we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup

From The Economics Of Contempt:

"Too Big to Fail" Experts on "Make Them Smaller" Idea

Gary Stern and Ron Feldman, Minneapolis Fed President and Senior Vice President, respectively, are without question the leading experts on the "too big to fail" (TBTF) issue. In 2004, they published an excellent book called, Too Big to Fail: The Hazards of Bank Bailouts. TBTF is an issue they've been thinking and writing about for many, many years.

I've argued that the "too big to fail, too big to exist" idea is ridiculous, and is "the kind of thing people say at cocktail parties to make themselves sound smart without having to do any serious work." People who think the solution to the TBTF problem is to cap bank size fundamentally misunderstand the nature of TBTF.

Stern and Feldman recently addressed this proposed solution, which they call the "make them smaller" movement. And they agree that it's only satisfying on a very superficial level:

These dynamics of firm risk-taking mean that the make-them-smaller reform offers protection with a Maginot line flavor. That is, it appears sensible and effective—even impregnable—but in fact it provides only a false sense of security that may lull policymakers into inaction on other fronts.

They make many of the same points I made, such as the disconnect between bank size and systematic importance, and the limiting effect such a hard cap would have on FDIC resolution policy. Here's Stern and Feldman on bank size as an inappropriate metric:

[S]uch a metric [asset size] will not likely capture some or perhaps many firms that pose systemic risk. Some firms that pose systemic risk are very large as measured by asset size, but others—Northern Rock and Bear Stearns, for example—are not. Other small firms that perform critical payment processing pose significant systemic risk, but would not be identified with a simple size metric. We believe that a government or public agent with substantial private information could identify firms likely to impose systemic risk, but only by looking across many metrics and making judgment calls. Policymakers cannot easily capture such underlying analytics in a simple metric used to break up the firms.

On the difficulty of maintaining a hard cap on bank size:

The dynamic challenge concerns both the ability of government to keep firms below the size threshold over time and the future decisions of firms that could increase the systemic risk they pose.

On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and thereby enlarging the latter. We would also anticipate firms’ stakeholders, who could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic benefits of larger size, and those arguments have some heft. Current academic research finds potential scale benefits in all bank size groups, including the very largest.³ (Indeed, policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.)
...
Even if policymakers could get the initial list of firms right and were able to keep the post-breakup firms small, this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk. Newly shrunken firms could, for example, shift their portfolios to assets that suffer catastrophic losses when economic conditions fall off dramatically. As a result, creditors (including other financial firms) of the "small" firms could suffer significant enough losses to raise questions about their own solvency precisely when policymakers are worried about the state of the economy. Moreover, funding markets might question the solvency of other financial firms as a result of such an implosion.

Such spillovers prompted after-the-fact protection of financial institution creditors in the current crisis, and we believe they would do so again, all else equal. One might call on supervision and regulation to address such high-risk bets. But the rationale for the make-them-smaller reform seems dubious in the first place if such oversight were thought to work.

Stern and Feldman's longtime proposal for solving the TBTF problem is to set up a credible insolvency regime for systematically significant banks and nonbank financial institutions, funded by insurance premiums that account for firms' spillover costs.

Posted by Economics of Contempt "

Me:

Don said...

Real Time Economics also posted this:

http://blogs.wsj.com/economics/2009/03/31/another-look-at-the-too-big-to-fail-problem/

"Stern offers a three-point approach for reducing the size and scope of spillovers from a firm’s failure to prevent the need for intervention:

1) Early identification: Central banks and other bank-supervision agencies can conduct failure simulation exercises to identify problems around derivatives contracts, resolution regimes and overseas operations. One option would be to require too-big-to-fail firms to prepare documentation of their ability to enter the functional equivalent of a prepackaged bankruptcy.

2) Prompt corrective action: Bank supervisors would take actions against a bank as its capital falls below certain triggers. “Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way,” he says.

3) Communication: Policymakers must communicate that creditors may be put at risk of loss."

I used to agree with this, and called my view Bagehot's Principles. But it won't work, precisely because of the very problem that they state makes limiting bank size unworkable: namely, politics:

"On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup."

"this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk"

Because they understand this, they present their plan as the following:

"In that vein, we recommend three interim steps that address concerns that might lead to support for the make-them-smaller option"

I'm fine with this, being a pragmatist, and because I follow Bagehot:

"We have confidence in our preferred approach of tackling spillovers directly by putting TBTF creditors at credible risk of loss."

That's Bagehot. Onerous conditions.

"Conclusion
There is no easy solution to TBTF. Our longstanding proposal to put creditors at risk of loss by managing spillovers will prove challenging to implement effectively. Cutting firms down to size may seem easy by comparison. It is not. The high stakes of making firms smaller will make it difficult to determine which to shrink, and even then, the government will not have an easy time managing risk-taking by newly shrunken firms.We do take the aims of the make-them-smaller reform seriously and in that vein suggest options in this regard that we think would be more effective, including a spillover-related tax built on the FDIC’s current deposit insurance premiums."

I agree, that limiting size is tough, and, even if you do, risk is still in the system. That's why I now favor Narrow/Limited Banking.

I support their proposals, but we've been trying them since Bagehot. Bagehot wasn't really for his own principles, in the sense that he was not a fan of the B of E, and saw these principles as being necessary because of having a Lender of Last Resort, like the B of E.

Since we have a LOLR, which will be taken as offering an implicit guarantee to intervene in a financial crisis, it is not enough to simply try and penalize banks. We must limit their function.

Don the libertarian Democrat

The FDIC resolution regime, he says, does not put creditors at banks at sufficient risk of facing losses

TO BE NOTED: From Real Time Economics:

"By Sudeep Reddy

Gary Stern, president of the Federal Reserve Bank of Minneapolis, has had the ultimate I-told-you-so year at the central bank.

His book, “Too Big To Fail: The Hazards of Bank Bailouts,” addresses the problems that arise when banks become too large, create risks to the financial system and then require government rescues to save the economy.

Stern

The book originally came out five years ago. That’s at least four years before bailouts of Bear Stearns, Citigroup, Bank of America, AIG and hundreds of banks that have received government money to help stay afloat.

In a speech at the Brookings Institution today, Stern kicked off his remarks (titled “Better Late Than Never”) with this line: “Destiny did not require society to bear the cost of the current financial crisis.”

Brookings this year is re-releasing the book (by Stern and co-author Ron Feldman), but Stern doesn’t seem terribly confident of the prospects for addressing the too-big-to-fail problem quickly. “I am quite concerned that policymakers may double-down on previous decisions,” he says, and some ideas in the current environment “will waste valuable time and resources.”

Stern offers a three-point approach for reducing the size and scope of spillovers from a firm’s failure to prevent the need for intervention:

1) Early identification: Central banks and other bank-supervision agencies can conduct failure simulation exercises to identify problems around derivatives contracts, resolution regimes and overseas operations. One option would be to require too-big-to-fail firms to prepare documentation of their ability to enter the functional equivalent of a prepackaged bankruptcy.

2) Prompt corrective action: Bank supervisors would take actions against a bank as its capital falls below certain triggers. “Closing banks while they still have positive capital, or at most a small loss, can reduce spillovers in a fairly direct way,” he says.

3) Communication: Policymakers must communicate that creditors may be put at risk of loss.

The re-release of Stern’s book comes as the Obama administration, the Federal Reserve and Congress discuss a new resolution regime for major financial institutions (similar to the FDIC’s power over banks).

While Stern says society will be better off with it, he doubts that approach “will correct as much of the [too-big-to-fail] problem as some observers anticipate.” The FDIC resolution regime, he says, does not put creditors at banks at sufficient risk of facing losses. “A new regime will not, by itself, put an end to the support we have seen over the last 20 months.”

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

"With limited purpose banking, financial crises would largely disappear. "

Here's a proposal with the same goal as my Bagehot's Principles in the FT:

"Putting an end to financial crises( I TOO BELIEVE THAT WE COULD DO THIS. )

January 27, 2009

by FT

By Christophe Chamley and Laurence J. Kotlikoff

T’was the year the country stood still. Not a car, truck, or bus rode the roads. No one drove to work, no one drove to shop, no one drove to visit. No one drove anywhere.

The reason was simple. No one could buy gas. Gas stations had gone broke.

Their owners had tired of netting pennies on the gallon. They wanted to surge their earnings. The big money, they learned from a Harvard MBA, was in securitising their services. So they started selling GODs - gas options for drivers.

Each GOD gave the driver the option to fill her tank for $3 per gallon. Drivers bought GODs religiously. And with gas selling for $2 a gallon, station owners didn’t worry.

Then the unthinkable happened. Gas prices sky-rocketed to $6 a gallon, and drivers began invoking their GODs( WHY WOULD THEY DO THIS IF THEY WERE GUARANTEED? ). Each GOD could save $3 per gallon per tank, and if you didn’t need gas, you held up a sign - “Gods for Cash!”

Station owners began cursing the GODs. They now had to buy gas at $6 a gallon and sell it for $3.

In short order, the owners went bust. They closed their stations and started looking for jobs in financial services. GODs became worthless, and the economy ground to a halt.

The economic moral is simple. If you want markets to function, don’t let critical market makers - those who connect suppliers and demanders (e.g., refineries and motorists) of essential products - gamble with their businesses. ( GAMBLE MEANS INVEST. THIS PROPOSAL IS SILLY. EVEN GOVERNMENT BONDS HAVE SOME RISK. THIS IS LIKE PROHIBITION, AND WILL SIMPLY MOVE MONEY TO OTHER COUNTRIES OR OTHER FORMS OF INVESTMENT. )

Apply the moral to banks and the regulatory prescription is clear. Don’t let banks take risky positions. Make banks stick to their two critical functions - mediating the payments system and connecting lenders to borrowers.

To safeguard the payment system, banks must hold 100 per cent reserves against their deposits either in cash or short-term US treasuries. With 100 per cent reserves, banks runs will be history.( COME ON. )

This is not true of the current system, notwithstanding Federal Deposit Insurance Corp insurance. The FDIC’s potential liability exceeds $4 tn; its assets are less than $50 bn. A run on the banks would require massive money creation and engender greater economic panic.

To ensure their second function - the uninterrupted connection of suppliers of and demanders for funds - banks should be limited to a) packaging conforming mortgages and conforming business loans (commercial paper) within mutual funds and b) marketing these mutual funds to the public. The model here is Fidelity, not Lehman Brothers.

Yes, this proposed banking system is not your father’s Oldsmobile. But Jimmy Stewart is not your banker. Some overpaid chief executive thousands of miles away is deciding whether to foreclose your home and shutter your business. The clerk running your branch isn’t applying personal knowledge in deciding to lend you money or call your loan. He’s plugging your credit rating, collateral, and loan amounts in a computer and conveying the answer.( I AGREE THAT THIS IS A NEGATIVE. )

With the government ready to absorb losses, banks are talking outrageous risks knowing that Uncle Sam will cover them if things go south( TRUE ). Raising the trivially low capital requirements of banks, as Paul Volker’s Group of Thirty Commission just proposed, won’t change this behaviour( I AGREE. ).

What will change this behaviour is to not let it happen( NO. WHAT WILL CHANGE THEIR BEHAVIOR IS TAKING THE BANKS AWAY FROM THEM AND PROSECUTING OR SUING THEM WHERE WARRANTED. ). Banks should be allowed to initiate only conforming, i.e., government-approved, AAA-rated mortgages and business loans. These would be long-term, fixed-rate loans with 20 per cent-down and payments below 25 per cent of income.

The government, via the Federal Financial Authority, would use tax records to verify loan payment-to-income ratios. It would also spot check collateral. Once approved, the banks would bundle and sell “their” loans within mutual funds.

Again, traditional bank runs wouldn’t arise( THEY HAVEN'T BEEN HAPPENING TODAY EITHER. ). And today’s bank runs( IT'S A CALLING RUN, WHICH IS DIFFERENT THAN A BANK RUN, ALTHOUGH OPERATIONALLY SIMILAR. ), which entail lenders and equity investors avoiding risky banks, wouldn’t either. Why? Because banks would bear zero risk. Mutual fund owners would bear risk, but not the banks. And these lenders would know they were buying government-approved AAA-rated loans, not Bear Stearns‘ CDOs.

This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.

With limited purpose banking, financial crises would largely disappear. Banks would never fail( WHAT ABOUT OTHER FINANCIAL CONCERNS ), never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs - like gas stations.

The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.

Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 per cent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode.

What about investment banks, brokerage firms, hedge funds, and insurance companies? What’s their right financial order?

Again, regulate to purpose. Investment banks take companies public and assist in mergers and acquisitions. They shouldn’t be permitted to invest in their clients’ companies. Brokerage firms are here to help us buy and sell assets, not to gamble on spreads. Hedge funds are here to help limit risk exposure. They aren’t here to insure these risks themselves. Finally, insurance companies are here to diversify risk, not write insurance against aggregate shocks. ( WHO SAID THEY WERE? THEY'RE HERE TO MAKE MONEY. )

The FFA and “less is more” limited purpose banking won’t prevent asset markets from occasionally going nuts. But the functioning of financial markets will no longer be in question. Nor will con artists, parading as “financial engineers,” ever again be free to wreak havoc on the nation’s finances and its citizenry.( THIS SEEMS LIKE AN OVERREACTION WHICH WILL HINDER GROWTH GOING FORWARD. MY LIST OF BAGEHOT'S PRINCIPLES WILL DO THE SAME THING IF IMPLEMENTED, WITHOUT PANICKING WITH UNWARRANTED RESTRICTIONS ON BANKING. )

Christophe Chamley is a member of Boston University and the Paris School of Economics. Laurence J. Kotlikoff is professor of economics at Boston University

"They should embrace the inevitable and just nationalize the two banks."

At least Felix Salmon agrees with me:

"Nationalize Citigroup and Bank of America

Both Citigroup and Bank of America are down more than 20% in early trade today, and I imagine that Hank Paulson and Tim Geithner are starting work on yet another weekend deal of some description, since at this rate it seems that neither institution is capable of surviving in its present form much longer. They should embrace the inevitable and just nationalize the two banks.( I AGREE )

Any deal will be necessarily complicated by the fact that Paulson dragged his heels when it came to requesting the second tranche of TARP funds, even after he blew through the first $350 billion in no time. As a result, it's far from clear what money Treasury can use to shore up two of America's most systemically-important financial institutions.

On the other hand, this isn't a bank run( TRUE ): Citi and BofA aren't suffering from liquidity problems. They have all the liquidity they need, thanks to the Fed. The problem is one of solvency: the equity markets simply don't believe that the banks' assets are worth more than their liabilities.( THAT'S WHY YOU NEED TOTAL GOVERNMENT GUARANTEES, INCLUDING CONTROL, IN A CALLING RUN )

I can't see a solution to this problem short of nationalizing both Citi and BofA, and summarily firing the hapless Vikram Pandit along with the overambitious Ken Lewis. Lewis thought he could buy his way out of trouble, by acquiring Merrill Lynch; instead, he was simply tying his own already-troubled institution to an even more troubled institution. Pandit, it's worth noting, tried the same hail-Mary technique, when he put together a deal to buy Wachovia, but that didn't last long.

Citigroup, at $3.50 a share, simply doesn't have the time to implement its new plan to get smaller slowly. And Bank of America, at $7.75 a share, doesn't have the capital needed to absorb Merrill Lynch. Both are now trading at option value: on the hope, essentially, that somehow equity holders won't be wiped out entirely. But they should indeed be wiped out, as part of a nationalization, along with preferred shareholders, including the government( I AGREE. BAGEHOT'S PRINCIPLES ). TARP will show an immediate loss on its investments, which will serve as a salutary reminder for whoever's in charge of disbursing the second tranche.

Nationalization is a messy solution, and one which will make no one happy. But it's better than desperately trying to kick the ball down the field until the banks come back in a few weeks for even more money. If we've learned anything from the last Citi bailout, it's that small interventions don't work( HYBRIDS DON'T WORK EITHER. ). What's needed now is a complete revamp of both banks' capital structures, and a brand-new owner."

This has been my predicted outcome from the beginning.

who will be doing the scrutinizing? The New York Fed? The SEC? The OCC? The OTS? Treasury? A new and untested super-regulator?

Felix Salmon reviews the new West End romp Bernanke at the LSE:

"Bernanke's Unconvincing Confidence

Ben Bernanke's speech in London this morning constitutes a clear overview of the various bullets that the Fed has fired into the onrushing crisis. But he starts off with a bold and puzzling claim:

I believe that the Fed still has powerful tools at its disposal to fight the financial crisis and the economic downturn, even though the overnight federal funds rate cannot be reduced meaningfully further.

The natural response to this is simple: if you still have powerful tools at your disposal, why haven't you used them already? ( I AGREE )And why did you enact that final rate cut to zero, which necessarily comes accompanied by all manner of nasty consequences in the repo markets and at money-market funds? That decision certainly made it seem as though the Fed believes a marginal further reduction in the Fed funds rate is still far more effective than any of its other policies.( A GOOD POINT )

Bernanke is of course a bank regulator as well as a setter of monetary policy, and so this kind of thing comes as no surprise:

Fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.

I do wonder, though, whether the Fed is making enough of a distinction between the financial system, on the one hand, and the companies which comprise it, on the other. Can't we build a strong financial system, perhaps through nationalizing failing institutions, in a way which doesn't reward the people who screwed up the old one( THAT WOULD BE PREFERABLE )? Rather than spinning off bad banks, why not spin off good banks instead, and put them under new ownership and new management?( TRUE )

This, however, is the closest that Bernanke comes:

Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail." It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period. The existence of too-big-to-fail firms also violates the presumption of a level playing field among financial institutions. In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking.

I take this to mean that Goldman Sachs and Morgan Stanley aren't going to be able to be freewheeling investment banks again, at least not for the foreseeable future: instead, they should expect "especially close regulatory scrutiny" -- as should the large commercial banks. But who will be doing the scrutinizing? The New York Fed? The SEC? The OCC? The OTS? Treasury? A new and untested super-regulator?( PUT IN BAGEHOT'S PRINCIPLES. THEY'LL GET THE MESSSAGE. )

Color me unconvinced, for the time being, that this will actually work, especially so long as the Fed chairman is generally chosen from the ranks of economists rather than regulators. After all, as Jeff Madrick says, the entire economics profession has garnered itself a big fat F during this crisis. Why should we trust the economists now -- even ones from Princeton?"

I disagree. I believe that Bernanke's got a good handle on the problems, but not on the solutions. I don't think that we can blame only him for the reticence to take the banks over and guarantee the entire system quickly, which is what I would have done. I certainly would have taken over Lehman, and not let it fall.

We should be skeptical, but that's because our system is based upon banks and other large financial concerns believing that they are too big to fail, and their lobbying and gaming the system assuring them of that fact. The Investor Class is in fact the major supporter and beneficiary of our current system, and changing that is a mighty tough task. That's the problem.

government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period

Chairman Bernanke's speech today:

Chairman Ben S. Bernanke

At the Stamp Lecture, London School of Economics, London, EnglandJanuary 13, 2009

The Crisis and the Policy Response

For almost a year and a half the global financial system has been under extraordinary stress--stress that has now decisively spilled over( YES. THAT'S HOW TO LOOK AT IT. THE TWO ARE SEPARATE EVENTS. ) to the global economy more broadly. The proximate cause of the crisis was the turn of the housing cycle in the United States and the associated rise in delinquencies on subprime mortgages( YES ), which imposed substantial losses on many financial institutions( AND STARTED A CALLING RUN ) and shook investor confidence in credit markets. However, although the subprime debacle triggered the crisis, the developments in the U.S. mortgage market were only one aspect of a much larger and more encompassing credit boom whose impact transcended the mortgage market to affect many other forms of credit( TRUE ). Aspects of this broader credit boom included widespread declines in underwriting standards( LOWER CAPITAL REQUIREMENTS. THE REAL PROBLEM. ), breakdowns in lending oversight by investors and rating agencies( FRAUD, NEGLIGENCE, FIDUCIARY MISMANAGEMENT, AND COLLUSION. ), increased reliance on complex and opaque credit instruments that proved fragile under stress( TOO LITTLE CAPITAL AND HARD TO SELL. ), and unusually low compensation for risk-taking( GOVERNMENT GUARANTEES. ).

The abrupt end of the credit boom has had widespread financial and economic ramifications. Financial institutions have seen their capital depleted by losses and writedowns and their balance sheets clogged by complex credit products and other illiquid assets of uncertain value. Rising credit risks and intense risk aversion( THE MAIN PROBLEM HERE IS THE FEAR AND AVERSION TO RISK. ) have pushed credit spreads to unprecedented levels( THEY ARE NOW COMING DOWN. ), and markets for securitized assets, except for mortgage securities with government guarantees( THAT'S WHY ), have shut down( SOME ARE, IN FACT, BEING BOUGHT BY SMART INVESTORS. ). Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence( THE PROACTIVITY RUN ) and precipitated a sharp slowing in global economic activity. The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial.

The global economy will recover, but the timing and strength of the recovery are highly uncertain. Government policy responses around the world will be critical determinants of the speed and vigor of the recovery( I AGREE ). Today I will offer some thoughts on current and prospective policy responses to the crisis in the United States, with a particular emphasis on actions by the Federal Reserve. In doing so, I will outline the framework that has guided the Federal Reserve's responses to date. I will also explain why I believe that the Fed still has powerful tools at its disposal to fight the financial crisis and the economic downturn, even though the overnight federal funds rate cannot be reduced meaningfully further( ZIRP ).

The Federal Reserve's Response to the Crisis
The Federal Reserve has responded aggressively to the crisis since its emergence in the summer of 2007. Following a cut in the discount rate (the rate at which the Federal Reserve lends to depository institutions) in August of that year, the Federal Open Market Committee began to ease monetary policy in September 2007, reducing the target for the federal funds rate by 50 basis points.¹ As indications of economic weakness proliferated, the Committee continued to respond, bringing down its target for the federal funds rate by a cumulative 325 basis points by the spring of 2008. In historical comparison, this policy response stands out as exceptionally rapid and proactive. In taking these actions, we aimed both to cushion the direct effects of the financial turbulence on the economy and to reduce the virulence of the so-called adverse feedback loop, in which economic weakness and financial stress become mutually reinforcing.

These policy actions helped to support employment and incomes during the first year of the crisis. Unfortunately, the intensification of the financial turbulence last fall led to further deterioration in the economic outlook. The Committee responded by cutting the target for the federal funds rate an additional 100 basis points last October, with half of that reduction coming as part of an unprecedented coordinated interest rate cut by six major central banks on October 8. In December the Committee reduced its target further, setting a range of 0 to 25 basis points for the target federal funds rate.

The Committee's aggressive monetary easing was not without risks. During the early phase of rate reductions, some observers expressed concern that these policy actions would stoke inflation. These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities. The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation expectations. However, the Committee also maintained the view that the rapid rise in commodity prices in 2008 primarily reflected sharply increased demand for raw materials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. Committee members expected that, at some point, global economic growth would moderate, resulting in slower increases in the demand for commodities and a leveling out in their prices--as reflected, for example, in the pattern of futures market prices. As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation has already declined significantly and appears likely to moderate further.( TRUE )

The Fed's monetary easing has been reflected in significant declines in a number of lending rates, especially shorter-term rates, thus offsetting to some degree the effects of the financial turmoil on financial conditions. However, that offset has been incomplete, as widening credit spreads, more restrictive lending standards, and credit market dysfunction have worked against the monetary easing and led to tighter financial conditions overall. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Thus, in addition to easing monetary policy, the Federal Reserve has worked to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector. In doing so, as I will discuss shortly, the Fed has deployed a number of additional policy tools, some of which were previously in our toolkit and some of which have been created as the need arose.

Beyond the Federal Funds Rate: The Fed's Policy Toolkit
Although the federal funds rate is now close to zero, the Federal Reserve retains a number of policy tools that can be deployed against the crisis.

One important tool is policy communication. Even if the overnight rate is close to zero, the Committee should be able to influence longer-term interest rates by informing the public's expectations about the future course of monetary policy. To illustrate, in its statement after its December meeting, the Committee expressed the view that economic conditions are likely to warrant an unusually low federal funds rate for some time.² To the extent( SMALL EFFECT ) that such statements cause the public to lengthen the horizon over which they expect short-term rates to be held at very low levels, they will exert downward pressure on longer-term rates, stimulating aggregate demand. It is important, however, that statements of this sort be expressed in conditional fashion( FINE )--that is, that they link policy expectations to the evolving economic outlook. If the public were to perceive a statement about future policy to be unconditional, then long-term rates might fail to respond in the desired fashion should the economic outlook change materially.

Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy. As I will elaborate, I find it useful to divide these tools into three groups. Although these sets of tools differ in important respects, they have one aspect in common: They all make use of the asset side of the Federal Reserve's balance sheet. That is, each involves the Fed's authorities to extend credit or purchase securities.

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to sound financial institutions. Over the course of the crisis, the Fed has taken a number of extraordinary actions to ensure that financial institutions have adequate access to short-term credit. These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed's discount window.³ For example, since August 2007 we have( 1 ) lowered the spread between the discount rate and the federal funds rate target from 100 basis points to 25 basis points;( 2 ) increased the term of discount window loans from overnight to 90 days; ( 3 )created the Term Auction Facility, which auctions credit to depository institutions for terms up to three months;( 4 ) put into place the Term Securities Lending Facility, which allows primary dealers to borrow Treasury securities from the Fed against less-liquid collateral; and ( 5 ) initiated the Primary Dealer Credit Facility as a source of liquidity for those firms, among other actions.

Because interbank markets are global in scope, the Federal Reserve has also approved( 6 ) bilateral currency swap agreements with 14 foreign central banks. The swap facilities have allowed these central banks to acquire dollars from the Federal Reserve to lend to banks in their jurisdictions, which has served to ease conditions in dollar funding markets globally. In most cases, the provision of this dollar liquidity abroad was conducted in tight coordination with the Federal Reserve's own funding auctions.

Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers. In the case of currency swaps, the foreign central banks are responsible for repayment, not the financial institutions that ultimately receive the funds; moreover, as further security, the Federal Reserve receives an equivalent amount of foreign currency in exchange for the dollars it provides to foreign central banks.

Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confidence, financial institutions will be able to meet the resulting demands for cash without resorting to potentially destabilizing fire sales of assets( A CALLING RUN. THESE WERE DECENT MOVES. ). Moreover, backstopping the liquidity needs of financial institutions reduces funding stresses( A CALLING RUN. THIS CAN ONLY BE DONE BY THE GOVERNMENT. I DON'T DISAGREE WITH WHAT HE'S TRYING TO DO AT ALL. I AGREE WITH HIM. I SIMPLY DISAGREE ABOUT SOME OF THE MEANS EMPLOYED. ) and, all else equal, should increase the willingness( THE PROBLEM IS THAT THIS HAS TO DO WITH THE FEAR AND AVERSION TO RISK. THE PROACTIVITY RUN WE'RE IN HAS CAUSED THIS TO REMAIN HIGH, EVEN AFTER ALL OF THESE ACTIONS BY THE FED. BUT IT IS GETTING BETTER. ) of those institutions to lend and make markets.

On the other hand, the provision of ample liquidity to banks and primary dealers is no panacea. Today, concerns about capital, asset quality, and credit risk continue to limit the willingness of many intermediaries to extend credit, even when liquidity is ample. Moreover, providing liquidity to financial institutions does not address directly instability or declining credit availability in critical nonbank markets, such as the commercial paper market or the market for asset-backed securities, both of which normally play major roles in the extension of credit in the United States.

To address these issues, the Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly( A GOOD IDEA ) to borrowers and investors in key credit markets. Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds. In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve's credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a "haircut"( A PENALTY ) and the Treasury is providing $20 billion of capital as supplementary loss protection( THIS WOULD BE A LOSS ). We expect this facility to be operational next month.

The rationales and objectives of our various facilities differ, according to the nature of the problem being addressed. In some cases, as in our programs to backstop money market mutual funds, the purpose of the facility is to serve, once again in classic central bank fashion, as liquidity provider of last resort( LOLR ). Following a prominent fund's "breaking of the buck"--that is, a decline in its net asset value below par--in September, investors began to withdraw funds in large amounts from money market mutual funds that invest in private instruments such as commercial paper and certificates of deposit( A BANK RUN ) Fund managers responded by liquidating assets and investing at only the shortest of maturities. As the pace of withdrawals increased, both the stability of the money market mutual fund industry and the functioning of the commercial paper market were threatened. The Federal Reserve responded with several programs, including a facility to finance bank purchases of high-quality asset-backed commercial paper from money market mutual funds. This facility effectively channeled liquidity to the funds, helping them to meet redemption demands without having to sell assets indiscriminately( A CALLING RUN ). Together with a Treasury program that provided partial insurance to investors in money market mutual funds, these efforts helped stanch the cash outflows from those funds and stabilize the industry.( THIS WORKED, SHOWING THAT A CALLING RUN CAN BE STOPPED BY GOVERNMENT ACTIONS AND GUARANTEES. )

The Federal Reserve's facility to buy high-quality (A1-P1) commercial paper at a term of three months was likewise designed to provide a liquidity backstop, in this case for investors and borrowers in the commercial paper market. As I mentioned, the functioning of that market deteriorated significantly in September, with borrowers finding financing difficult to obtain, and then only at high rates and very short (usually overnight) maturities. By serving as a backup source of liquidity for borrowers( A GUARANTOR ), the Fed's commercial paper facility was aimed at reducing investor and borrower concerns about "rollover risk," the risk that a borrower could not raise new funds to repay maturing commercial paper. The reduction of rollover risk, in turn, should increase the willingness of private investors to lend, particularly for terms longer than overnight. These various actions appear to have improved the functioning of the commercial paper market, as rates and risk spreads have come down and the average maturities of issuance have increased.

In contrast, our forthcoming asset-backed securities program, a joint effort with the Treasury, is not purely for liquidity provision. This facility will provide three-year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans( QUALITATIVE EASING ). Unlike our other lending programs, this facility combines Federal Reserve liquidity with capital provided by the Treasury, which allows it to accept some credit risk( TRUE ). By providing a combination of capital and liquidity, this facility will effectively substitute public for private balance sheet capacity, in a period of sharp deleveraging( A CALLING RUN ) and risk aversion( WHAT WE NEED TO DEFEAT ) in which such capacity appears very short. If the program works as planned, it should lead to lower rates and greater availability of consumer and small business credit. Over time, by increasing market liquidity and stimulating market activity, this facility should also help to revive private lending. Importantly, if the facility for asset-backed securities proves successful, its basic framework can be expanded to accommodate higher volumes or additional classes of securities as circumstances warrant( THIS GOVERNMENT GUARANTEE IS NEEDED TO STOP A CALLING RUN. ).

The Federal Reserve's third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio. For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. Notably, mortgage rates dropped significantly on the announcement of this program and have fallen further since it went into operation ( TRUE ). Lower mortgage rates should support the housing sector. The Committee is also evaluating the possibility of purchasing longer-term Treasury securities. In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.

These three sets of policy tools--lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities--have the common feature that each represents a use of the asset side of the Fed's balance sheet, that is, they all involve lending or the purchase of securities. The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound.( TRUE )

Credit Easing versus Quantitative Easing
The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet( YES ). However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition( QUALITATIVE EASING ) of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally( OK ).

The stimulative effect of the Federal Reserve's credit easing policies depends sensitively on the particular mix of lending programs and securities purchases that it undertakes. When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market. Because various types of lending have heterogeneous effects, the stance of Fed policy in the current regime--in contrast to a QE regime--is not easily summarized by a single number, such as the quantity of excess reserves or the size of the monetary base. In addition, the usage of Federal Reserve credit is determined in large part by borrower needs and thus will tend to increase when market conditions worsen and decline when market conditions improve. Setting a target for the size of the Federal Reserve's balance sheet, as in a QE regime, could thus have the perverse effect of forcing the Fed to tighten the terms and availability of its lending at times when market conditions were worsening, and vice versa.( OK )

The lack of a simple summary measure or policy target poses an important communications challenge. To minimize market uncertainty( FEAR AND AVERSION TO RISK ) and achieve the maximum effect of its policies, the Federal Reserve is committed( ESSENTIAL ) to providing the public as much information as possible about the uses of its balance sheet, plans regarding future uses of its balance sheet, and the criteria on which the relevant decisions are based.⁴

Exit Strategy
Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary( TRUE ). The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded( THEN IT HAS ). However, banks are choosing to leave the great bulk of their excess reserves idle( STILL... ), in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.( TRUE )

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs( TRUE ). To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize. In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy.( GOOD )

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return( MORE WILL BE ASKED OF IT NOW ) to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters. Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term( BECAUSE WE WANT TO MAKE A PROFIT ), which will slow the rate at which our balance sheet can shrink. We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

Importantly, the management of the Federal Reserve's balance sheet and the conduct of monetary policy in the future will be made easier by the recent congressional action to give the Fed the authority to pay interest on bank reserves. In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors( A POOR INCENTIVE IN CURRENT CIRCUMSTANCES ). However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate.

Moreover, other tools are available or can be developed to improve control of the federal funds rate during the exit stage. For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system. In considering whether to create or expand its programs, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster full employment and price stability.( GOOD LUCK )

Stabilizing the Financial System
The Federal Reserve will do its part to promote economic recovery, but other policy measures will be needed as well. The incoming Administration and the Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity. In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.

In the United States, a number of important steps have already been taken to promote financial stability, including the Treasury's injection of about $250 billion of capital into banking organizations, a substantial expansion of guarantees for bank liabilities by the Federal Deposit Insurance Corporation, and the Fed's various liquidity programs. Those measures, together with analogous actions in many other countries, likely prevented a global financial meltdown in the fall that, had it occurred, would have left the global economy in far worse condition than it is in today. ( TRUE. ALLOWING A CALLING RUN TO CONTINUE UNTIL IT NATURALLY ENDS WOULD HAVE BEEN A DISASTER, FINANCIALLY AND SOCIALLY. )

However, with the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees( THIS IS THE SOLUTION ) may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions' balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered. Public purchases of troubled assets are one possibility. Another is to provide asset guarantees( I FAVOR THIS. HOWEVER, I MIGHT PREFER WE JUST TOOK THEM OVER. ), under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks. Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank( A POSSIBLE APPROACH, IF THE BANKS ARE GUARANTEED. ). These methods are similar from an economic perspective, though they would have somewhat different operational and accounting implications. In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.( WHAT'S IMPORTANT ARE THE GUARANTEES. THEORETICALLY, WE COULD JUST BUY THESE THINGS, BUT THE POLITICAL PITFALLS ARE HUGE. WHO WOULD DO IT? WILL IT BE SEEN AS OVERPAYING? ANY GOVERNMENT INTERVENTION WILL RAISE THE PRICE OF THE TOXIC ASSETS, SO SOME KIND OF ONEROUS EXCHANGE WOULD BE NECESSARY. UNDER THAT CONDITION, ANY OF THE THREE CHOICES WOULD WORK. BUT IT CAN'T BE AS POORLY NEGOTIATED AS TARP. )

The public in many countries is understandably concerned by the commitment of substantial government resources to aid the financial industry when other industries receive little or no assistance. This disparate treatment, unappealing as it is, appears unavoidable( IT WON'T WORK. SOME MONEY WILL HAVE TO BE SPENT ELSEWHERE. ). Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt. Indeed, the destructive effects of financial instability on jobs and growth are already evident worldwide. Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest( GOOD LUCK. ).

Even as we strive to stabilize financial markets and institutions worldwide, however, we also owe the public near-term, concrete actions to limit the probability and severity of future crises. We need stronger supervisory( MY VIEW ) and regulatory systems under which gaps and unnecessary duplication( RATIONALIZATION ) in coverage are eliminated, lines of supervisory authority and responsibility are clarified, and oversight powers are adequate to curb excessive leverage and risk-taking. In light of the multinational character of the largest financial firms and the globalization of financial markets more generally, regulatory oversight should be coordinated( A GOOD IDEA ) internationally to the greatest extent possible. We must continue our ongoing work to strengthen the financial infrastructure--for example, by encouraging the migration of trading in credit default swaps and other derivatives to central counterparties and exchanges( FINE ). The supervisory authorities should develop the capacity for increased surveillance of the financial system as a whole( MY VIEW ), rather than focusing excessively on the condition of individual firms in isolation; and we should revisit capital regulations, accounting rules, and other aspects of the regulatory regime to ensure that they do not induce excessive procyclicality in the financial system and the economy( TRUE ). As we proceed with regulatory reform, however, we must take care not to take actions that forfeit the economic benefits of financial innovation and market discipline( I AGREE ).

Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail." It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period( THAT'S WHAT ALLOWED THEM TO DO IT. THEY WERE COUNTING ON YOU. IT WORKED. THIS IS THE MAIN CAUSE OF OUR CRISIS. THE IMPLICIT GUARANTEES THAT WERE THE UNDERPINNING OF THIS RISKY INVESTMENT. ). The existence of too-big-to-fail firms also violates the presumption of a level playing field among financial institutions. In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking( TRUE ). Also urgently needed in the United States is a new set of procedures for resolving failing nonbank institutions deemed systemically critical( ESSENTIAL ), analogous to the rules and powers that currently exist for resolving banks under the so-called systemic risk exception.( THEY SHOULD FALL UNDER BAGEHOT'S PRINCIPLES. )

Conclusion
The world today faces both short-term and long-term challenges. In the near term, the highest priority is to promote a global economic recovery. The Federal Reserve retains powerful policy tools and will use them aggressively to help achieve this objective. Fiscal policy can stimulate economic activity, but a sustained recovery will also require a comprehensive plan to stabilize the financial system and restore normal flows of credit.

Despite the understandable focus on the near term, we do not have the luxury of postponing work on longer-term issues. High on the list, in light of recent events, are strengthening regulatory oversight and improving the capacity of both the private sector and regulators to detect and manage risk.

Finally, a clear lesson of the recent period is that the world is too interconnected for nations to go it alone in their economic, financial, and regulatory policies. International cooperation is thus essential( I AGREE ) if we are to address the crisis successfully and provide the basis for a healthy, sustained recovery.

MY MAIN CRITICISM HAS BEEN THE DITHERING ABOUT THE DEPTH AND BREADTH OF THE GUARANTEES. IN A CALLING RUN, THE GOVERNMENT MUST MAKE PLAIN THAT IT WILL DO ANYTHING THAT IT CAN TO STOP IT. BY SEEMING TO BE DECIDING ON A CASE BY CASE BASIS IN AN UNCLEAR MANNER, THE NECESSARY GUARANTEES WERE NOT FORTHCOMING. THIS HAS, PARADOXICALLY, LED TO MORE MONEY HAVING TO BE SPENT. THE WHOLE POINT IS TO EASE THE FEAR AND AVERSION TO RISK, AND STOP THE CALLING RUN BEFORE GOVERNMENT FUNDS ARE ACTUALLY NEEDED. THAT'S THE WHOLE POINT OF THE GUARANTEES. TO FORESTALL THEM BEING USED. THE CURRENT PROBLEM WAS CAUSED BY NOT HAVING BAGEHOT'S PRINCIPLES IN PLACE, WHICH WOULD HAVE MADE COMING TO THE GOVERNMENT FOR HELP A VERY UNPLEASANT DECISION INDEED( WE WOULD HAVE TAKEN THEM OVER IN ESSENCE ). IN OUR CURRENT CRISIS, COMING TO THE GOVERNMENT WAS THE LEAST ONEROUS DECISION. GET THE DIFFERENCE? )

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Footnotes

1. A basis point is one-hundredth of a percentage point. Return to text

2. Board of Governors of the Federal Reserve (2008), "FOMC Statement and Board Approval of Discount Rate Requests of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco," press release, December 16. Return to text

3. Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. The New York Fed's Open Market Desk engages in trades on behalf of the Federal Reserve System to implement monetary policy. Return to text

4. Detailed information about the Federal Reserve's balance sheet is published weekly as part of the H.4.1 release. For a summary of Fed lending programs, see Forms of Federal Reserve Lending to Financial Institutions (229 KB PDF). Return to text"

In hindsight, we readily see that at least one of the purported pathways to depression was never followed.

Here's something Casey Mulligan should get right, since he understands that the financial sector is not exactly wedded to the rest of the economy, but doesn't:

"October Hysteria in Hindsight

Copyright, The New York Times Company

After Lehman failed and “credit markets froze” in the second half of September 2008, many people proclaimed that a second Great Depression( I DIDN'T ) would unfold. In hindsight, we readily see that at least one of the purported pathways to depression was never followed.

During the first days of October 2008, it was claimed that businesses would not be able to borrow from banks even for basic operational expenses, such as making their payrolls. As employees had to work without pay (so the story goes), the businesses patronized by those employees would suffer, and the downward spiral would continue. Then presidential-candidate Barack Obama said that “the credit market is seized up and businesses, for instance, can't get loans to meet payroll.” It was even suggested that “recession proof” employers such as colleges and municipalities would not be able to pay their employees.

Now that a couple of months have passed, let’s look at payroll spending measured by the Bureau of Economic Analysis. The chart below shows payroll spending (measured in billions of dollars) for each of the months of second half of 2008 (December data not yet available), including contributions to pension and health funds for employees. Aggregate payroll spending was highest in August, and has remained within 0.1 percent of the August high ever since.



The Lehman Brothers investment bank failed on September 15. The bank was deeply intertwined with other financial institutions – its failure to pay its obligations put its creditors at risk – and brought the credit crisis to its crescendo. By the end of the month, the intense financial chaos motivated Mr. Obama and others to warn that banks needed lots of money from taxpayers, or else the banks’ business customers would not be able to pay their employees.

Because the bailout bill took time to pass, and then additional time for the Treasury to design and execute its $700 billion Capital Purchase Program (CPP), no bank received any money from the Treasury pursuant to the CPP until the last couple of days of October. Thus, if the warnings were right, payroll spending should have been precipitously lower in October than in the previous months. Instead, payroll spending was almost $1 billion dollars higher in October than in September – not exactly the collapse that we feared.

Some of the details of the CPP became known earlier in October. Anticipation of the CPP expenditures cannot explain why payroll spending did not collapse in October, because the purported pathway to depression was about the day-to-day cash needs of otherwise strong businesses. Even the United States Treasury admitted last week that “capital [from its CPP] needs to get into the system before it can have the desired effect.”

Even when some (but by no means all) of the CPP funds finally got “into the system” in the last days of October and the full month of November, Congress was dismayed to see that banks were not using the funds to lend. Nevertheless, payroll spending did not collapse in November, either.

It is true that payroll employment fell by about 850,000 in October and November – and that’s serious as compared to the last couple of recessions – but the payroll spending data show that the employment loss was small compared to the spending collapse forecasted in early October. The fact is that more than 136,000,000 workers received their paychecks – more than $1.3 trillion worth in October and November combined – essentially the same aggregate payroll that was paid out in the two months prior to Obama’s warning.

None of the above denies or confirms that our economy is headed for economic depression, because there are multiple pathways for getting there. Nor does it deny that the Treasury CPP might help in some way. But it does refute one of the scariest pathways to Depression – a collapse of payroll spending – that politicians from both parties alarmingly described to the American public in order to justify spending $700 billion of taxpayer funds on a bailout of United States banks."

Now, we have been dealing with two distinct events:
1) A Calling Run, followed by:
2) A Proactivity Run.

The Calling Run involved a panicked scramble to get out of declining assets and into cash, or guaranteed investments. The reason that this could effect lending was because many of the assets and investments that were being fled were loans, or other financial assets and investments held by banks. Quite naturally, if your lending practices and loans are leading you to a mad scramble to unload and untangle them, losing you an unknown sum of money, it is only natural that your lending would be curtailed. The fact that Mulligan doubts this defies belief. He only has to ask himself whether he would keep lending normally if his normal lending had led to enormous losses. Apparently he would. One explanation of the lending going on is the fact that many people had preexisting lines of credit and they accessed them. That's what these lines of credit were there for. As well, the government did intervene enough to keep some lending going on. Finally, there are small banks, for instance, who have been able to keep lending through this crisis. In any case, this run does not automatically lead to a Proactivity Run, because the financial sector is somewhat separate from the general economy. In any event, employment would certainly lag the Calling Run, at least until the extent of the Calling Run becomes clear.

In this crisis, the Proactivity Run, as opposed to simply some prudent downsizing, quite obviously began in the second half of November. It wouldn't be dramatic even here immediately, because some workers would be kept on until after the end of the holidays. By now it is obvious in both employment and consumption. In my opinion, the dithering about these bailouts, including the Automotive Bailout, have led to an Uncertainty Shock as to the level of government support. Now that the government has guaranteed more and more businesses, leading to the belief that the government will do whatever it takes to stop these runs, we are beginning to see a diminution in the fear and aversion to risk, as evidenced by the TED and VIX. My evidence for my position is the actual flow of investments.

One final thing. I don't know what is included in that compensation figure above, but, having run a business, I can tell you that if you let people off, you pay UI for them for a while. As well, if business stays higher than the employer estimates, he might have to pay more wages than he anticipates to the remaining workers. I have often found, after trimming my staff, that my payroll expenses remained the same for some time. A very annoying occurrence, but a real world one.

Finally, let me state the following: The Calling Run was not inevitable, and, even after it hit, the Proactivity Run was not inevitable. A system based on Bagehot's Principle's, I contend, would have stopped both. The handling of this crisis by the government, while better than nothing, has been a mess. That's how I see it.

our fear circuitry kicks in and panic ensues, a flight-to-safety leading to a market crash. This is where we are today.

From Freakonomics:

"This Is Your Brain on Prosperity: Andrew Lo on Fear, Greed, and Crisis Management

By Stephen J. Dubner

Andrew Lo

Andrew W. Lo is the Harris & Harris Group Professor at M.I.T. and director of its Laboratory for Financial Engineering. (Here are some of his papers.)

To my mind, he’s one of the most fluent guides to the state of modern finance in that he combines the rigors of a quant with a behavioralist’s appreciation for human intricacy( HUMAN AGENCY EXPLANATION ). He has agreed to write a guest post here (hopefully not his last — please encourage him!), an insightful look at how “extended periods of prosperity act as an anesthetic in the human brain,” lulling everyone involved into “a drug-induced stupor that causes us to take risks that we know we should avoid( WISHFUL THINKING ).”

Fear, Greed, and Crisis Management: A Neuroscientific Perspective
By Andrew W. Lo
A Guest Post

The alleged fraud perpetrated by Bernard Madoff is a timely and powerful microcosm of the current economic crisis, and it underscores the origin of all financial bubbles and busts: fear and greed( TRUE ).

Using techniques such as magnetic resonance imaging, neuroscientists have documented the fact that monetary gain stimulates the same reward circuitry as cocaine — in both cases, dopamine is released into the nucleus accumbens. Similarly, the threat of financial loss activates the same fight-or-flight circuitry as physical attacks, releasing adrenaline and cortisol into the bloodstream, which results in elevated heart rate, blood pressure, and alertness.( OK )

These reactions are hardwired into human physiology, and while some of us are able to overcome our biology through education, experience, or genetic good luck, the vast majority of the human population is driven( INFLUENCED ) by these “animal spirits” that John Maynard Keynes identified over 70 years ago.

From this neuroscientific perspective, it is not surprising that there have been 17 banking-related national crises around the globe since 1974, the majority of which were preceded by periods of rising real-estate and stock prices, large capital inflows, and financial liberalization. Extended periods of prosperity act as an anesthetic in the human brain, lulling investors, business leaders, and policymakers into a state of complacency, a drug-induced stupor that causes us to take risks that we know we should avoid( I AGREE THAT WISHFUL THINKING IS VERY IMPORTANT. HOWEVER, THOSE RISKS TAKEN INCLUDE CRIME, AND THE COMPLACENCY INCLUDES GOVERNMENT GUARANTEES AND EFFECTIVENESS. ).

In the case of Madoff, seasoned investors were apparently sucked into the alleged fraud despite their better judgment because they found his returns too tempting to pass up. In the case of subprime mortgages, homeowners who knew they could not afford certain homes proceeded nonetheless, because the prospects of living large and benefiting from home-price appreciation were too tempting to pass up. And investors in mortgage-backed securities, who knew that the AAA ratings were too optimistic given the riskiness of the underlying collateral, purchased these securities anyway because they found the promised yields and past returns too tempting to pass up.( SOME OF THIS IS CRIMINAL OR NEGLIGENT BEHAVIOR. )

If we add to these temptations a period of financial gain that anesthetizes the general population — including C.E.O.’s, chief risk officers, investors, and regulators — it is easy to see how tulip bulbs, internet stocks, gold, real estate, and fraudulent hedge funds could develop into bubbles. Such gains are unsustainable, and once the losses start mounting, our fear circuitry kicks in and panic ensues( I AGREE ), a flight-to-safety leading to a market crash. This is where we are today.( I AGREE COMPLETELY )

Like hurricanes, financial crises are a force of nature that cannot be legislated away, but we can greatly reduce the damage they do with proper preparation.( I DISAGREE. GOVERNMENT GUARANTEES AND BAGEHOT'S PRINCIPLES CAN RID US OF THIS PESTILENCE. )

Because the most potent form of fear is fear of the unknown, the most effective way to combat the current crisis is with transparency and education. In the short run, one way to achieve transparency is for our president-elect to convene a “crisis summit” once in office, in which all the major stakeholders involved in this crisis, and their most knowledgeable subordinates, are invited to an undisclosed location for an intensive week-long conference( NO ).

During this meeting, detailed information about exposures to “toxic assets,” concentrations of risky counterparty relationships, and other systemic weaknesses will be provided on a confidential basis to regulators and policymakers, and various courses of action can be proposed and debated in real time( NO. COLLUSION CENTRAL. ). Afterward, a redacted( YES. OF MEANING. ) summary of this meeting should be provided to the public by the president, along with a specific plan for addressing the major issues identified during the conference. This process would go a long way toward calming the public’s fears and restoring the trust and confidence that are essential to normal economic activity.( NO. GOVERNMENT GUARANTEES WILL. JAWBONING IS OF LIMITED, ALTHOUGH SOME, USE. )

In the long run, more transparency into the “shadow banking” system; more education for investors, policymakers, and business leaders; and more behaviorally oriented regulation( FINALLY. YES. ) will allow us to weather any type of financial crisis( I AGREE ). Regulation enables us to restrain our behavior during periods when we know we will misbehave; it is most useful during periods of collective fear or greed and should be designed accordingly( YES ). Corporate governance should also be revisited from this perspective; if we truly value naysayers during periods of corporate excess, then we should institute management changes to protect and reward their independence.( HOW ABOUT THEIR EFFECTIVENESS.)

If “crisis is a terrible thing to waste,” as some have argued, then we have a short window of opportunity — before economic recovery begins to weaken our resolve — to reform our regulatory infrastructure for the better. The fact that time heals all wounds may be good for our mental health, but it may not help maintain our economic wealth."

I disagree. Poor regulation and legislation result in a crisis. However hard and counterintuitive it is, we must address these issues in calmer times. This is no harder for a human to do than value investing.

"On the contrary, among the biggest supporters of both have been the world’s investors, at least insofar as their collective judgment "

Another good James Surowiecki post:

"Libertarians Against the Market

Tyler Cowen, in his ongoing effort to ensure that the government spends as little as possible in its attempt to stimulate the economy, cites approvingly a post by Arnold Kling arguing against a big fiscal-stimulus package, because the risks vastly outweigh the potential rewards (actually, Kling doesn’t really think there are any potential rewards from a stimulus plan). Kling enumerates those “risks” in a list. This is not a very useful list, because it contains absolutely no evidence for any of his assertions—he simply assumes the existence of his risks to be a fact—and no assertion about how likely any of these “risks” are, which makes it a little hard to do a cost-benefit analysis. Kling says that “on close examination,” the case for stimulus is weak, but, in this post, at least, he offers no such “close examination,” merely a laundry list of familiar (and unproven) criticisms of government spending.

The most curious thing about Kling’s post, though, is the way he closes—namely by complaining that even though he and his side “have logic on their side,” they will be “mocked and vilified in the media” for their opposition to a big stimulus package, and that that package will be pushed through as a result of “elite groupthink”—the same groupthink, in fact, that pushed through the Paulson rescue plan. The implicit assertion here is that the support for a stimulus package, as for the rescue plan, is driven by this élite group of interventionist economists and politicians, who are overriding what would otehrwise be commonsense economic policy.

What’s odd about this is that the support for the stimulus package, as well as support for the Paulson plan, hasn’t just come from liberal economists or Democratic politicians. On the contrary, among the biggest supporters of both have been the world’s investors( TRUE ), at least insofar as their collective judgment is reflected in market prices. As I showed yesterday, investors overwhelmingly supported the Paulson plan: it was only when it was killed, that stock prices really started their downward spiral( I AGREE ). And it was only after Obama unveiled his economic team and made clear how big his stimulus plans were that the market began its sharp recovery( I AGREE ) (the S. & P. 500 is now up twenty-five per cent since Nov. 20th). And as The Economist’s mystery blogger noted yesterday, anyone’s who’s paying attention to the stock market knows what would happen if Obama announced today that he was abandoning his plans for a major stimulus package:

Markets would plummet, with significant knock-on effects, based on the actual news that government spending would not nearly close the American output gap, but also given the signal that America was no longer committed to serious stimulus.( TRUE )

The point is that it isn’t just some group of pointy-headed Keynesians saying that a big stimulus package will be good for the economy: the collective wisdom of the market is saying the same thing( TRUE ). And it seems peculiar for a supposed believer in the efficiency and intelligence of markets—which, as a libertarian economist, I assume Kling is—to simply disregard what the market is saying in this case. In effect, libertarian economists are saying that they have a better sense of what’s good for the economy than the aggregated wisdom of investors does. And that makes them sound peculiarly like the Platonic economic planners that they typically decry( TRUE ).

There is no doubt that our Investor Class wants a government bailout large enough to stop both the Calling Run and the Proactivity Run. TARP and other various government actions have tried to stop the first, while the stimulus is an attempt to stop the second. Only explicit government guarantees and actions are believed to be sufficient enough to stop these runs. Leaving the two Runs to run their course could lead to extreme losses of wealth and jobs, large enough to effect social stability. This outcome must be avoided at all costs.

The Investor Class had no Plan B. They believed, quite correctly, that the government would have to intervene in a financial crisis. Investing has been done for at least the last twenty years with this understanding, as well as the understanding that government has an important role in funding and helping the Investor Class. They do not believe in limited or no government, and would have no idea to do business in such an environment. As Wittgenstein said, "If a lion could talk, we could not understand him". I say, "If the free market showed up, the Investor Class would not know how to do business in it". They are the ones with the money, not theoreticians.

In the future, we will need a LOLR and SOLR to undergird our financial system. The explicit conditions of these guarantees will be meant to prevent Calling and Proactivity Runs. This can work. In other words, the intent is to keep the government from having to actually spend money, by allowing time for financial knots to unwind at minimal cost and disruption. Only the government can do this. In order to keep moral hazard from being a consequence, a strict application of Bagehot's Laws and a strict regime of supervision, not regulation, which focuses on aims and methods, as opposed to relying on particular laws, can keep moral hazard from becoming a problem. For one thing, by the end of the process, the Investor Class members which need a bailout will essentially be bust. It will not be a pleasant experience for them, as opposed to TARP.

The current political culture is a result of compromises over time. It cannot be easily changed, and should not be quickly changed. But, over, time, the system can be made fairer and freer for most people. Starting out with the changes listed above would be an excellent down payment.

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis.

Simon Johnson on the Baseline Scenario:

"The Economic Crisis and the Crisis in Economics

with one comment

The Economic Crisis

The global financial crisis of fall 2008 was unexpected( THE SEVERITY WAS UNEXPECTED. ). A few people had been predicting that serious problems were looming, and even fewer had placed bets accordingly, but even they were astounded by what happened in mid-September( I THINK THAT THEY WERE ASTOUNDED BY THE GOVERNMENT LETTING LEHMAN FAIL ).

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis. (See http://BaselineScenario.com for more on what came before, how events unfolded during fall 2008, and where matters now stand).

• 1. On the weekend of September 13-14, 2008, the U.S. government declined to bailout Lehman. The firm subsequently failed, i.e., did not open for business on Monday, September 15. Creditors suffered major losses, and these had a particularly negative effect on the markets given that through the end of the previous week the Federal Reserve had been encouraging people to continue to do business with Lehman.( A CALLING RUN BEGAN. )
  
• 2. On Tuesday, September 16, the government agreed to provide an emergency loan to the major insurance company, AIG. This loan was structured so as to become the company’s most senior debt and, in this fashion, implied losses for AIG’s previously senior creditors; the value of their investments in this AAA bastion of capitalism dropped 40% overnight.
• 3. By Wednesday, September 17, it was clear that the world’s financial markets - not just the US markets, but particularly US money market funds - were in cardiac arrest. The Secretary of the Treasury immediately approached Congress for an emergency budgetary appropriation of $700bn (about 5% of GDP), to be used to buy up distressed assets and thus relieve pressure on the financial system( IN ORDER TO STOP THE CALLING RUN. ). A rancorous political debate ensued, culminating in the passing of the so-called Troubled Asset Relief Program (TARP), but the financial and economic situation continued to deteriorate both in the US and around the world.

Thus began a financial and economic crisis of the first order, on a magnitude not seen at least since the 1930s and - arguably - with the potential to become bigger than anything seen in the 200 years of modern capitalism. We do not yet know if the economic consequences are “merely” a severe recession or if there will be a prolonged global slump or worse.

The Crisis in Economics

Does this economic crisis constitute or imply a crisis for economics? There are obviously two answers to this question: no, and yes.

Let me discuss the “no crisis” view first. There are actually several variants on this view. The first is that the post-Keynesian consensus comes through the crisis just fine. In fact, the current emphasis on fiscal stimulus in the US (and the debate about fiscal stimulus elsewhere) supports the position that we are back to Keynesian fundamentals. There is a decline in private spending underway, and governments around the world are seeking to replace that with public spending (or, if you prefer, the private sector suddenly wants to save more, so the public sector better rush to save less.)

A more nuanced version of this view adds some financial accelerators, or perhaps we should now call them decelerators. We obviously had a series of bank runs in mid-September, but not just by small depositors and not just on banks. We also had a situation where falling values for collateral triggered more asset sales (either for accounting reasons or due to market pressure of various kinds), and this led to further lowering of collateral. ( A CALLING RUN )

More broadly, there was also some kind bad expectations trap, in which everyone expected everyone else to default ( AND THAT THE GOVERNMENT WOULDN'T INTERVENE ) and that kind of fear of counterparty risk is obviously self-fulfilling.

In other words, this view is that we can retrofit our favorite mainstream models to accommodate what happened, at least at a fairly high level of abstraction. There is no crisis for macroeconomic thinking, let alone for economics.

An alternative interpretation is that mainstream macroeconomics is in big trouble. You can think about this in terms of whether standard thinking provides plausible answers to four current policy issues. (Daron Acemoglu of MIT has an important essay in preparation, arguing that there are deeper problems for economics, including for the most fundamental microeconomics - such as how we think about firms and reputations - in the light of the crisis.)

First, let’s begin with whether macroeconomics can answer definitively or even informatively the most important question of the day. Are we in danger of falling into another Great Depression, with a prolonged, worldwide fall in output and employment?

The mainstream answer to this question is: no, because we’ve learned a lot about economics since the Great Depression and because we also learned a great deal about policy both during and after the 1930s.

I’m not so convinced( I AGREE. WE CAN. ). For example we know that a key policy mistake in the early 1930s was to allow banks to fail. This will not happen again, at least not for “systemic institutions” - as the G7 made clear in October. But bank failure was a problem because it contributed to a big contraction in credit - this has been well established in the work of Ben Bernanke and others. Unfortunately, we know relatively little about how to stop today’s process of falling credit around the world, known as “global deleveraging.”( A CALLING RUN )

Second, consider the current consensus on saving the day in the US and around the world through a large US fiscal stimulus - probably $800bn over several years, which would constitute the largest peacetime boost ever for the US economy. Is this really the right approach?( NOT REALLY, BUT IT WILL HAVE TO DO. )

We know that allowing the price level to decline was an essential error of the early 1930s, as this increased the real debt burden for everyone with fixed nominal obligations. We think we know how central banks can prevent this kind of deflation, and Mr. Bernanke’s now famous November 2002 speech laid out a clear road map for appropriate policies - even to the extent of “quantitative easing,” i.e., extending more credit without sterilization through selling Treasuries, thus increasing the monetary base. ( THIS SHOULD BE DONE. )

Still, I am struck by the fact that while the opinion leaders among US-based macroeconomists eventually called for some version of “credible irresponsibility” (to counter deflation or even produce inflation) in Japan during the 1990s, we have still not reached the point where such terms have joined the acceptable lexicon for most of the mainstream on the US economy today. (Some leading economists, I find, are willing to talk in these terms in private, but not yet in public.)

I would stress that nothing in the Fed policy or the Obama Plan has yet turned the corner on this issue. In fact, inflation expectations have not risen significantly since it became clear Mr. Obama would win the election and introduce a major fiscal stimulus.

Think about that in terms of monthly payments on your (or my) house. Let’s say the interest rate on your mortgage is 6%, which is roughly the average for the U.S. When inflation runs around 2% (as is typical), the real, inflation-adjusted rate you pay is lower - actually only 4%. But the price level is now expected by the financial market to be flat on average for each of the next 5 years. So in this case the real interest rate will be 6%. In other words, the advent of deflation implies a massive unexpected transfer of income from borrowers to lenders. With the face value of outstanding mortgages over $10trn, this will likely depress spending by more than can be compensated for by any reasonable fiscal stimulus. ( IF IT HAPPENS, A GOOD POINT. )

The appeal of recreating positive inflation expectations is that it would put downward pressure on the dollar and thus push our major trading partners to cut interest rates and engage in their own forms of monetary expansion - or face appreciation of their currencies and a fall in exports( TRUE. BUT THIS HAS RISKS FOR THE SAVER COUNTRIES. ). The result will be higher global inflation, to be sure, but this is the only realistic way to persuade European Union members to take the measures necessary to stimulate their stronger economies or even save their own weaker economies from default.

President Obama can ask our allies to provide stimulus until he is blue in the face, but the fact of the matter is that the very size of our own fiscal expansion gives the Germans and others the incentive to free ride - they are hoping to recover on the back of exports to our infrastructure projects( TRUE ). It is only more expansionary monetary policy in the US that will force their hands in the right direction, for us and for them.( IT WOULD SEEM SO. )

Third, what is the deeper cause of this crisis? A supersized financial system - the obesity of banks and shadow banks - helped create the vulnerabilities that made the September crisis possible. This financial system captured its regulators( COLLUSION ) and took on far more risk than it could manage( TRUE ) (or even understand( I DON'T AGREE )). And this is a statement not just about US banks, but also about most parts of the global financial system.

The answer lies with the political economy( GOOD ) of the US financial system, including the power politics of large financial firms( ABSOLUTELY ). These grew large relative to the institutions that support and constrain them. In effect, we created an emerging market-type of structure. There is nothing in the mainstream textbooks or working papers about this - the general working assumption has been that institutions in the US were significantly better than in emerging markets. The time has obviously come to question in what sense this is really true.

The US banks have received generous bailouts, at least after the Lehman-AIG events, with no change in management( VERY BAD ). Have they become stronger or weaker? After the crisis we will have probably no more than 6 major banks in the US, with little threat from new entrants and small hope of controlling their actions indefinitely through effective regulation( I AGREE ).

The problems are even more pressing if it is the case that these banks need to be recapitalized fully. They oppose this policy, for obvious reasons. The fiscal stimulus may well prove ineffective in the face of this political opposition, which is still well represented at the heart of the new administration’s economic strategy. Again, however, I find leading economists to be surprisingly quiet on this key issue.

The fourth question is: what are the implications for the eurozone? Again, there is a huge divergence of opinions among economists on this point. Personally, I’m struck by the growing pressure on some of the weaker sovereigns that belong to the euro currency union. Greece faces the most immediate problems, as demonstrated both by widening credit default swap spreads and - over the past few weeks - increasing spreads of Greek bonds over German government bonds. The cost of servicing Greek government debt is thus rising at the same time as Greece has to roll over debt worth around 20 percent of GDP in the coming year.

Greece has a debt-to-GDP ratio over 90 percent, and the perceived risk of default is significant. In our baseline view, Greece receives a fairly generous bailout from other eurozone countries (and probably from the EU). This, however, does not come early enough to prevent problems from spreading to Ireland and other smaller countries (which then also need to implement fiscal austerity or to receive support). Italy is also likely to come under pressure, due to its high debt levels, and here there will be no way other than austerity. With or without a bailout, Greece and other weaker euro sovereigns will need to implement fiscal austerity.

The net result - in my opinion - is less fiscal stimulus than would otherwise be possible, and in fact there is a move to austerity among stronger euro sovereigns as a signal. Governments will therefore struggle to dissave enough to offset the increase in private sector savings. But the global mainstream economics approach still seems to be emphasis on fiscal policy coordination.

In any case, monetary policy in Europe will be slow to respond. The European Central Bank decision-making process seeks consensus and some key members are still more worried about inflation down the road than deflation today. Eventually the ECB will catch up, but not before there has been considerable further slowing in the eurozone. ( I AGREE )

Probably existing macroeconomic thinking can accommodate this kind of analysis. It’s a blend of financial market analysis with political economy. But I don’t know any models, let alone much empirical work, that bears directly on - or comes close to testing - any dimensions of this issue. Economics is in thin air.

My guess is that, among other things, we need to change dramatically our ways of thinking about fiscal policy. This needs to prepare for irregular but large crises, which implies being more countercyclical - and that implies less growth in boom times. Monetary policy will not stop bubbles and regulators will always fall behind; responsibility for making sure we can handle major financial crises rests with fiscal policy. ( I NEED TO SEE ALL OF THE PROPOSALS. )

Rethinking the Structure of the Global Economy

If economics is in so much trouble, what does this imply for thinking about economic policy - both in terms of sensible crisis management and more medium-term attempts to rebuild a reasonable global system?

In order to create the conditions for long-term economic health, we need to identify the real structural problem that created the current situation and likely means the global economy has entered a new phase of instability. It wasn’t a particular set of payments imbalances (read: US-China)( I AGREE ), as these can and will change (which does not excuse policymakers who refused to address this issue). It wasn’t the failure of a particular set of domestic regulators( SOME OF IT IS COLLUSION. SO I DISAGREE. ), as regulatory challenges and responses change over time (which doesn’t excuse the specific regulators).

Let me suggest a way to think about these economic issues, although I know this will not sit well with many macroeconomists (although it may go down better with those who focus on longer run growth issues). The underlying problem was that, after the 1980s, the “Great Moderation” of volatility in industrialized countries created the conditions under which finance became larger relative to GDP and credit could grow rapidly in any boom. In addition, globalization allowed banks to become big relative to the countries in which they are based (with Iceland as an extreme example). Financial development, while often beneficial, brings risks as well. (None of these points would have sat well with mainstream finance or economics two years ago, but perhaps the consensus around some of these points has shifted recently.)

The global economic growth of the last several years was in reality a global, debt-financed boom, with self-fulfilling characteristics - i.e., it could have gone on for many years or it could have collapsed earlier. The US housing bubble was inflated by global capital flows, but bubbles can occur in a closed economy (as shown by experiments, http://baselinescenario.com/2008/12/07/financial-crisis-bubbles-causes-psychology/]). The European financial bubble, including massive lending to Eastern Europe and Latin America, occurred with zero net capital flows (the eurozone had a current account roughly in balance). China’s export-driven manufacturing sector had a bubble of its own, in its case with net capital outflow (a current account surplus).

But these regional bubbles were amplified and connected by a global financial system that allowed capital to flow easily around the world. We are not saying that global capital flows are a bad thing; ordinarily, by delivering capital to the places where it is most useful, they promote economic growth, in particular in the developing world. But the global system also allows bubbles to feed on money raised from anywhere in the world, exacerbating global systemic risks. When billions of dollars are flowing from the richest countries in the world to Iceland, a country of 320,000 people, chasing high rates of interest, the risks of a downturn are magnified, for the people of Iceland in particular.

The prevalence of debt in the global boom was also a major contributing factor to today’s recession (although major disruptions could also arise from the busting of pure equity-financed booms). Debt introduces discontinuities on the downside: instead of simply becoming losing money, companies with high debt levels go bankrupt in hard times. Lehman, AIG, and now GM all created systemic risks to the US and global economies because one default can trigger a series of defaults among other companies - and simply the fear( I AGREE HERE ) of those dominos falling can have systemic effects( A CALLING RUN ). Similarly, emerging market defaults can have systemic effects by spreading fear and causing investors to pull out of unrelated by similarly situated countries (and causing speculators to bet against their currencies and stock markets).

Ideally, global economic growth requires a rebalancing away from the financial sector and toward non-financial industries such as manufacturing, retail, and health care (for an expansion of this argument, see our opinion piece on this topic, available through [http://baselinescenario.com/2008/11/11/obama-economic-strateg/]. Especially in advanced economies such as the US and the UK, the financial sector has accounted for an unsustainable share of corporate profits and profit growth. However, the financial sector, despite the experiences of the last year, is still powerful enough to resist significant structural reform( TRUE ). While this will not prevent a return to economic growth, it will maintain all of the risks that led to the current situation - in particular, the risk of synchronized booms and busts around the world.

Understanding how to prevent stability from creating future vulnerability will require us to rethink a great deal about economics and how economies operate. Political economy is probably the place to begin( YES ), but a lot more needs to be done on fundamentals. Whether or not our economies manage to avoid a major global depression, economics is in crisis."

I like his approach, but simply reach different conclusions. In order to stop Calling Runs, as in this crisis, government guarantees are necessary, in the same way that FDIC insurance helps stop banking runs. The main adversary is fear, which can only be quelled by a LOLR with the power and funds to guarantee that an orderly unwinding is possible, and that a Calling Run will only lead to worse losses for the parties involved. In my estimation, the lack of guarantees was what caused the crisis, with the result that we had a flighty to safety. In other words, a flight to guaranteed investments. Even Implicitly Guaranteed Investments, like Agency Bonds, have turned out to be too risky. In order to lessen the probability that such a Calling Run occurs again, a version of Bagehot's Principles should be instituted.

The subrime and other bad loans are, in my book, Fraud, Negligence, Fiduciary Mismanagement, and Collusion. They violate the rules of Banking 101. The same holds true for CDOs, CDSs, and other investments meant to lessen the capital requirements of investments. It was not the instruments or equations, but the flaunting of Investing 101 rules, that caused the problems. The culprits are individuals, not incentives, the system, or whatever Mechanistic Explanation that is offered. The credit ratings agencies fall under the same rubric. These were not honest mistakes.

Underlying the decisions made by these investors and bankers, was a belief that the government would intervene in a serious financial crisis in a timely and effective way. There was no Plan B. In other words, no plans were ever made for a large blow up, not because they were held to be impossible, the S & L Crisis and LTCM and Tech Bubble showed that view was false, but because the government showed that it would intervene and, as well, investigation and prosecution of graft would be minimal and ineffective.

Finally, we do not have a free market system. We have a Hybid called a Welfare State. Anyone who examines the beliefs and presuppositions of the investor class in this country will immediately see that this investor uses and assumes the implicit backing of the government. Under no circumstances could they be considered free market fanatics, unless by that is meant the use of BS to explain their beliefs.

The only real threat to this Hybrid comes from major social disruption and dislocation, which many assume is not possible. This view is false. Massive Unemployment together with perceived, correctly by the way, cronyism in the government could well lead to a massive falling off in the belief in our system. The alternative would likely be some form of totalitarianism. In any case, we should endeavor to never find out.