, who said he expected the economy to find its footing, but thought it would not post a vigorous rebound, or even a more modest 'U' shaped recovery.

"I would be delighted, but surprised, if meaningful sustained growth gets under way before the end of the year," Fisher said.

Fisher also acknowledged criticism that some of the Fed's robust actions to shelter the U.S. economy had veered onto turf that could be called fiscal policy. This has raised questions of Fed independence, as well as whether U.S. lawmakers might want more say in the running of the central bank.

"There have been suggestions that Congress should be involved in the selection of Federal Reserve Bank presidents," Fisher said, referring to himself and the 11 other heads of the dozen regional Federal Reserve banks.

The U.S. president appoints the seven members of the Fed's Board of Governors in Washington, subject to the approval of the Senate, but the 12 regional Fed chiefs are selected by their local business communities, and approved by the Board.

"I trust that Congress will resist this initiative and not upset the careful federation that has for so long balanced the interests of Main Street with those of Washington, just as we at the Federal Reserve must resist the urgings of some to accommodate the short-term financing needs of the Treasury," he said.

(Reporting by Alister Bull; Editing by Diane Craft)"

"From the Dallas Fed:

Richard W. Fisher

Remarks before the Washington Association of Money Managers
Washington, D.C.
May 28, 2009

I want to thank the Washington Association of Money Managers for having me here this evening and Fred Boos for that kind introduction. Thank you also for allowing two of my best friends, Evan Thomas and the Reverend Derrick Harkins, to join me tonight.

Neither Evan nor Derrick is a money manager. Evan is editor-at-large of Newsweek and is one of the great American nonfiction writers. He wrote The Wise Men and one of the great biographies of Bobby Kennedy. Yet, as an Annapolis man, I love him best for his work on John Paul Jones—the father of the American Navy. But that is not why he is here tonight. We are "cousins" through marriage: Both he and my wife, Nancy, descend from the family tree of Norman Thomas, a Presbyterian minister who ran for the presidency six times as a socialist and pacifist. Evan is here because in a most nonpacifist manner, he plans to dispatch with me on the golf course this weekend and wants to make amends ex ante.

I shall appeal to Reverend Harkins for some ex ante divine intervention in Saturday's match! Derrick leads the Nineteenth Street Baptist Church and has been my pastor for many years, going back to when he led the New Hope Baptist Church in Dallas. He is one of our country's most eloquent preachers, and I am honored that he is here.

With such a distinguished man of the cloth present among this group of people dedicated to the pursuit of mammon, I thought I would give a little sermonette this evening.

Here are four quotes from financial scripture:

The first is from Charles Mackay's Memoirs of Extraordinary Popular Delusions, written in 1841:

"Every age has its peculiar folly—some scheme, project or phantasy [sic] into which it plunges, spurred on either by the love of gain, the necessity of excitement, or the mere force of imitation."

"Men, it has been well said, think in herds; it will be seen that they go mad in herds...."

The second is taken from the father of central banking—Walter Bagehot—from his essay "Edward Gibbon," in the 1856 edition of National Review:

"[A]t particular times … people have a great deal of … money…. At intervals … the money of these people … is particularly large and craving: it seeks for some one to devour it, and there is [a] 'plethora'; it finds some one, and there is 'speculation'; it is devoured, and there is 'panic.'"

From Liaquat Ahamed, who has written a superbly entertaining book, published earlier this year, titled Lords of Finance: The Bankers Who Broke the World:

"I maintain that the Great Depression was not some act of God or the result of some deep-rooted contradictions of capitalism but the direct result of a series of misjudgments by economic policymakers.…"

Finally, Paul Volcker as quoted in Bill Neikirk's Volcker: Portrait of the Money Man in 1987:

"The Federal Reserve has no way of offsetting the financial market pressure associated with excessive deficits.… Pushing more money into the system to finance the Treasury would only serve to heighten fears about inflation and the future course of interest rates."

Tonight, I will reference each of those passages as we explore where we have been, where we are today and the fiscal predicament that awaits us further down the road. But first, some context.

Reverend Harkins will no doubt have heard the story of the humble Presbyterian pastor who visited a shelter where he found a man who looked particularly downtrodden. This generous pastor took pity upon the man. He took him to a barber for a shave and a haircut and to a store for a pair of shoes, a shirt, a tie and a new suit. The pastor then dropped the man back at the shelter, handed him $20 and told him, "Son, you have been saved. My church is just one block away from here. I want you to come to my church on Sunday and praise the Lord."

Sunday came but the man did not. So immediately after the service, the pastor went to the shelter. There was the man, sitting in a rocking chair, all dressed up and beautifully groomed, reading a newspaper. "Son, I had asked you to come to my church this morning to give testimony to having been saved. Where were you?" asked the pastor.

"Pastor," the man replied, "I surely did go to church. I woke up this morning, shaved my whiskers, combed my hair, put on this beautiful shirt and tie you bought me and dressed in this new suit. I put on these fancy new shoes. When I looked in the mirror, I felt like a millionaire. So I used the $20 to take a cab to the Episcopal church."

I certainly don't need to tell a room full of Washington money managers what got the nation into its current economic situation. A sudden new set of circumstances, easy money seemingly heaven-sent and the short-sighted suspension of time-tested, prudent financial practice led us on the road, not to salvation, but to economic perdition.

The new set of circumstances included the economic and financial windfalls that came from at least two major structural changes. The first was the end of the Cold War and the commercial reorientation of China, Vietnam, India and Eastern Europe, which unleashed enormous new capacity for the increased production of goods and services, held down costs and restructured the global economic map. The second was the explosion of computational power and communication ease that came from technological advancement and the Internet, facilitating globalization and leapfrogging frontiers that formerly separated the economic landscape. The world was our oyster. It simultaneously gave us new consumers and suppliers. It provided new sources of funds as well as new places to invest.

Easy money may well have been encouraged by central banks that held interest rates too low for too long. But it was exacerbated by lenders, investors and consumers who—keen on enhancing returns that seemed pedestrian with a flat yield curve anchored by low, risk-free rates—"craved" and "devoured" new risk instruments, to paraphrase Bagehot. As a result, they came up with new "schemes" and "projects" and "phantasies" made more enticing by expanded markets and financial innovation.

Short-sightedness was manifest in the abandonment of prudential practices. For the banker and lender, the time-tested principle of "know your customer" took a back seat to the mad rush to package and sell exposure to others. For the consumer, "living within your means" became a less compelling discipline in a world where a house was not just a home but a means to financial gain. For the investor, prudence took on another dimension with the presumed ability to mathematize judgment and hedge away the risk of default.

And yet, while the world had indeed changed, the behavioral pathology documented by Mackay and Bagehot in the 19th century—a pathology based on their studies of countless debacles through history—prevailed. A "plethora" of commercial and financial opportunity begat "speculative" excess that inevitably begat a "panic." The thundering "herd," spurred on by "the love of gain, the necessity of excitement or mere force of imitation" and "mad" with irrational exuberance for the upside, suddenly realized in 2008 it had "devoured" more risk than it could stomach and panicked. The financial system seized up and the economy descended into recession.

Who is to blame? Well, if you had been listening to the radio on Feb. 26, 1933, you would know the answer. You would have heard a crazed Father Charles Coughlin, pastor of the Shrine of the Little Flower in Royal Oak, Mich., rail against "the Morgans, the Kuhn-Loebs, the Rothschilds, the Dillon-Reads, the Federal Reserve banksters, the Mitchells[1] and the rest of the undeserving group, who without … the blood of patriotism … flowing in their veins have shackled the lives of men and of nations with the ponderous links of their golden chain."

Advance the tape 76 years. If you substitute Goldman Sachs for the Rothschilds, Lehman Brothers for Kuhn-Loeb, AIG for Dillon Read, Ken Lewis or John Thain for "Sunshine Charlie" Mitchell and keep the text about Federal Reserve "banksters," you will have captured the liturgy of invective heard from Father Coughlin's contemporary secular cousins. Nothing is new under the sun; old prejudices and conspiracy theories never die.[2] On airwaves and in the blogosphere, on editorial pages and even in the halls of Congress and foreign parliaments, critics are casting about for whom to blame for "shackl(ing) the lives of men" and women from Bethesda to Beijing with the "ponderous links" that took us to the very edge of the abyss of global economic collapse.

I will let you draw your own conclusions about who is to blame. In my time at the Federal Reserve, starting in 2005 and working predominantly under the chairmanship of Ben Bernanke, my colleagues and I have been focused primarily on finding a way to undo past errors and mend the system.

I believe that the initiatives taken by the Federal Reserve prevented us from falling into the chasm of an economic depression. Beginning in August of 2007, we confronted a total breakdown of the financial system. Having announced our extension of term lending to banks in December, in rapid order, we then set in motion a series of steps to provide liquidity, strengthen the security of certain banks, become the equivalent of market maker for key financial instruments such as commercial paper and certain asset-backed securities and, in ways appropriate to the times, deliver on our mandate as lender of last resort.

You are all familiar with the efforts taken by the Federal Reserve to these ends. I won't review them program by program this evening. I think it fair to say that with these actions the Federal Reserve has done everything in its power to avoid making the modern equivalent of the "misjudgments" that Liaquat Ahamed argues were made by our predecessors in the 1930s (and, I should add parenthetically, that everyone and their brother feel Japan made in the 1990s).

There is evidence that our actions have succeeded in pulling the financial markets and the economy from the edge of the abyss. There are, as many have noted, some "green shoots" beginning to sprout that will help end the contraction in output and set the stage for a recovery. This is not to be Pollyannaish or imply that these sprouts are spreading like kudzu. But the knock-on effect of the Fed's direct efforts does seem to have reignited animal spirits in markets that had been frozen. The commercial paper market has been revived. Mortgage rates have declined significantly. Issuance of corporate bonds has become robust. The premium over Treasuries that investment-grade corporations pay to borrow in the open market has fallen by more than 35 percent since peaking last December. The same can be said of higher risk bonds as well as jumbo mortgages—all markets considered to be at the far end of the risk spectrum. This round-trip back from last fall's unprecedented flight to quality is also reflected in the stock market, as equity markets have coursed upward and volatility has diminished.

While it takes some time for these improved financial conditions to start helping the broad economy, I am pleased to see a reaction on Main Street: The most recent reports indicate that purchasing managers see an abatement in the pace of decline in new orders; manufacturers surveyed by the Kansas City, Philadelphia, Richmond and Dallas Feds, to varying degrees, report a moderation in their previous rates of decline in activity;[3] retail sales are no longer plunging; and, as all of you heard from the Conference Board on Tuesday, consumers' assessment of the economy over the next six months—driven primarily by slowing job losses—appears to be less pessimistic.

These are encouraging signs. But, to be sure, we are not out of the woods. We have miles to go before we sleep.

Compared with the fourth quarter of last year, first quarter results for the nation's largest banks are encouraging, yet obvious challenges remain. Confidence among business women and men—the creators of lasting, productive jobs and prosperity—has shown signs of revival but remains elusive. Consumers at home remain cautious, for fear of losing their homes or their jobs. The markets we sell into abroad—Mexico and Europe, for example—remain strikingly weak, while others such as China are perhaps more robust but are insufficiently sized to fill the hole left by consumers at home and in our larger export markets.[4]

Under these conditions, I have been forecasting a slow recovery. Not a V-shaped snapback—nor even a U-shaped one—but a very slow slog as we find a more sensible and sustainable mix between consumption, savings and investment. It is worth recalling that employment did not reach its nadir until 21 months after the end of the 2001 recession, though headwinds then were not nearly as severe as those we face today.

You know the numbers that have been reported for the nation for the first quarter: Even after upcoming revisions, I venture we will find we contracted at somewhere between an annualized 5 and 6 percent. The pace of decline will moderate in the current quarter, and then we are likely to bounce along the bottom for a while. I would be delighted, but surprised, if meaningful sustained growth gets under way before the end of the year. Regardless, increases in unemployment, while mitigated by the expansion of government (particularly the need for census takers), will likely take us to a 10 percent jobless rate before we reverse course. And global excess capacity is likely to remain excessive for some time to come.

As to price stability—the touchstone of central banking—given the vast amount of slack worldwide, the near-term outlook for inflation is meek. Indeed, the recent pressures have been to the deflationary side. As evidenced in the Dallas Fed's most recent manufacturing survey, firms receiving lower prices for their goods outnumbered those receiving higher prices 11-to-1, although firms do expect deflationary pressures to begin subsiding.[5]

Neither deflation nor inflation engenders confidence. Both distort the decisionmaking of households as well as businesses. Both inhibit sustainable employment growth. If you want to know the outlook for inflation over the next quarter or next year, look at current domestic and global slack: It is doubtful that inflation will raise its ugly head until employment and capacity utilization tighten. Looking further out, however, Milton Friedman—who, in keeping with the theme of this evening, I suppose I could safely refer to as the Moses of monetary policy—reminds us that inflation, defined as "a steady and sustained rise in prices," is "always and everywhere a monetary phenomenon."[6] Bearing this in mind, we must be careful with the deployment of our monetary initiatives.

As the nation's central bank, the Fed performs two major roles, in addition to its regulatory duties. One is the standard conduct of monetary policy—a blunt instrument of adjusting interest rates and the money supply to achieve our long-term objectives of price stability and sustainable employment.

The Fed's other role is, as mentioned, to act as a lender of last resort( NB DON )—to stabilize financial markets when confidence breaks down and markets become unduly segmented and dysfunctional. This entails targeted injections of liquidity to keep markets functioning under dire circumstances. Reflecting the larger role of securities markets in funding loans, the Federal Reserve has extended its lender of last resort role beyond banks. Since the fall of 2007, the Federal Reserve has been aggressive in putting programs in place to revive the functioning of key credit markets and pull the economy away from the brink. I point to the term auction (TAF) and commercial paper (CPFF) facilities as examples of initiatives that have worked as planned by the FOMC and are now shrinking in size. These actions are not permanent injections of money that may later fuel inflation, but rather are temporary injections of liquidity to stabilize malfunctioning markets. As such, they are intended to promote financial stability, sustainable growth and price stability.

Congress, spurred on by the new president, has been aggressive with fiscal policy. The good news is that if fiscal policy has been properly designed—and time will tell if it has been—it should propel the economy farther away from the edge and put it on its way to a new cycle of economic growth, somewhat tentatively at first but hopefully gathering momentum as time passes.

Unfortunately, that momentum faces a real, long-term threat: storm clouds on the horizon in the form of daunting fiscal imbalances.

That deficits will be high over the next few years seems clear, with a $1.8 trillion deficit expected this year and $3.8 trillion in new debt issuance now forecast over the next five years. Perhaps more important, annual deficits exceeding half a trillion dollars are projected for at least 10 years into the future, emphasizing that we as a nation will continue to spend considerably more than we take in long after the current economic crisis.

The country's major newspapers recently reported with great urgency the administration's finding that Social Security would begin spending more than it takes in by 2016—seven short years from now. Left unreported was the fact that the discounted present value of entitlement debt, over the infinite horizon, reached $104 trillion.[7] This is almost eight times the annual gross domestic product of the United States—and almost 20 times the size of the debt our government is expected to accumulate between 2009 and 2014.

Most of this entitlement shortfall comes from Medicare rather than Social Security. As you may know, Medicare has three main components: Part A for hospital stays, Part B for doctor visits and Part D for prescription drugs. The fiscal shortfall for Part A alone is $36.4 trillion—about one third of all entitlement debt. Part B's shortfall is just a tad larger, clocking in at $37 trillion. Part D—the latest addition to the Medicare program—registers a shortfall of $15.5 trillion. And Social Security, the program about which various reforms have been so frequently mooted in recent years, registers a deficit of $15.1 trillion—only one seventh of the total unfunded liability from entitlement programs.

This is the fiscal predicament to which I alluded earlier—a looming budgetary threat to our long-term economic prosperity. And while the announcement that the Social Security trust fund will begin its decline one year earlier is an important fiscal event, the swelling of overall entitlement debt to more than one hundred trillion dollars has far more serious implications for economic growth—implications we are poorly positioned to address given the budget deficits we face today.

Our successor generations are coming to grips with this daunting reality. Faced with the prospect of a government that they believe may be unable to deliver on its promise of long-term fiscal balance—particularly with regard to entitlement programs—these individuals might logically begin to alter their consumption patterns, spending less today to save more for tomorrow. There is nothing wrong with increasing savings. But, in an economy driven by consumption, this intertemporal hedging may dampen the pace of future economic growth.

Of course, any student of history knows that throughout time, governments unwilling to face the music and fund their liabilities have turned to monetary authorities to print their way out of their predicament. We all know by heart the pathologies that afflicted Weimar Germany, Argentina and other countries. And we have daily reminders from bond vigilantes like Bill Gross about the prospect of losing our AAA rating. This cannot be allowed to happen in America. Which is why I am pleased to see that the new administration has embraced what was hitherto perceived as the third rail of American politics and brought the issue of unfunded entitlement liabilities to the fore. For the sake of our grandchildren, I hope that the administration and the Congress will take this vexing beast of a problem by the horns and tame it.

Against that background, it is important that monetary policymakers be especially sensitive to concerns voiced about the dramatic expansion of the Fed's balance sheet in an era of high deficits. I return to the Book of Ahamed and the Book of Volcker. Ahamed speaks of the miscalculations of policymakers. Volcker warns that the Fed cannot monetize deficits without heightening fears of inflation and negatively impacting the future course of interest rates.

Those of us responsible for developing monetary policy must constantly bear both observations in mind. We have been very careful to calibrate our actions so as to accommodate the needs of credit markets and the economy—not political imperatives. We are well aware that some of our balance sheet additions, designed to pull markets and the economy from the edge, have raised a few eyebrows (like the $1.25 trillion in mortgage-backed securities we have pledged to purchase if necessary—although it has unquestionably driven mortgage rates to historic lows). And while it is not unusual for the System Open Market Account to buy Treasuries along the yield curve, the Federal Open Market Committee's (FOMC) decision to purchase $300 billion in U.S. Treasuries—a decision made to improve the tone in private credit markets—has been viewed by some as skating a little too close to the edge of political accommodation.

I can tell you that the FOMC is well aware of the doubts being voiced about its intentions. I can also tell you that nobody I know on the committee wants to maintain our current posture for any longer and to any greater degree than is minimally necessary to restore the efficacy of the credit markets and buttress economic recovery without inflationary consequences. Indeed, as I speak, we are studying ways to unwind our balance sheet in a timely way.

In the meantime, looming before us is the prospect of a heavy calendar of debt issuance by the Treasury. Between now and the end of the current fiscal year in October, the Treasury will issue just over $1 trillion in net new debt, with at least that much to follow in fiscal 2010. As the Book of Volcker warns, the Federal Open Market Committee can ill afford to be perceived as monetizing debt, lest we come to be viewed as an agent of, rather than an independent guardian against, future inflation and drive real interest rates higher.

You may wish to note that, press and analysts' reports to the contrary, a keen student of the H.4.1 and the Foreign and International Monetary Authority (FIMA) custody holdings reports of the Fed will detect that foreign official holdings of U.S. Treasuries and agencies have been growing at a robust pace, not shrinking. And from what I can detect from the activity of so-called indirect bidders in Treasury auctions—indirect bidders submit competitive bids through others rather than directly; central banks are among those who commonly bid indirectly—there continues to be strong demand for longer duration Treasuries—again, contrary to rumors and press reports. Thus, to date, our actions have not given rise to concern that we will violate Paul's Dictum.

This is important, for there are concerns in some quarters that the Federal Reserve will be politicized. For example, there have been suggestions that Congress should be involved in the selection of Federal Reserve Bank presidents, who, unlike the seven members of the Board of Governors, are not appointed by the president nor confirmed by the Senate. I trust that Congress will resist this initiative and not upset the careful federation that has for so long balanced the interests of Main Street with those of Washington, just as we at the Federal Reserve must resist the urgings of some to accommodate the short-term financing needs of the Treasury.

Your central bank has worked hard to pull the economy back from the abyss. To be sure, the FOMC has taken risks to do so. We have no doubt erred on occasion, but for the most part, I think we have gotten it right—primarily because each of us has an abiding faith in the time-tested virtues of conducting responsible monetary policy. We will work hard to remain virtuous, always bearing in mind that our job is to conduct monetary policy with the simple, yet profound, mission of underpinning sustainable economic growth without sacrificing price stability.

So much for the Gospel according to the Dallas Fed! Thank you for letting me speak to you tonight. I will now do my utmost to avoid answering any questions you have.

About the Author

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas.

Notes

The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System.

1. "Sunshine Charlie" Mitchell was the head of National City Bank, the forerunner to Citigroup.
2. For instance, in a current best-selling book in China, Currency Wars, it is asserted that the major central banks—including the Federal Reserve and the Bank of England—are controlled by a small group of private bankers. These bankers make their profits through the control of the nation's money supply.
3. Texas produces more than 8 percent of the total manufactured goods in the United States, ranking second behind California in factory production.
4. Through April, China's overall imports from the rest of the world dropped 23 percent from last year's level to $78.8 billion. The U.S. is presently exporting $5.6 billion a month in goods to China.
5. "Texas Manufacturing Remains Weak But Outlook Continues to Improve," Federal Reserve Bank of Dallas, press release, May 26, 2009.
6. The quotes are taken from Milton Friedman's "Inflation: Causes and Consequences" in his book Dollars and Deficits, published by Friedman in 1968. Friedman clearly recognized that any of a wide variety of shocks can give rise to short-term changes in the price level. Too often, those who quote his inflation dictum fail to distinguish between temporary and sustained price movements.
7. Estimates for Social Security are compiled from the official 2009 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds. The $15.1 trillion figure presented here is the amount by which promised benefits exceed expected revenues, primarily from payroll taxes, over the infinite horizon using a long-run discount rate of 2.9 percent.

   Estimates for Medicare are compiled from the official 2009 Annual Report of the Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds. The $88.9 trillion cumulative figure presented here is the amount by which promised benefits for Medicare Parts A, B and D exceed expected revenues over the infinite horizon using a long-run discount rate of 2.9 percent.

   Neither estimate incorporates the value of program trust funds, currently estimated at $2.4 trillion for Social Security and $0.3 trillion for Medicare. Because spending down these trust funds will require the use of general revenue, some budget analysts include them when calculating unfunded liabilities. If this is done, then the total figure would rise from $104 trillion to $106.7 trillion.

   These figures also do not include current or projected future nonentitlement debt, including the $10.7 trillion national debt as of the end of 2008, the $1.8 trillion deficit for this year, the $3.8 trillion in projected debt between 2010 and 2014, and any future debt that might be compiled after 2014. If projected debt between now and 2014 were added, and no further nonentitlement debt were accumulated in the future, then the total figure would rise from $106.7 trillion to $123.0 trillion."

The conclusion that I draw from this is that we should try a combination of all checklist measures

From the Economist's View:

"No Time to Dither"

Brad DeLong:

There is no time to dither in a meltdown, by J. Bradford DeLong, Project Syndicate: Are the world's governments capable of keeping the world economy out of a deep and long depression? Three months ago, I would have said yes, without question. Now, I am not so certain.

The problem is not that governments are unsure about what to do. The standard checklist of what to do in a financial crisis ... has been gradually worked out over two centuries...

The problem comes when expansionary monetary policy ... and central-bank guarantees of orderly markets prove insufficient. Economists disagree about when ... governments should move beyond these first two items on the checklist.

Should governments try to increase monetary velocity by selling bonds, thereby boosting short-term interest rates? Should they employ unemployed workers directly, or indirectly, by bringing forward expenditures or expanding the scale of government programs? Should they explicitly guarantee large financial institutions' liabilities and/or classes of assets?

Should they buy up assets at what they believe is a discount from their long-run values, or buy up assets that private investors are unwilling to trade, even at a premium above their likely long-run values? Should governments recapitalize or nationalize banks? Should they keep printing money even after exhausting their ability to inject extra liquidity into the economy via conventional open-market operations, which is now the case in the United States and elsewhere?

Three months ago, I said that ... trying a combination of these items - even a confused and haphazard combination - was better than doing nothing. All five of the world's major economies implemented their own confused and haphazard combinations of monetary, fiscal, and banking stimulus policies during the Great Depression, and the sooner they did - the sooner each began its own New Deal - the better. ...

The conclusion that I draw from this is that we should try a combination of all checklist measures - quantitative monetary easing; bank guarantees, purchases, recapitalizations, and nationalizations; direct fiscal spending and debt issues - while ensuring that we can do so fast enough and on a large enough scale to do the job.

Yet I am told that the chances of getting more money in the US for an extra round of fiscal stimulus this year is zero, as is the chance of getting more money this year to intervene in the banking system on an even larger scale than America's Troubled Asset Relief Program (TARP).

There is an 80 percent chance that waiting until 2010 and seeing what policies look appropriate then would not be disastrous. But that means that there is a 20 percent chance that it would be.

Posted by Mark Thoma"

Me:

"by the Victorian-era editor of The Economist, Walter Bagehot; and by the economists Irving Fisher, John Maynard Keynes, Milton Friedman, among many others.

The key problem in times like these is that investor demand for safe, secure, and liquid assets - and thus their value - is too high, while demand for assets that underpin and finance the economy's productive capital is too low. The obvious solution is for governments to create more cash to satisfy the demand for safe, secure, liquid assets."

"The conclusion that I draw from this is that we should try a combination of all checklist measures - quantitative monetary easing; bank guarantees, purchases, recapitalizations, and nationalizations; direct fiscal spending and debt issues - while ensuring that we can do so fast enough and on a large enough scale to do the job."

This is probably the best post about who to study and what to do that I've read since this crisis began. To the extent that we've actually been following this checklist in a series of lurches, we've managed to stay out of a Debt-Deflationary Spiral. However, we're not out of the woods yet.

Posted by: Don the libertarian Democrat

Seeing the dreadful state in which the public were, we rendered every assistance in our power..

From Brad DeLong:

"The Panic of 1825

The Bank of England's policy. From Walter Bagehot (1873), Lombard Street, p. 73:

Jeremiah Harman: We lent [cash] by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.."

Me:

I am still a follower of Bagehot:

"Bagehot's Principles"( MY VERSION ):

1) If the Fed exists, it will be the Lender Of Last resort, and that has to be taken in to account in real world Political Economy. It should lend freely in a crisis to solvent banks.

2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.

3) The terms must be onerous.( THIS IS WHY WE MUST NATIONALIZE SOME BANKS. IT'S THE ONLY THING THAT THEY REALLY FEAR IN THE US. THEY'LL HOARD MONEY TO AVOID NATIONALIZATION. NEED I SAY MORE. )
4) The LOLR should get something valuable in return.

Here are a few others:

5) The taxpayer's interests should come first.

6) Moral Hazard needs to be constantly applied by quickly liquidating problem banks in normal times.

7) Any entity receiving a guarantee will have to be supervised or regulated effectively, and violations should be quickly and severely punished.

8) There is no doubt that any entity receiving a LOLR guarantee will need to be more conservative in its practices in order to limit the liability of the taxpayer.

9) There should be a class of financial concerns that can act more freely, but they should not receive LOLR guarantees. They will be strictly supervised or regulated though, and are subject to laws against fraud, etc."

Lombard Street can be read here:

http://bagehot.classicauthors.net/LOMBARDSTREET/LOMBARDSTREET9.html

"That's just the sort of thing that troubled Bagehot almost a century and a half ago"

I've wanted to do this post for some time, and today seemed a good time. First, George Selgin in the Pittsburgh Tribune-Review:

"Bagehot was right

By George Selgin

Sunday, October 19, 2008

Who can forget the end of "Planet of the Apes" when Charlton Heston, kneeling before the half-buried remains of the Statue of Liberty, slams his fists into the sand and cries, "You maniacs! You blew it up! Ah, damn you ... damn you all to hell!"( I CAN'T )

Now imagine the same scene, but with a half-buried Morgan Stanley building standing in for Miss Liberty and a time-traveling Walter Bagehot playing the lead and you've got the perfect Hollywood dramatization of the real-life tragedy that, with luck, is having its denouement on Wall Street.

Bagehot? The great Victorian man of letters, best remembered today as the second and most celebrated editor of the British magazine The Economist, wasn't exactly a hunk. But he certainly could have delivered those futile last lines with real conviction, for he was among the first to recognize the vast destructive potential of that newfangled weapon of Victorian finance: the modern central bank. ( TRUE )

Bagehot first alerted readers to this potential and offered his suggestions for containing it in an article that appeared in The Economist after the great panic and credit crisis of 1866. That panic witnessed the spectacular collapse of Overend, Gurney & Co., which had long been Great Britain's premier investment house.

Bagehot understood that, during such panics, the Bank of England alone commanded the confidence needed to serve other financial firms as a "lender of last resort."( TRUE ) But as Bagehot put it later in his book "Lombard Street: A Description of the Money Market" (1873), the bank's "faltering way" -- its arbitrary and inconsistent use of its unique lending powers -- tended only to make things worse.( TRUE. WE'VE SEEN THE RESULTS OURSELVES )

"The public," Bagehot wrote, "is never sure what policy will be adopted at the most important moment: it is not sure what amount of advance will be made. ... And until we have on this point a clear understanding with the Bank of England, both our ability to avoid crises and our terror at crises will always be greater than they would otherwise be."( TRUE. THIS IS WHAT HAS BEEN HAPPENING, WHICH I CALL AN OVERREACTION OF FEAR AND AVERSION TO RISK BEYOND THE FUNDAMENTALS )

The ultimate source of trouble, Bagehot believed, was the very existence of the Bank of England and the special privileges it enjoyed. But because nothing save a revolution seemed likely to do away with the "Old Lady of Threadneedle Street," as it was called, Bagehot's preferred, practical solution was for the bank expressly to commit itself to lending freely during crises, though on good collateral only, and at "penalty" rates. ( ALL STILL TRUE )

The restrictive provisions were supposed to limit aid to otherwise solvent firms panic had rendered illiquid. ( THAT'S IT )

Bagehot's recommendation has since become a sort of master precept of central banking -- albeit one that's mainly honored in the breach by central bankers. ( TRY NEVER )

To be fair to today's central bankers, there's never been much agreement on how to apply Bagehot's rule in practice. Just what do "good collateral" and "penalty rates" mean in times like these? ( WE'D BETTER FIGURE IT OUT )

While no one might precisely be able to define good collateral -- and one can debate whether the rate at which banks offer to lend unsecured funds to other banks, known as the London Interbank Offered Rate, or LIBOR rate, plus 8 percent constitutes a "penalty" rate -- who even pretends that recent central bank lending has been based on good collateral? ( NOT ME. EXHIBIT ONE: TARP )

But rescuing insolvent firms is the least of it. The real damage comes from the Treasury's utter lack of any consistent last-resort lending rule. The recently enacted financial institutions bailout bill does little to clarify this. ( TRUE )

That's just the sort of thing that troubled Bagehot almost a century and a half ago, when central banks were still in their swaddling clothes. Yet central bankers and governments still don't get it, despite the lip service they pay to this great thinker from our past. ( TRUE )

George Selgin is a research fellow at The Independent Institute (www.independent.org) and a professor of free market thought at West Virginia University."

Fine. You can immediately see the relevance of Bagehot, and roughly from where I get my Bagehot's Principles. Here again, some of Bagehot's Principles:

1) If the Fed exists, it will be the Lender Of Last resort, and that has to be taken in to account in real world Political Economy. It should lend freely in a crisis to solvent banks.

2) The rules for LOLR( from here on down this includes any government guarantee ) intervention should be clear, public, and followed, otherwise Moral Hazard is ineffective. All guarantees must be explicit.

3) The terms must be onerous.

4) The LOLR should get something valuable in return.

Here are a few others:

5) The taxpayer's interests should come first.

6) Moral Hazard needs to be constantly applied by quickly liquidating problem banks in normal times.

7) Any entity receiving a guarantee will have to be supervised or regulated effectively, and violations should be quickly and severely punished.

8) There is no doubt that any entity receiving a LOLR guarantee will need to be more conservative in its practices in order to limit the liability of the taxpayer.

9) There should be a class of financial concerns that can act more freely, but they should not receive LOLR guarantees. They will be strictly supervised or regulated though, and are subject to laws against fraud, etc.

Now, a different point of view from one of my favorite writers:

"Walter Bagehot Was Wrong

By JAMES GRANT, Grant's Financial Publishing Inc. | June 19, 2008
http://www.nysun.com/opinion/walter-bagehot-was-wrong/80283/

The governor of the Central Bank of Luxembourg raised some eyebrows when he questioned the integrity of the fast-growing balance sheet of the European Central Bank. Yves Mersch, a member of the ECB's governing council as well as the Ben Bernanke of the Grand Duchy of Luxembourg, raised the issue at a gathering of the International Capital Market Association in Vienna two weeks ago.

(The Granger Collection, New York / Copyright � The Granger Collection, New York / The Granger Collection)">

The Granger Collection, New York / Copyright � The Granger Collection, New York / The Granger Collection

BAGEHOT

Insofar as a currency derives its strength from the balance sheet of the issuing central bank, the euro is unsound and becoming more so, as Mr. Mersch did not quite say. We, however, will say it for him. In fact, we will say the same for most of the leading monetary brands, that of the United States not excluded. The mortgage mess is the immediate cause of the new debasement( PRINTING MONEY ). A long-held article of central banking dogma is the remote cause.

Mr. Mersch landed on the front page of the Financial Times by acknowledging that the ECB is accepting a dubious kind of mortgage collateral( TRUE ) in exchange for loans to the world's liquidity-parched financial institutions. In so many words, Mr. Mersch charged that the commercial banks are gaming the central bank, a situation he called of "high concern." Reading Mr. Mersch, we thought of Thomson Hankey.

Mr. Mersch has the look of a comer in world central-banking councils. Hankey, though he served a term as governor of the Bank of England in 1851 and 1852, is known today, if at all, as a sparring partner of the great Victorian Walter Bagehot (say "Badge-oat"). It was Bagehot who laid down the law that, in a credit crisis, a central bank should lend freely against good collateral at a high rate of interest. Hankey emphatically disagreed, and he answered Bagehot in a little book titled, "The Principles of Banking," first published in 1867 in the wake of the famous Overend Gurney run, the one to which the 2007 Northern Rock panic is sometimes compared.

Way back then, the Bank of England was an investor-owned institution conducting a conventional, for-profit commercial banking business. It had but one avowed public purpose, and that was to manage the workings of the international gold standard. It stood ready to exchange currency for gold coin, and gold coin for currency, at the statutory rate of �3.17s.9d. to the ounce, or �3.89 in metric terms, no questions asked.

Lender of Last Resort

For Bagehot, the Bank of England was no ordinary deposit-taking institution but the lender, or liquidity provider, of last resort. Actually, Sir Francis Baring had anticipated Bagehot in that judgment. In the crisis year of 1797, Baring had fixed the Bank with the name, "le dernier resort." Neither Bagehot nor Baring seemed to anticipate that, before many hundreds of years would pass, the Bank � indeed, many central banks � would become, so to speak, "le premier resort." ( VERY TRUE. THAT'S WHAT WE HAVE NOW )Anyone with good collateral should expect to find accommodation at the Bank's discount window at a suitably high penalty rate( ONEROUS ), Bagehot said. What passed for good banking collateral in the mid-19th century were bills of exchange, i.e., short-dated, self-liquidating IOUs. Mortgages, inherently illiquid, were inadmissible. Hankey liked to quote a relative of his, one C. Poulett Thomson, on the art of banking. It wasn't very hard, said Thomson, as long as the banker "would only learn the difference between a Mortgage and a Bill of Exchange."

By now, a busy reader of Grant's Interest Rate Observer might be wondering why the editor is reaching back to 1867 for actionable ideas on the 21st-century monetary situation. Medical science has made a certain amount of progress since Dr. Strickland's Pile Remedy, Constitution Life Syrup, and Webster's Vegetable Hair Invigorator represented state-of-the-art therapeutics. Neither has monetary economics stood still � has it?

You be the judge. Hankey, in a losing cause, marshaled two principal arguments against the Bagehot doctrine. No. 1, moral hazard: Let profit-maximizing people come to believe that the Bank of England will bail them out, and they themselves will take the risks, and pile on the leverage, that will require them to be bailed out( I BELIEVE THAT THIS IS THE MAIN CAUSE OF OUR CURRENT CRISIS ). No. 2, simple fairness: If Britain's banking interest can claim a right to the accommodation of the Bank of England, why shouldn't the shipping interest, the construction interest, the railroads, "and, last of all, the much-maligned agricultural interest," do the same? Shouldn't all economic actors "be equally entitled to benefit by any favors for which the public have a right to look from such an institution as the Bank of England( NO. THEY CAN PETITION THE GOVERNMENT )?"

At this writing, the Federal Reserve, the ECB, and the Bank of England are taking extraordinary measures to accommodate the demand for liquidity from the institutions that couldn't seem "to learn the difference between a Mortgage and a Bill of Exchange," or between a triple-A corporate bond and a triple-A mortgage, which is a slightly different kind of confusion( TRUE. BUT I CONTEND THAT THEY DID REALLY KNOW THAT THEY WERE DOING ).

To bail out these slow learners( I DISAGREE. THEY UNDERSTOOD THE SYSTEM. EXHIBIT ONE: THE CURRENT BAILOUT ), the central banks are lending government securities against the inherently illiquid mortgage collateral that never had a place on the balance sheet of a properly run monetary institution in the first place( I AGREE. WE DON'T NEED GLASS TO UNDERSTAND GOOD BANKING ). In fact, in Hankey's day, it was a breach of good form( WE NEED MORE OF IT CHUM ) for a central bank even to acquire government securities (the preferred assets were commercial loans, foreign exchange, and gold). How far the world has come: Gold, the most liquid of monetary assets, today is officially demonetized, whereas mortgages, the least liquid of banking assets, are now � all of a sudden, because there seems to be no choice � being embraced, or, at least, tolerated. Certainly, they are being monetized ( BUT GOLD COULD BE AS WELL ).

"Ready money," writes Hankey in a passage on liquidity that seems to speak directly to the post-Bear Stearns world of 2008, "is a most valuable thing, and cannot from its very essence bear interest; every one is therefore constantly endeavoring to make it profitable and at the same time to retain its use as ready money, which is simply impossible( YOU CAN HAVE SHORT TERMS, AND LOANS TO TIDE YOU OVER ). Turn it into whatever shape you please, it can never be made into more real capital than is due to its own intrinsic value, and it is the constant attempt to perform this miracle which leads to all sorts of confusion with respect to credit. The Bank of England has long been expected to assist in performing this miracle; and it is the attempt to force the Bank to do so which has led to the greater number of the difficulties which have occurred on every occasion of monetary panics during the last twenty years."

History Chooses Bagehot

So Hankey would have every banker, trader, merchant, and speculator watch out for himself, proceed with prudence, not overreach, not overborrow, and � above all � not depend on the Bank of England for emergency accommodation if he got into a jam( GOOD LUCK. I DON'T SEE THIS FOR BANKS, BUT I DO SEE IT FOR OTHER FINANCIAL CONCERNS. PERHAPS WE DO NEED GLASS TO PUT THIS DIFFERENCE INTO LAW. ALSO, STRICTLY SPEAKING, BAGEHOT DIDN'T DISAGREE WITH THIS. I AM A TIMID BELIEVER IN CENTRAL BANKS AND THE LSOR CONCEPT )About 150 years later, Northern Rock and the Bank of England are both arms of the British government (the Bank joined the public sector in 1946). The Bank has just rolled out its Special Liquidity Scheme to exchange the government's gilts for the private sector's mortgages, and the gold price, expressed in sterling, stands at �468.2 an ounce, up from �3.89 in Hankey's time. From 1867 to date, the annual rate of debasement( I THINK GRANT LIKES THIS TERM'S MORAL CONNOTATIONS ), sterling against gold, comes to 3.3%.

Hankey's ideas did not go down to defeat for no reason. The gold standard was as hard as it was clean. When the price level fell, as it did in the final quarter of the 19th century, it just fell. No gold-standard central bank resisted the trend with newly created credit (as every major central bank does, or would do, today). A certain kind of person � Grant's knows the type � takes it to be a good thing that, under the monetary arrangements of Hankey's day, no monetary policy committee fixed interest rates or sized up the money supply or regulated the price level or supervised a return to macroeconomic equilibrium when imbalances appeared. Rather, as Hankey observed, interest rates moved and macroeconomic adjustments took place, more or less spontaneously. No government commanded them. ( THEORETICALLY, I AGREE. BUT'S IT'S NOT POSSIBLE )

To judge by all that has happened since the gold standard bit the dust, we would have to say that the people have registered their collective preference for the comforting sight of a Bernanke or a Mersch at the helm of a central bank. There is something pleasing to many, or to most, about a government functionary taking responsibility for interest rates( THEY DON'T TRUST BANKERS. CAN YOU BLAME THEM ? ), the price level and/or the labor market, whether or not that individual can actually make the magic demanded of him (we are sure he or she cannot).

Nowadays, the consensus of belief has it that America fills the bill of a "market-based system," whereas Europe is closer to a "bank-based system." But the truth is that the worldwide mortgage mess has pushed America away from markets and Europe away from banks. Both systems are moving closer to a state of government or central-bank control. And both the dollar and the euro are, therefore, moving even further away from an orthodox notion of soundness (not that either was within hailing distance of it before the credit clouds rolled in last summer)( WE'VE A HYBRID SYSTEM. IT'S SIMPLY REBALANCING ITSELF IN WAYS THAT WE DON'T APPROVE OF. BUT WE'LL SURVIVE ).

A Grand Comeuppance

In the United States this election year, the galloping socialization( NOT TRUE ) of the mortgage market proceeds with hardly a peep of discussion, let alone protest. Thus, mortgage originations by the government-sponsored enterprises reached 81% of overall originations in the fourth quarter of 2007, up from 37% in the second quarter of 2006. In the first quarter of this year, Fannie copped a 50% share of originations, double its take in calendar 2006. But in comparison to the biggest GSE, Fannie and Freddie might as well be standing still.

In Boston, before a Mortgage Bankers Association audience on May 6, the chairman of the Federal Housing Finance Board, Ronald Rosenfeld, noted that the Federal Home Loan Banks, which his agency supervises, are closing in on $1 trillion in outstanding loans, or "advances" ($925 billion currently are outstanding, up by $300 billion since last June). "The FHLBs," Reuters reported of Mr. Rosenfeld's remarks, "are facing increased risk due to the concentration of loans to big financial institutions that recently 'decided to become very involved in the FHLB system,' Mr. Rosenfeld said. Those banks include Countrywide, Washington Mutual Inc.( THOSE TWO AREN'T GOOD NAMES ) and Wells Fargo & Co., he said. The top borrowers of the FHLB system account for 37% of all advances, he said. 'That's an astonishing number, and an astonishing amount of concentration,' he said. ( A BAD IDEA )

"The FHLBs can continue to provide money for their commercial bank members as long as demand persists in the market for agency debt." Foreign central banks can't seem to get their fill( THEY DID GET THEIR FILL OF AGENCIES ). In the 12 months through March, according to a recent Home Loan Bank slide show, central banks took down 40% of the system's debt issuance. Russia's central bank has shown a particularly hearty appetite for the GSEs' emissions: 21% of Russian monetary reserves are parked in the obligations of Fannie, Freddie, and the Home Loan Banks, according to a May 19 Bloomberg report.

Taking an evolutionary view of present-day monetary disturbances, we see a kind of grand comeuppance( WE'VE HAD IT ). Embracing Bagehot and rejecting Hankey, central bankers have pushed aside the classical doctrines of liquidity. In the way that financial ideas seem always to be carried to an extreme( TRUE ), they have pushed too hard. Under their noses, the global credit apparatus froze up, and now it falls to them to thaw it out. A measure of the difficulty of that work is the huge volume of lending that the Bank of England and the ECB, especially, have chosen to undertake; over the past 12 months, the balance sheets of the ECB and the Bank of England have grown by 21% and 19.4%, respectively. (In comparison, the Fed is a model of restraint.)

In his critique of the Bagehot doctrine, Hankey understandably failed to foresee how the financial engineers of the future would respond to the opportunities presented to them by ambulance-chasing central banks of the 21st century. According to the Financial Times, investment bankers the world over are bundling up mortgages to deposit in the special liquidity facilities created by the ECB and the Bank of England. "The Bank of England," the paper reported on May 16, "recently created a facility for UK banks to access funding for mortgages and the Financial Times has learnt that almost �90 billion ($175 billion) worth of bonds are being created to be placed there � almost twice the �50 billion initially expected when the scheme was launched only three weeks ago. ...

"Investment bankers who work in securitization," the FT went on, "say that their main business is structuring bonds that are eligible for ECB liquidity operations. Some analysts have concerns about whether the bonds being created will ever be saleable if markets recover( YES )."

We believe that more analysts ought to be concerned about the risk that these monetary exertions will result in a new cycle of currency debasement. For ourselves, we expect it. A brilliant man was Walter Bagehot, but Hankey had the foresight."

I would say that Bagehot was more realistic. However, the solution to our crisis is to return to Bagehot, with Hankey's views as our conscience. Again, Grant doesn't give Bagehot his due. I'm not so sure that he would have disagreed with Hankey but for Bagehot's Principle:

If the B of E exists, then it will be the LOLR, and that real life fact needs to be taken into account in your policies.

Since the B of E exists, Bagehot is really the person we must turn to.

This article and more can be found at Grant's Interest Rate Observer, grantspub.com. � 2008 Grant's Financial Publishing Inc., all rights reserved.

"If such a man is very busy, it is a sign of something wrong."

Tyler Cowen with a post about Bagehot:

"Bagehot: Beware the busy banker

As Walter Bagehot, the great nineteenth-century editor of the Economist who reveled in the quaint paradoxes of English life, described them, members of the Court [TC: they governed the Bank of England] were generally "quiet serious men...(who) have a good deal of leisure." Indeed, he felt it an ominous sign for a private banker to be fully employed. "If such a man is very busy, it is a sign of something wrong. Either he is working at detail, which subordinates would do better and which he had better leave alone or he is engaged in too many speculations...and so may be ruined."

That is from Liaquat Ahamed's Lords of Finance: The Bankers Who Broke the World, which I am still enjoying. Here is my previous post on the book."

"that the central bank should lend to illiquid but solvent banks, at a penalty rate, and against collateral deemed to be good under normal times."

Xavier Freixas and Bruno M. Parigi consider the concept of the Lender Of Last Resort on Vox:

"This column argues that the financial crisis of 2007 and 2008 redefines the functions of the lender of last resort, placing it at the intersection of monetary policy, supervision and regulation of the banking industry, and the organisation of the interbank market.

Since the creation of the first central banks in the 19th century, the existence of a lender of last resort (LOLR) has been a key issue for the structure of the banking industry. Banks finance opaque assets with a long maturity with short-lived liabilities – a combination that is vulnerable to sudden loss of confidence ( A BANK RUN ). To avoid avoidable disasters when confidence evaporates, the classical view (Thornton 1802 and Bagehot 1873) is that the central bank should lend to illiquid but solvent banks, at a penalty rate( ONEROUS ), and against collateral deemed to be good under normal times( YES ).

With the development of well-functioning financial markets, this view has been considered obsolete( IT IS ? ). Goodfriend and King (1988) in particular argue that the central bank should just provide liquidity to the market and leave to banks the task of allocating credit and monitoring debtors. This view, however, assumes that interbank markets work perfectly and in particular are not plagued by asymmetric information – but that is one of the main reasons why banks exist. The problem with asymmetric information is that liquidity shocks affecting banks might be undistinguishable from solvency shocks, thus making it impossible to distinguish between illiquid and insolvent banks( TRUE ) (Goodhart 1987 and Freixas, Parigi and Rochet 2004).

LOLR and bank closure policy

LOLR is thus connected with the efficient bank closure policy and, more generally, with the costs of bank failures and of the safety net. In cases of illiquidity, the LOLR is channelling liquidity and improving the efficiency of the monetary policy framework( TRUE ). In insolvency cases, the LOLR acts as part of a safety net and thus is directly related to the overall regulatory framework( TRUE ).

Clearly, the design of an optimal LOLR mechanism has to take into account both the banking regulation context and the monetary framework that is intended to cope not only with inflation but also with the management of aggregate liquidity ( YES ).

These issues are compounded by the fact that financially fragile intermediaries are exposed to the threat of systemic risk. Systemic risk may arise from the existence of a network of financial contracts from several types of operations: the payment system, the interbank market, and the market for derivatives. The tremendous growth of these operations recent decades has increased the interconnections among financial intermediaries and among countries. This has greatly augmented the potential for contagion( TRUE ) (Allen and Gale 2000 and Freixas, Parigi and Rochet 2000).

The panic of 2008 and subprime crisis of 2007

The panic of 2008, originating with the subprime crisis of 2007, offers key insights into systemic risk and illustrates vividly the new role of a lender of last resort.

Years of accommodating monetary policy( LOW INTEREST RATES ), regulatory arbitrage to save capital( SEEKING INVESTMENT WITH LOWER CAPITAL STANDARDS ), and waves of financial innovations( CDSs, CDOs, etc. ) – which by definition tend to escape traditional prudential regulation( TRUE ) – have created the conditions( I'LL ACCEPT CONDITIONS, BUT NO MORE ) for slack credit standards and rating agencies that fail to call for adequate risk premia( BUT THEY TOOK ADVANTAGE OF THE CONDITIONS FREELY ).

The opacity of the assets of the banks and of the financial vehicles they created to hold mortgages resulted in a dramatic and sudden reappraisal of risk premia( FEAR AND AVERSION TO RISK, AND THE ACCOMPANYING FLIGHT TO SAFETY ). As with a thin market typical of the Akerlof lemons problem (Freixas and Jorge 2007), financial intermediaries have become reluctant to lend to each other if not for very short maturities. The fear that the interbank market might not work well and might fail to recycle the emergency liquidity provided by the central banks around the world in various and coordinated ways has induced banks to choose the rational equilibrium strategy of hoarding some of the extra liquidity instead of recycling it to the banks in deficit.

The resulting equilibrium closely resembles the gridlock described by Freixas, Parigi and Rochet (2000), where the fear that a debtor bank will not honour its obligations induces the depositors of the creditor bank to withdraw deposits, thus triggering the liquidation of assets in a chain reaction. This is the modern form of a “bank run” – financial intermediaries refuse to renew credit lines to other intermediaries, thus threatening the very survival of the system( TRUE. IT IS LIKE A BANK RUN. THAT'S ESSENTIALLY WHAT THE FLIGHT TO SAFETY IS ).

Liquidity in a non-functioning interbank market

Clearly channelling emergency liquidity assistance through the interbank market will not work if the interbank market is not functioning properly. Thus, to limit the systemic feedbacks of the sudden deleveraging of financial institutions, the Fed has taken the unprecedented steps of both increasing the list of collateral eligible for central bank lending and extending emergency liquidity assistance to investment banks, government sponsored entities, money market mutual funds, and a large insurance company (AIG). Preventing a complete meltdown of the financial system has required the central bank to guarantee (and accept potential losses) that most if not all claims on financial institutions will be fulfilled( THAT'S IT. GUARANTEE ).
The panic of 2008 has showed that it would be erroneous to adopt a narrow definition of the LOLR, stating that its role should be limited to the funding of illiquid but solvent depository institutions, while capital injections should be the Treasury’s responsibility( TRUE ). This would lead to a very simplistic analysis of the LOLR’s functions, as the complex decisions would be either ignored or handed over to the Treasury. Such a narrow view of the lender of last resort would create an artificial separation between lending by the lender of last resort at no risk and the closure or bail-out decision by the Treasury. In fact, the recent crisis has proved that the lender of last resort cannot deny support to a systemic, too-big-to-fail financial institution in need( BINGO! AND THE MARKET AND INVESTORS BELIEVED THAT AND HAVE BEEN ACTING UNDER THAT PRESUMPTION ).
To understand the interventions of the lender of last resort in the current crisis, the view of its role has to be a broad one encompassing the closure or bail-out decision defining the lender of last resort as an agency that has the faculty to extend credit to a financial institution unable to secure funds through the regular circuit.

LOLR policy as part of the banking safety net

Once we establish that the lender of last resort policy has to be part of the overall banking safety net, the interdependence of the different components of this safety net becomes clear.

• First, the existence of a deposit insurance( FDIC ) system limits the social cost of a bank’s bankruptcy, and therefore, reduces the instances where a LOLR intervention will be required. ( TRUE )
  
• Second, capital regulation( REQUIRING HIGHER CAPITAL ) reduces the probability of a bank in default being effectively insolvent, and so has a similar role in limiting the costly intervention of the LOLR.( TRUE)
  
• Third, the procedures to bail-out or liquidate a bank, determined by the legal and enforcement framework will determine the cost-benefit analysis of a LOLR intervention( WE WISH ).

Adopting a perspective of an all-embracing safety net does not mean that the safety net has to be the responsibility of a unique agent. Often several regulatory agencies interact, because different functions related to the well functioning of the safety net are allocated to different agents( OK ).

It is quite reasonable to separate monetary policy from banking regulation, and the separation of the deposit insurance company from the central bank makes the cost of deposit insurance more transparent. Also, the national jurisdiction of regulation makes cross-border banking a joint responsibility for the home and host regulatory agencies, an issue of particular concern for the banking regulatory authorities in the EU.

Lessons for the LOLR’s role

• First, we have witnessed how an additional aggregate liquidity injection is not a sufficiently powerful instrument to solve the crisis. ( TRUE )
  

The illiquidity of financial institutions around the world is, in fact, directly linked not only to their solvency but also to asset prices.

• Second, central banks around the world have been much more flexible in providing support to the banking industry than initially expected( I DON'T AGREE ).

In other words, that central bank cannot credibly commit to a bail-out policy( YES IT CAN ). Indeed, the arguments regarding the bail-out of banks only if their closure could have a systemic impact (too-big-to-fail), that were intended for an individual bank facing financial distress were soon discarded in favour of a more realistic approach.

The case of Northern Rock, certainly not a systemic bank, illustrates this point. Its liquidation in such a fragile banking environment would have triggered a domino effect with contagion from one institution to another. From that perspective the lesson is that when facing a systemic crisis, the LOLR has to take into account also the “too-many-to-fail” issue, and consider how it will treat all banks that are in a similar position( TRUE ).

• A third point is that, in a systemic crisis, the safety net is extended to non-bank institutions. ( TRUE )
  

This may be the result of financial innovation. Yet, because AIG had been issuing credit default swaps, its bankruptcy would have affected the fragility of the banking industry by leading to losses and a lower capital.

• Fourth, regulators around the world have a mandate to protect the interests of their national investors. ( COME ON )
  

The international coordination of regulators, and in particular, the European coordination has been helpless when faced with the real cost of the Icelandic crisis. So, the theoretical models of non-cooperative behaviour( YEP ) are the ones to cope ex-ante with the burden-sharing issue."

Truthfully speaking, countries have been pursuing a beggar thy neighbor policy right from the start. A good article, but of limited scope.

Editor’s note: This article draws in part on the work Freixas and Parigi (2008).

References

Allen, F. and Gale, D. (2000). Financial Contagion, Journal of Political Economy, 108, 1-33
Bagehot, W. (1873). Lombard Street: A Description of the Money Market. London: H.S. King
Freixas, X. and Jorge, J. (2007). The role of Interbank Markets in Monetary Policy: A model with rationing, Journal of Money, Credit and Banking, forthcoming.
Freixas, X. and Parigi, B.M. (2008) “Lender of last resort and bank closure policy” CESifo working paper 2286, April 2008
Freixas, X., Parigi, B.M. and Rochet, J-C. (2000). Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank, Journal of Money, Credit and Banking August, 32, Part 2, 611-638
Freixas, X., Parigi, B.M. and Rochet, J-C. (2004). The Lender of Last Resort: A 21st Century Approach, Journal of the European Economic Association, 2, 1085-1115
Goodfriend, M. and King, R. (1988). Financial Deregulation Monetary Policy and Central Banking, in W. Haraf and Kushmeider, R. M. (eds.) Restructuring Banking and Financial Services in America, AEI Studies, 481, Lanham, Md.: UPA
Goodhart, C. A. E. (1987). Why do Banks need a Central Bank?, Oxford Economic Papers, 39, 75-89
Thornton, H. (1802). An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, London: Hatchard

"For a classic understanding of central banking, do not read Ben Bernanke. Instead, read Walter Bagehot."

David Merkel on the Aleph Blog with a review of one of my favorite books:

"This is a wonky book, and not for everyone. It details the actions of monetary policy in the United Kingdom for much of the 19th Century. In Great Britain, that was a century of incredible growth, and yet stability of the overall price level. The Gold Standard worked, and the UK Government di not try to cheat on it, as it did in the early 20th century before the Great Depression.

One of Bagehot’s main ideas was that during a crisis, central banks should lend at a penalty rate without limit, and that would re-liquefy the marginal banks in the system that just needed a little to get by. Bad banks would fail; good banks would not need to borrow. We can contrast that with present policy of the Fed to lend against marginal collateral at favorable rates. Ain’t no chance of us getting out of the problem that way. All we do is create a new class of arbitageurs to extract money from the taxpayers, or Treasury note buyers.

The mangement of a good central bank is very conservative, and keeps a reserve large enough to avoid all disasters. This again is the diametric opposite of the Federal Reserve, which was not in a conservative posture, and believes it can solve all of the credit problems through the wanton expansion of its balance sheet.

For a classic understanding of central banking, do not read Ben Bernanke. Instead, read Walter Bagehot. If you want to buy it, you can find it here: Lombard Street: a description of the money market. Or, you can get it for free here.

PS — Remember, I don’t have a tip jar, but I do do book reviews. If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don’t pay anything extra. I’m not out to sell things to you, so much as provide a service. Not all books are good, and not every book is right for everyone, and I try to make that clear, rather than only giving positive book reviews on new books. I review old books that have dropped of the radar as well, like this one, because they are often more valuable than what you can find on the shelves at your local bookstore.( IF YOU BUY THE BOOK, DO IT THROUGH HIS WEBSITE )

"And Senate Republicans now run the risk of being portrayed as Marie Antoinettes with Southern accents."

William Kristol with a post that takes a perspective that I believe is more effective for the GOP:

"In 1953, the president of General Motors, Charles Wilson, was nominated by President Eisenhower to be secretary of defense. During his confirmation hearings, Wilson was asked if he’d be able, as defense secretary, to make decisions contrary to the interests of G.M. He answered yes, but added that he couldn’t imagine such a situation, because “for years I thought what was good for our country was good for General Motors, and vice versa.”

It wasn’t a ridiculous view. It was widely shared — by big-business-loving Republicans and big-union-embracing Democrats, by big-car-driving suburbanites and big-tank-occupying soldiers.

Today, G.M., Ford and Chrysler get no respect. Maybe they don’t deserve much. Detroit has many sins to answer for, and it’s been doing plenty of answering. But — and I say this as someone who grew up in non-car-driving family in New York and who is the furthest thing from an auto aficionado — there is a kind of undeserved disdain, even casual contempt, that seems to characterize the attitude of the political and media elites toward the American auto industry.

As Warren Brown, who writes about cars for The Washington Post, recently put it, “There is a feeling in this country — apparent in the often condescending, dismissive way Detroit’s automobile companies have been treated on Capitol Hill — that people who work with their hands and the companies that employ them are inferior to those who work with their minds and plow profit from information. How else to explain the clearly disparate treatment given to companies such as Citigroup and General Motors?”

Now there are other ways to explain the disparate treatment of G.M. and Citigroup. Finance is different from manufacturing, and banks from auto companies. It may be that the case for a huge bank bailout was strong, and that the case for a more modest auto package is not. Still, it seems to me true that the financial big shots haven’t been treated nearly as roughly in Congress or in the media as the auto executives, who have done nothing remotely as irresponsible as their Wall Street counterparts."

I think that this is a widely held view. It accords with the view that the Financial Bailout is a Crony Bailout.

"What’s more, in their disdain for the American auto companies, the left and right wings of the establishment agree. Of course, the particular foci of criticism are different — the left berates the auto companies’ management, the right the United Automobile Workers. But even on the left, while Democratic politicians still try to look out for the interests of the U.A.W., there’s not really that much sympathy for the workers. The ascendant environmentalists disdain (to say the least) the internal combustion engine and everyone associated with it. Most of today’s limousine liberals are embarrassed by their political alliance with the workers who built those limousines.

Meanwhile, on the right, free-market analysts have explained that our regulatory scheme of fuel-efficiency standards is counterproductive. But despite the fact that the government is partly responsible for the Big Three’s problems, the right hasn’t really been stirred to enthusiastically promote a deregulatory agenda to help the auto companies. What excites it is mobilizing to oppose bailouts for unionized workers.

Last week, Senate Republicans picked a fight with the U.A.W. on union pay scales — despite the fact that it’s the legacy benefits for retirees, not pay for current workers, that’s really hurting Detroit, and despite the additional fact that, in any case, labor amounts to only about 10 percent of the cost of a car. But the Republicans were fighting Big Labor! They were standing firm against bailouts! Some of the same conservatives who (correctly, in my view) made the case for $700 billion for Wall Street pitched a fit over $14 billion in loans for the automakers.

So Senate Republicans chose to threaten to filibuster the House-passed legislation embodying the George Bush-Nancy Pelosi deal. The bill would have allowed President Bush to name a car czar, who could have begun to force concessions from all sides. It also would have averted for now a collapse of the auto industry, and shifted difficult decisions to the Obama administration."

This is pure Interest Group Politics.

"Instead, Bush will now probably have to use the financial rescue funds to save G.M. — instead of being able to draw from sums previously authorized for the green transformation of the auto industry, a fight he had won in the negotiations with Pelosi. And Senate Republicans now run the risk of being portrayed as Marie Antoinettes with Southern accents.

Whichever party can liberate itself from its well-worn rut to propose policies that help both American businesses and workers has a great opportunity. That party’s leaders could begin by offering management and labor at the Big Three a little more sympathy, and heaping upon them a little less calumny. Where’s Charles Wilson when we need him? "

The French Revolution again. Along with Posner, Kristol makes two people considered to be on the right of our political spectrum who get the Political Economy of the situation. Perhaps we can't count them out yet.

As for the final point, he makes a case of it. However, I do believe that the UAW should make major concessions and the Management be replaced, quite simply because the Taxpayer's money is being invested. For me, it follows from Bagehot's notion of onerous conditions.

"Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Yesterday, I disputed the notion that Low-Information Assets allow more Trust than High-Information Assets. I said that Trust, which Banks need to survive, is never to be taken for granted, and that investors always need to be aware of a Bank' s financial status. Here's Tony Jackson in the FT:

"What are banks for? In normal times, the question would seem redundant. But, with the banks now drifting rudderless in a sea of popular resentment, the answers are alarmingly vague.

Precisely to whom do banks owe their first duty of care? Is it to their shareholders, their depositors or their borrowers? Or all of those?

The thought was partly prompted by a recent letter to this paper from a retired British banking grandee, Sir Ronald Grierson. “A bank is a bank,” he wrote, “and, if the security of its depositors is not its main concern, it should be required to adopt another name. Members of the public are entitled to take this for granted.”

I do not agree with this. We have just learned that such an attitude is not wise. But, together with this notion of Low-Information assets engendering more Trust, I can already see where many of us went wrong.

"Under UK law as it presently stands, Sir Ronald is, strictly speaking, wrong about that. At present – though this is to change – a UK bank is just another company. As such, its primary duty is to its owners."

Is this a surprise?

"More of that in a moment. First, how has the banks’ duty to shareholders been discharged in practice?

In two words, stunningly badly. UK bank shares are almost all below their level of five years ago, in most cases disastrously so. Many may never recover previous peaks."

Job well done.

"To be fair, shareholders sometimes tried to exercise their own duty of control, if ineffectually. For years, they resisted the acquisitive ambitions of Royal Bank of Scotland, only to lose their resolve at the top of the cycle. RBS’s resulting ABN Amro purchase is one main reason for its subsequent collapse into state ownership."

Job well done.

"The same recklessness characterised many borrowers. A depressing number of now-bankrupt companies made big debt-financed acquisitions at the peak of the boom. Others, such as Chrysler and EMI, are in crisis because the banks lent vast sums at the last minute to an equally reckless private equity industry."

Job well done.

"So, in general, you might think, let the borrower beware. The snag is, of course, that too much lending leads inevitably to too little, thus posing systemic threats to the economy – a problem now being urgently addressed by various governments."

If it's inevitable, how come people seemed unprepared? Of course, I don't believe that many were that surprised.

"Nor are all borrowers in the same category. I recently found myself perusing the personal ads on a supermarket notice board in the English Midlands. A striking number were for “house sharing” – seeking other families to move in and share the financial burden.

There is the plain sense here of a duty foregone. Most people know little or nothing of finance. But banks are accredited experts. If a bank says you are good for a loan, it is putting that expertise into practice.

To borrow Sir Ronald’s phrase, you are entitled to take that for granted. And, if the result is a choice between sharing your home with strangers or losing it, you are entitled to feel aggrieved."

You cannot take anything for granted. You should assess the competence of the bank that you put money in, or borrow money from. You are legally and morally entitled to your business with the bank being on the up and up.

"Let us now revert to the depositors. It might seem extraordinary that the UK has no special provisions to protect them from collapse, as opposed to insuring them after it. Most other countries, from the US and Japan to Mexico and South Korea, have had such provisions for many years."

I'm assuming he means the FDIC. Can we imagine how much worse this crisis would be without it? I assume that many free market followers would end it, although I don't hear many calling for it in this crisis.

"The usual method is a so-called “resolution regime”, whereby, if a bank seems in danger, the state intervenes and takes it into protection. It is then sold on, usually to a healthier bank. The implicit assumption is that the interests of depositors trump those of shareholders or creditors."

I believe that this is true.

"In the UK, as Sir Ronald also observed, that task was performed by the Bank of England until its independence in 1997. In the ensuing reshuffle of responsibilities, that part got left out. It is now being reinstated under legislation due for completion in February. But it took the collapse of Northern Rock to bring it about."

I believe that we have that here.

"This is the more extraordinary because, as Professor Julian Franks of the London Business School observes, the UK has had just such a regime for its utilities ever since they were privatised in the 1980s. And a bank is nothing if it is not a utility.

Both the electricity and water regulators, for instance, have powers of last resort to protect customers. If an electricity supplier goes bust, the regulator takes it over and sells it on. This happened in October to a small supplier with some 40,000 customers, Energy4Business. There was no fuss, no publicity. It was routine."

Are Banks like a Utility?

"This all leaves a worrying sense of muddle. In both the UK and US, the response of the authorities to the banking crisis has been piecemeal and uncertain, at least partly because there is no clear sense of priorities. It all badly needs sorting out."

This is true. There is a difference between Pragmatism and Trial and Error, and lurching backwards and forwards in a manner that signals unpreparedness and incompetence.

"Let the last word on this go to the Victorian banker and commentator Walter Bagehot. “The business of banking,” he wrote, “ought to be simple: if is hard, it is wrong”.

Ditto for the legal framework. Lawmakers take note."

As per usual, Bagehot is correct, and his statement is simply a version of Searle's Sagacity.

"as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions.

Yesterday, Eric S .Rosengren of the Boston Fed gave a talk focusing on some principles for future regulatory reform, which I found out about on the WSJ:

"I am very pleased to be with you today, as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions. I am very pleased to be with you today, as it is a particularly appropriate time for all of us to be at a conference focused on risk management and risk modeling for financial institutions.[Footnote 1] As you know, many banks around the world have, of late, found themselves needing equity infusions from governments, or expanded guarantees for their liabilities."

Actually, a more appropriate time for a conference on risk management and modeling is when things are seemingly going very well, but this is now a step in the right direction.

Banks have needed:
1) Money from government
2) Implicit guarantees made explicit

"A widespread need for banks’ recapitalization has occurred at least twice in the past century, and in many countries has occurred much more frequently than that. Many banks’ risk models were supposed to be calibrated for “once-in-a-thousand-years” events; however, these models seriously underestimated risk."

They not only underestimated risk, but, in doing so, were magnifying risk. That's the reason a " Once-in-a-thousand-year" event occurred in about five years.

"Certainly there is much still to study and understand about the recent financial turmoil that emerged in the summer of 2007. But it seems abundantly clear, and not all that surprising, that risks calibrated from a few years of data from good times can dramatically under-estimate risk exposure for a particular asset, as well as the high correlation of risks across asset classes during periods of significant stress. "

When you read how little data they had to base their predictions on, there's no way but to consider that ridiculous and negligent behavior. You have to ask what incentives or goals predisposed people to accept such preposterous presumptions.

"Furthermore, while capital models were intended to suggest minimum capital requirements that would keep institutions sound during risky times, the models were frequently used to justify expansion of dividends and stock buybacks, because they suggested that banks were overcapitalized during boom times. So this conference occurs at a good time, as we all try to re-evaluate how best to model and manage risk."

Lowering capital requirements is inherently risky. Period. This was a conscious and obvious attempt to find investments with lower capital requirements. Period.

"And it is not only our risk models that need to be reevaluated. Our regulatory framework clearly needs to be reconsidered, in light of recent events. Both in the U.S. and globally, we had in place a complex set of regulations and supervisory structures intended, in part, to increase the likelihood that financial intermediaries would remain well capitalized without government assistance. Like the risk models, bank regulators did not foresee the dramatic illiquidity that could emerge during a period of acute financial turmoil – nor the changes in the value of assets on balance sheets, or the degree of correlation of those asset values."

We've had a system, at least since the S & L Crisis, of implicit and explicit government guarantees to intervene in a financial crisis. We've had a pretty well established set of precedents from the S & L Crisis and Tech Bubble that fraud, negligence, fiduciary mismanagement, and collusion, are rarely and arbitrarily prosecuted. We've had a regulatory structure that did not do much regulating, and which was easily influenced by lobbying. Put those in your risk pipe and smoke it.

"While regulatory reform proposals are already beginning to surface, I see value in first evaluating the principles that should frame the discussion. Before we begin to work on regulatory details we need to evaluate whether the problem was poor execution of a well-considered regulatory framework, or that important principles were absent from the framework. While in my view the recent experience shows elements of both, I want to focus today on regulatory principles rather than their implementation."

It's more like the pool is being drained down to the level where regulatory reform proposals are being taken seriously. Was the problem:
1) Poor enforcement of good rules
2) Poor rules
3) A combination of both ( Yes. And he agrees )

He will focus on 2. Better to focus on rules than people. They might be offended.

"But before discussing regulatory principles, I would like to briefly discuss our current economic situation, in order to put the recent crises in context.

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Recent Economic Conditions

Many countries have already experienced two consecutive quarters of negative GDP growth and the NBER has recently declared that the U.S. entered the recession at the end of last year. In the U.S., GDP in the second quarter was positive, helped in part by a fiscal stimulus package. In the third quarter, GDP declined by 0.5 percent, and it looks like in the fourth quarter it will decline somewhat more significantly – since consumer and investment spending appear to be dropping quite precipitously. This is due, in part, to the interplay of developments in asset markets and the real economy. U.S. consumers – and, increasingly, consumers across Europe – have been buffeted by declining housing prices and falling stock prices. The resulting loss of consumer wealth, coupled with a rapidly rising unemployment rate, suggests the holiday buying season will not be robust as was hoped earlier this year."

What's with the constant use of "robust"? We're in a recession.

"The likelihood of further weakening of labor markets, and a reluctance of consumers or businesses to increase spending until economic conditions are more certain, together imply a continued difficult environment for banks. There are several conditions necessary for financial markets to resume a more normal state, and I would like to briefly discuss each."

Fire away.

"First, we need short-term credit markets to return to normalcy. Conditions in short-term credit markets have improved significantly since the end of September. As shown in Figure 1, rates in the market for high-grade financial commercial paper have resumed a more normal relationship to the Federal Funds rate target, compared to the mid September to mid October timeframe. This improvement in what was a very large spread has been greatly aided by the various short-term credit facilities established by the Federal Reserve to help reduce the stress in short-term credit markets. These facilities have also enhanced the ability of financial firms and issuers of commercial paper to extend the maturities on commercial paper issues (see Figure 2), which at the end of September had become dependent on overnight financing. The facilities have also reduced the risk that financing would not be available over the year end, as many commercial-paper issuers have now financed themselves beyond that point. But despite these improvements, short-term credit markets remain strained. Figure 3 shows that the spread between Libor[Footnote 2] and the Overnight Index Swap rate has fallen from its late-September peak but remains well above the level that prevailed prior to the outbreak of financial turmoil in summer of 2007."

This makes sense.

"Second, we need to see some improvement in the housing market before financial markets will resume a more normal state. In the U.S., residential investment began declining in the first quarter of 2006 and has declined in each quarter since. And as Figure 4 shows, house prices have declined nationally, and in some markets the declines have already exceeded 25 percent. A number of proposals have been floated to help stem foreclosures, but to date there has been relatively modest progress – faced, as we are, by the dual problems of falling housing prices and rising unemployment. Stabilization in house prices and a drop in foreclosures would help the overall economy as well as the banking sector that is exposed to construction loans, residential mortgage loans, and mortgage-backed securities."

This makes sense. How to do this is where we disagree.

"Third, officials must take into account – and develop policies and actions that reflect – the degree to which monetary policy tools are currently deployed. The stance of U.S. monetary policy reflects our rate reductions, with the Federal Funds rate target currently at 100 basis points. Given that interest rates cannot be negative, further monetary-policy actions are limited by the zero lower bound for interest rates. While other monetary policy tools can be employed, increasingly many observers and commentators are suggesting that fiscal stimulus will be an important element of economic recovery."

The word"deployed" again. Strange. We need a stimulus. Yes.

"Principles to Guide the Design of Regulatory Structure

With actions already taken to stabilize short-term credit conditions, and the widely-reported likelihood of further fiscal measures, I would hope that over the next year there can be a broader discussion of lessons learned from our recent problems, and what measures can be taken to reduce the risk of a recurrence. There can sometimes be a tendency to move to proposals for regulatory design before building a consensus on the underlying principles that should guide the debate. To that end, I would like to use my remaining time to discuss a few key principles that I hope will inform the many proposals that are likely to emerge."

I agree that principles should be developed first.

"Principle 1:
Financial regulation must be more clearly focused on the key goal of macroeconomic stability as well as the safety and soundness of individual institutions.

I lead with this principle, because I believe it has not necessarily received sufficient attention in our current regulatory structures. There is a clear link between the financial regulation of institutions and the stability of markets and the macroeconomy. Some countries have had frequent and severe banking crises, while other countries have been much more successful at weathering periods of international financial turmoil.

On the one hand, too conservative a regime of financial regulation can stymie innovation and creativity, thus preventing borrowers and lenders from interacting in the most efficient ways. On the other hand, inadequate oversight can cause periods of financial turmoil that are quite destructive to the financial infrastructure and the real economy. Future regulatory design must allow for innovation without increasing risks to the financial infrastructure and the real economy."

This is what I believe. The main objective should be to examine financial innovations as they occur as to whether they:

1) Transfer Risk

2) Magnify Risk

Whether regulation or supervision is needed is secondary to a clear and thorough examination of the new financial products or arrangements.

"Principle 2:
Because it is a key determinant of macroeconomic stability, systemic financial stability must receive greater focus, with roles and responsibilities during a financial crisis more clearly articulated.

Regulatory structures should be designed to minimize the probability of systemic disruption or instability. In the future, the definition of a “systemically important” firm must be clear in advance, and the regulatory structure should be designed to minimize the chance that such firms will take actions that would put systemic stability at risk. In addition, should a crisis arise despite the best efforts of regulators, the conditions and processes to “save” such firms must be well understood in advance."

I agree with this and have said so over and over. All government guarantees must be made explicit and agreed upon beforehand, as well as there being a minimal but clear and effective mode of regulation, involving rationalization and oversight of the regulators themselves as to their effectiveness and competence.

"Importantly, care must be given to the design of rescue options to minimize the incidence of moral hazard, or additional risk-taking by a party that is insured, “saved,” or otherwise insulated from the consequences of its activities. Of course, the best way to avoid moral hazard is to avoid crisis situations in which organizations need “saving.” The next best way is to have well-defined processes in place in advance, which minimize the effects of moral hazard.[Footnote 3]"

This is the most important point for me. We need to clearly differentiate between businesses that have government guarantees and those that don't, and regulate risk accordingly. What I've called Bagehot's Principles need to be applied, including killing off insolvent businesses quickly and effectively to enforce moral hazard as an ongoing regime. If you let it slide, your actions will overcome your words, and moral hazard will be significantly increased.

One addition to Bagehot's Principles might be:

We might save your bank, but you and and the people responsible for the bank's problems will not be saved, and might even suffer personal losses.

"Essential to determining which institutions are systemically important is a comprehensive view of what you might call the “financial entanglements” – interdependencies – among financial instruments and institutions.[Footnote 4] In an ideal situation, financial institutions could fail or have their assets transferred to other organizations with little disruption to counterparties or markets. Recent experience indicates that the uncertainty around counterparty risk in non-exchange-traded transactions is significant during periods of market stress. And it is difficult to ascertain the true extent of counterparty risk and whether a failure will result in significant disruptions in markets where the financial institution serves as a key player."

This is key, if for no other reason that, and this seems silly saying this, a financial institution can actually know what it has in assets and liabilities from day to day.

"In the U.S., the central bank can provide liquidity to the marketplace, but decisions to take on credit risk that pose substantial risks to taxpayers should ideally be in the hands of the Treasury Department, with oversight by Congress. However, during this period of financial turmoil the Treasury Department did not have the pre-existing authority to intervene expeditiously in such a crisis situation. The result was that the central bank became directly involved in urgent, time-sensitive issues that involved significant credit risk."

We need one agency to be in charge.

"To be better prepared for systemic problems, “standing” fiscal and monetary facilities are needed, to provide the ability to react more quickly than was possible of late. Until the passage of the Troubled Assets Relief Program (TARP), the U.S. Treasury Department did not have the ability to react to emerging problems as quickly as it would have liked. Similarly, many of the Federal Reserve facilities required significant accounting, legal, and back-office infrastructure that took some time to put in place."

We should plan for crisis management situations.

"In addition, as you all know, liquidity has been provided to institutions and markets where previously the central bank had little direct regulatory involvement. For example, facilities that were needed to provide liquidity to investment banks and money-market funds were established despite the absence of direct regulatory oversight by the Federal Reserve at the time the facility was initiated. Also, markets such as those for asset-backed commercial paper and unsecured commercial paper were not markets in which the Federal Reserve was actively engaged prior to the crisis. In the future, it would be ideal to clarify in advance which institutions and markets could require liquidity, and make sure the central bank has sufficient information about these institutions and markets to better serve in its role as lender of last resort."

This is also key, and follows from making everything explicit and agreed to beforehand.

"Principle 3:

Liquidity risk must receive greater policy focus in determining regulatory structures.

At the outset of the recent financial turmoil, many observers assumed that liquidity risk was well contained. In the case of investment banks, many of their assets were financed by repurchase agreements – short-term loans that were fully collateralized. Because the repurchase agreements were collateralized, most parties assumed there was a relatively low risk of a “run” because the collateral could always be sold in the event of a default. However, concerns with valuations of assets used for repurchase agreements resulted in many investors refusing to continue to lend even overnight once the counterparty was feared to be at risk of failure."

You have to be able to sell assets in order to get the money you need back.

"In addition, money market mutual funds were assumed to have relatively little liquidity risk, because they were constrained by regulations that compel them to hold only investment-grade securities of short duration. However, after one well-known money market mutual fund announced that its investors would not be able to redeem their entire principal (“breaking the buck”), many funds faced a wave of redemption requests they had great difficulty meeting – until action was taken to put in place temporary U.S. Treasury insurance as well as a new Federal Reserve liquidity facility."

People have to believe that they can get their money back when they need it.

"The financial turmoil has highlighted the reality that our regulatory structure had not fully anticipated the types of liquidity shocks that have occurred. Going forward, more attention should be focused on ensuring that the causes of liquidity disruptions are better understood, and that we are better equipped to avoid liquidity problems.[Footnote 5]"

Financial institutions need to be able to sell assets in order to meet capital requirements.

"Also, we must be cognizant of an issue that has compounded these liquidity problems – the interaction with accounting rules. Regulatory and accounting frameworks need to consider how best to address periods of sustained illiquidity."

Mark-to-market, Etc.?

"In order to prevent bank runs, many countries have not only insured bank deposits but have also guaranteed other liabilities. We need to better understand how best to structure liabilities to avoid the need for such debt guarantees in the future. In the recent turmoil, for many institutions it was the unexpected lack of a stable and fluid market for short-term debt to finance their balance sheets that created liquidity problems.[Footnote 6]"

We'd rather not have the government get involved.

"Principle 4:

Careful thought must be given to coordinating the work of the various domestic and international regulators in the design of the regulatory structure.

In the United States there exists a patchwork of overlapping regulators. Much of our regulatory design results from reactions to the Great Depression. Given all the changes that have occurred since then, it is probably appropriate to take a fresh look at our regulatory structure – not just the bank-regulatory agencies but also the inter-relationship of their work with that of the Securities and Exchange Commission and the Financial Accounting Standards Board."

This is what I've already called Rationalization.

"Ideally, a new structure would minimize the adverse effects of competing regulatory goals. It will also need to consider how different regulatory bodies can be better coordinated so that information moves more freely between them. Also, international coordination is becoming much more important, as firms have become more global. And as with monetary policy, I believe that to the extent possible, creating independent regulatory agencies with clear mandates is critical to success."

Same point, including ones I've already made about how regulations should be framed.

"Principle 5:

Responsibility for strengthening market infrastructure should receive more attention in regulatory design.

The current crisis has highlighted the need for better transparency. If every transaction is unique, it becomes difficult to determine valuations during periods of illiquidity. To the extent possible, contracts governing securitization should be standardized, with clearly defined steps to resolve competing interests when the underlying assets lose value."

I don't mind this, but frankly doubt its usefulness. Better, it should happen, but room should be left for some innovation.

"Similarly, contracts between institutions provide less transparency than transactions through exchanges. Exchange-traded assets provide a price that is widely observable – on contracts for assets that are clearly defined. To the extent that more assets move to be exchange-traded, counterparty risk is reduced, and transparency is increased."

This I agree with.

"I also believe that payment and settlement activities need greater oversight. The back-office difficulties involved in unwinding complex trades that were not exchange-traded highlight the need for more attention to settlement activities."

It might also deter graft.

"Conclusion Of course, these five principles are not the only ones of import. Others may stress other very worthy points taken from the lessons of the recent episode. For example that financial regulation must be grounded in an understanding of institutional relationships – “real world” details, which clearly do matter. "

You know you're in a strange situation when someone feels it necessary to remind everybody that we need to deal with the "real world".

"Or, as I mentioned when discussing moral hazard, that financial regulation needs to do a better job of recognizing the role of incentives. For example, compensation structures affect actions – as is evident in situations where short-term risk-taking is rewarded very lucratively and losses are not borne by the originators of the risk."

That's addressed by my addition to Bagehot's Principles.

"The current crisis provides the opportunity and impetus to reexamine a regulatory framework that originated in the Great Depression. While I believe there is a clear need to redesign the current regulatory structure, it is important that we not lose important features of the current market. It is critical that any regulatory design not stifle the industry’s innovation and creativity. However, the regulatory structure needs to be more adaptable to innovations – in order to ensure that new safety and soundness, and systemic, concerns are not ignored. And it needs to be aware of the details of the evolving financial-market structure."

That's why we need to focus on principles, and on our ability to discern what investment products are doing.

"Additional regulations do run the risk of moral hazard where the presence of a safety net creates an incentive to take additional risk. While any countercyclical monetary, fiscal, or regulatory policy runs this risk, it should be minimized. Ideally, situations requiring public support should occur only after losses have been borne by equity holders, and existing management and directors have been held responsible for the losses."

This is the main cause of the crisis for me. It stemmed from the self deception involved in the implicit guarantees, that everyone in the financial world believed were explicit. Everyone was pretending that these guarantees weren't there, while everyone was acting as if they were. This allowed a fairy tale view of what risk there was in the system, which led to an unnaturally childish view of risk by the individuals involved, since, if everything got scary, the investors had a fairy godmother called the government to bail them out. The fairy tale world turned out to be the one with no government guarantees, not the one that people were pretending wasn't real. We need a very onerous and specific set of principles for the government to be involved, and enforce moral hazard religiously from the outset. No more self deception and fairy tales, please.

"To the extent a new regulatory structure reduces counterparty risk, or requires offsets in capital for transactions involving significant counterparty risk, the likelihood of spillover effects from one firm’s failure should be significantly reduced. Ideally a new structure will reduce the likelihood of future financial turmoil of the length and severity of current financial problems."

We should raise capital requirements, and have a system in which capital can easily be raised if needed. An interesting talk.

"Thank you for having me join you today, and thank you for the opportunity to share my views on principles to guide the redesign of U.S. financial regulation."

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Complete speech, with exhibits

X Footnote 1

Of course, the views I express today are my own, not necessarily those of my colleagues on the Board of Governors or the Federal Open Market Committee (the FOMC).

X Footnote 2

The London Interbank Offered Rate.

X Footnote 3

In a recent speech Chairman Bernanke, while stressing the importance of market discipline and the problem of moral hazard, said that "the failure of a major financial institution at a time when financial markets are already quite fragile poses too great a threat to financial and economic stability to be ignored. In such cases, intervention is necessary to protect the public interest. The problems of moral hazard and the existence of institutions that are 'too big to fail' must certainly be addressed, but the right way to do this is through regulatory changes, improvements in the financial infrastructure, and other measures that will prevent a situation like this from recurring. Going forward, reforming the system to enhance stability and address the problem of 'too big to fail' should be a top priority for lawmakers and regulators." The Chairman’s speech, Federal Reserve Policies in the Financial Crisis, is available at http://www.federalreserve.gov/newsevents/speech/bernanke20081201a.htm.

X Footnote 4

I discussed the benefits that central bank policymakers gain from having supervisory roles and relationships in a speech in Seoul in March. “Bank Supervision and Central Banking: Understanding Credit During a Time of Financial Turmoil” is available on the Boston Fed’s website at http://www.bos.frb.org/news/speeches/rosengren/2008/032708.htm

X Footnote 5

For more on issues of liquidity, liquidity-risk concerns, and systemic risk, see speeches entitled “Liquidity and Systemic Risk” and “The Impact of Financial Institutions and Financial Markets on the Real Economy: Implications of a Liquidity Lock.’”

X Footnote 6

Some observe that another lesson of the recent turmoil involves possible over-reliance on short-term debt throughout the financial system.

X Figure 1:
Asset-Backed Commercial Paper Rate and the Federal Funds Target Rate

July 1, 2008 - November 28, 2008

Source: Federal Reserve Board / Haver Analytics

X Figure 2:
Commercial Paper Issuance

July 2, 2007 – November 28, 2008

Source: Federal Reserve Board / Haver Analytics

X Figure 3:
Spread: One-Month London Interbank Offered Rate (LIBOR) to Overnight Index Swap (OIS) Rate

January 1, 2007 - November 28, 2008

Source: Financial Times, Bloomberg / Haver Analytics

X Figure 4:
S&P/Case-Shiller Home Price Indices: Composite and Selected Metropolitan Areas

January 2001 - September 2008

Source: S&P/Case-Shiller / Haver Analytics