Competitive Quantitative Easing (QE) offers scope for growing the global aggregate demand pie, with an endogenous enforcement mechanism

TO BE NOTED: From Pimco:

Global Central Bank Focus

Paul McCulley | April 2009

Comments Before the Money Marketeers Club Playing Solitaire with a Deck of 51, with Number 52 on Offer

Click here for Paul McCulley's biography. New York City - March 19, 2009 Thank you, Dana, for that wonderfully kind introduction. It is a deep honor to be speaking before this august club for the fourth time. When I look at the list of speakers over the last 50 years, I am very humbled. As I’ve mentioned before when here, this forum is one of the very few for which I actually write a speech. Not that I actually deliver it the way I write it – that might be congenitally impossible for me! – but because I want to be held accountable, to be forced to both own and eat my own words. And to re-read them again and again, before speaking yet again. Looking Backward In May 2004,1 just before the Fed embarked on a tightening process from 1% Fed funds, my axe to grind was that the conventional wisdom of a constant neutral real Fed funds rate was wrong. Put more wonkishly, as I’m wont to do, I challenged the notion of a constant constant in the Taylor Rule. As all in our profession know, John Taylor conveniently assumed that if the active cyclical terms in his Rule – (1) the gap between actual inflation and targeted inflation and (2) the gap between actual and potential GDP (Gross Domestic Product) – drop out, because inflation is at target and GDP is at potential,2 then the real Fed funds rate should approximate the potential real growth rate of the economy, determined by demographically-driven labor force growth and productivity growth. That’s the constant term in the Taylor Rule, and John assumed it to be constant. I took issue with this concept of the constant in Taylor being constant on two key fronts, one a matter of theory and the other a matter of practicality. On the theoretical front, I have always made a distinction between cash and capital or, in the words of today, the difference between capital and liquidity. I’ve always believed in the capitalist notion of no risk, no reward. Thus, I’ve always struggled with the notion that government-guaranteed cash, or liquidity, if you prefer, should pay a positive after-tax real rate of return. Yes, I believe nominal cash yields should be high enough to offset the inflation rate, which is an implicit tax. And since we tax nominal returns, I have also always believed that the nominal cash yield should be high enough to not only offset the implicit inflation tax, but also the explicit tax on the inflation tax. But I’ve never believed that cash should generate a real after-tax return. Again, no risk, no reward. Cash always trades at par, at least in nominal terms, and that’s a very precious attribute. You can have it if you want it. But if you do, you should not get paid for it, but rather pay for it, in the form of forgoing any after-tax real return. If you want a positive after-tax real return, you gotta take some risk, summarized best, perhaps, by the possibility of your investment trading south of par. Which means that I did and do believe that a positive neutral after-tax real rate of interest does exist, even if it is not constant. But for me, unlike John, it’s the after-tax real rate of interest on high grade, long-term, private sector debt obligations. Back in May 2004, I posited that we should use the long-term swap rates as a proxy – the credit risk of the AA global banking system. (Note I said system, not any individual bank.) That after-tax real rate of return should, I argued, be consistent with John Taylor’s assumption – widely embraced in our profession – that there is a functional connection between potential real growth rates and real interest rates. Thus, John and I were actually in the same analytical church, but we were sitting in very different pews, singing from a different hymn book. We both wanted to tie the neutral real rate to the potential real growth rate of the economy. But he focused on the overnight risk-free rate, which the Fed directly controls, while I focused on the long-term private sector rate, determined by the market. Translated, John was and is a Fed funds man while I was and am a financial conditions man. Which brings me to my practical beef with John: I don’t believe that the neutral rate – whichever one you choose – is constant, but rather time-varying, a function of changes in broad financial conditions. With my colleague, and good friend, Ramin Toloui, I wrote a lengthy essay on this issue this past February.3 No need to replow that plowed ground again tonight, except to say that the financial crisis over the last year proves my point in spades. Be that as it may, most of you thought I was singing way off key back in 2004. And truth be told, I felt that at the margin too, as I recognized my theoretical construct implied a very steep yield curve, an open invitation for entrepreneurial financial operators to lever to the eyeballs into the carry trade. Thus, I openly acknowledged that if the Fed were to embrace my notion of a neutral zero after-tax real rate on cash, then it would be necessary to put regulatory limits on the use of leverage by financial intermediaries. At that time, policy makers were doing just that with the GSEs (Government Sponsored Enterprises), putting limits on growth of their balance sheets. I was encouraged by this. But falsely so, as the next several years demonstrated painfully, with unbridled growth in the Shadow Banking System, a term I coined in August 2007 at Jackson Hole. Recall, Shadow Banks are levered-up intermediaries without access to either FDIC deposit insurance or the Fed’s discount window to protect against runs or stop runs. But since they don’t have access to those governmental safety nets, Shadow Banks do not have to operate under meaningful regulatory constraints, notably for leverage, only the friendly eyes of the ratings agencies. The bottom line is that the Shadow Banking System created explosive growth in leverage and liquidity risk outside the purview of the Fed. Or, as I said here last time in November 2007, again playing the wonk, Shadow Banking both (1) shifted the IS Curve to the right and also (2) made it steeper, or less elastic, if you will. In such a world, Fed rate hikes had little tempering effect on the demand for credit, or if you prefer, little tightening effect on financial conditions. And so it came to pass with the Fed hiking the nominal Fed funds rate to 5¼%, double that which I had forecast in May 2004, as financial conditions refused to tighten in sympathy with the Fed’s desire. I was proven spectacularly wrong. It was the Forward Minsky Journey, as I lectured here last time. And it ended in the Minsky Moment, defined as the moment when bubbly asset prices – made so by the application of ever-greater leverage – crack, kicking off the imperative for deleveraging, notably by the Shadow Banking System. We can quibble about the precise month of the Moment. I pick August 2007, but would not argue strenuously with you about three months either side of that date. Whatever moment you pick for the Moment, we have, ever since, been traveling the Reverse Minsky Journey, violently shifting the IS Curve back to the left, with an even steeper slope. This prospect implied, I argued 16 months ago, that the Fed would inevitably cut the Fed funds rate dramatically, in more-than-mirror image of the hiking process, as financial conditions would refuse to ease in sympathy with the Fed’s intentions. In turn, I forecast that by the next time you invited me here again, the Fed funds rate would likely be at or below the 2½% level that I had so petulantly forecast back in May 2004. I also forecast that I might be contemplating buying a second home, after never having owned more than one. Looking Forward Which brings us to today, with the nominal Fed funds rate pinched against zero. I simply wasn’t bold enough in my forecast last time here. And while I haven’t bought a second home, I am indeed contemplating buying one. I’d like for it to be in a certain city a few hundred miles south of here, but that’s a decision above my power grade, even if below my pay grade. But I digress. What I want to discuss with you tonight is just how simple the solution to our current global economic and financial crisis is on paper, contrasting that to just how difficult and complex the solution is in reality. The present crisis, in textbook terms, is a case of the dual, mutually reinforcing maladies of the Paradox of Thrift and the Paradox of Leverage. In many respects, they are the same disease: what is rational at the individual citizen or firm level, notably to increase savings out of income or to delever balance sheets, becomes irrational at the community level. If everybody seeks to increase their savings by consuming less of their incomes, they will collectively fail, because consumption drives production which drives income, the fountain from which savings flow. Likewise, if everybody seeks to delever by selling assets and paying down debt, or by selling equity in themselves, they can’t, as the market for both assets and equity will go offer-only, no bid. Both of these maladies require that the sovereign go the other way, (1) dis-saving with even more passion than the private sector is attempting to increase savings, thereby maintaining nominal aggregate demand and thus, nominal national income; and (2) becoming the bid side for the levered private sector’s offer-only markets for assets and equity. It really is that simple, at least on paper, as Keynes and Minsky wisely taught. The problem with the desirable textbook solution is that it suffers from constrained political feasibility. Actually, dealing with the Paradox of Thrift is practically much easier, even if less critically important, than dealing with the Paradox of Deleveraging. While Congress may belly-ache and wrangle incessantly about the precise size and composition of fiscal stimulus packages, it is safe to say that but for a few wing nuts, we are all Keynesians now in the matter of cracking the Paradox of Thrift. In contrast there is limited political consensus for using the sovereign’s balance sheet and good credit to break the Paradox of Deleveraging. Put differently, while we may all now be Keynesians, we are not all Minskyians. What is ineluctably needed involves socializing the losses of a banking system – both conventional banking and shadow banking – after the spectacular winnings of the Forward Minsky Journey were privatized. It simply doesn’t sit well politically. In fact, it stinks to high heaven. Thus, to quote my partner Mohamed El-Erian, we must contemplate a scenario in which the economically desirable solution is not politically feasible, while that which is politically feasible may not necessarily be economically desirable. Last Sunday, on 60 Minutes, Ben Bernanke addressed this nasty reality directly when he said that perhaps the most severe risk we face is the lack of political will. I applaud him, both for doing the interview, speaking directly to the American people, and for speaking the truth. But that doesn’t necessarily mean that the truth will set us free. As Kris Kristofferson wrote long ago, and Janis Joplin made famous, we cannot dismiss out of hand the proposition that freedom is just another word for nothing left to lose. I trust not. But the honest answer is that we honestly don’t know. We are living in a world of hysteresis, in which outcomes become path-dependent, where multiple outcomes are possible, where both policy input and economic/financial outcomes become hostage to serial correlation. How’s that for talking wonkish? Concluding Comment Seriously, let me conclude by once and again quoting Mohamed, who observes that what we are experiencing is not a crisis within the market-driven, democratic capitalist system of most of our careers, but rather a crisis of the system itself. This is not a spat within a marriage, but rather a test of the sustainability of the marriage itself. It’s playing solitaire with a deck of 51. Fortunately, the 52nd card is now on offer, if only policy makers are willing to seize it and play it: Competitive Quantitative Easing (mixed with Credit Easing, in some cases). Usually, when we think of competitive global policies, we think of them in a negative way, as in competitive hiking of tariffs or competitive currency depreciation. While different in execution, these two forms of competition are economically very similar, a competitive attempt to secure a larger piece of a too-small global aggregate nominal demand pie. In contrast, Competitive Quantitative Easing (QE) offers scope for growing the global aggregate demand pie, with an endogenous enforcement mechanism. How so? First, let’s consider what QE is all about. In an oversimplified nutshell, it involves a central bank voluntarily surrendering for a time its independence from the fiscal authority, taking the short-term policy rate to the zero neighborhood, thereby obviating any need to control growth in its balance sheet. For those of us in the room old enough to remember the jargon — and there are more than a few! — QE obviates any need for the central bank to keep “pressure on bank reserve positions,” so as to hit a positive target for its policy rate. It’s not quite that simple, I recognize, for central banks that are allowed to pay interest on excess reserves, as is now the case with the Fed. Conceptually, with the ability to pay interest on excess reserves, a central bank could “go QE” and still peg a positive policy rate. But that’s a technicality without great substance at the moment, notably with the Fed, whose target range for the Fed funds rate is 0–.25%. Close enough to zero for me! Thus, the Fed is practically unconstrained in how big it can grow its balance sheet. Which, in turn, sets the stage for the Fed to voluntarily work corporately with the fiscal authority — Congress and the Treasury — to monetize longer-dated Treasury securities, facilitating a huge expansion in Treasury debt issues at exceedingly low interest rates. Ordinarily, we would be aghast at such a prospect, as every bone in our bodies would scream that such an operation would, in the long run, be inflationary. And our bones would be right. The very reason for central bank independence within the government – but not of the government – is precisely to prevent the central bank from being the handmaiden of the fiscal authority, who inherently wants to spend more than it taxes, running deficits, overheating the economy in an inflationary way. But if and when the dominant macroeconomic problem is a huge output gap, borne of deficient aggregate demand, fattening the fat tail of deflation risk, the argument for strict central bank independence goes into temporary submission. Note, I said temporary, not permanent. There is no more sure way, in the proverbial long run, to destroy the purchasing power of a currency than to let vote-seeking politicians have the keys to the fiat-money printing press. But there can be extraordinary and exigent circumstances when it does make sense for a central bank to work cooperatively, if not subordinately, with the fiscal authority to break capitalism’s inherent debt-deflation pathologies. Indeed, none other than Chairman Bernanke made the case forcefully in May 2003, speaking in Japan about Japan (my emphasis, not his): The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say “no” to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty. Thus, the Fed’s announcement just yesterday that the central bank would be buying up to $300 billion of Treasuries, primarily in the two- to ten-year maturity range, is fully consistent with both what Mr. Bernanke said six years ago and with evident debt-deflationary pathologies, both here in the United States and around the world. Indeed, what intrigues me the most right now is the concept of global Competitive QE, rather than competitive tariff hiking or competitive currency depreciation. If all countries, or most major countries anyway, “go QE,” then the global game changes from fighting for bigger slices of a too-small global nominal aggregate demand pie to actually correlated efforts to enlarge the nominal pie. Note I said “correlated” not “coordinated.” There need not necessarily be any explicit coordination between countries, because those that choose not to play will likely experience a rise in their real effective exchange rate, a deflationary impulse to their underutilized economies. Thus, there need not be an explicit enforcement mechanism to propel Competitive QE, merely individual countries acting in their own best interest. This is the best kind of cooperative behavior, explicitly because it need not be coordinated, but rather brought about by, you guessed it, Adam Smith’s invisible hand! To be sure, the ECB (European Central Bank) has difficulty with the concept of QE, in part because Euroland represents monetary union without political union and, thus, fiscal policy union. Put differently, if the ECB wants to be accommodative of more Keynesian fiscal policy stimulus, de facto monetizing it, what fiscal authority does the ECB call to cut the deal? It’s an open question, but my sense is that about ten big figures higher from here for the Euro, the ECB would find the answer! Thank you, again, for the great honor of being here tonight. Paul McCulley Managing Director mcculley@pimco.com 1 “Comments Before The Money Marketeers Club: A Brave New World,” Global Central Bank Focus, May 2004 2 Or if you prefer, unemployment is at its full employment level. 3 “Chasing the Neutral Rate Down: Financial Conditions, Monetary Policy, and the Taylor Rule,” Global Central Bank Focus, February 2008

"Suddenly risk adverse reserve managers sold what was cheap and bought what was dear, magnifying rather than dampening market moves."

From Brad Setser:

"Central banks aren’t always a stabilizing presence in the market

Posted on Monday, January 5th, 2009

By bsetser

Over the last couple of years it was often asserted that sovereign investors — due to their long time horizons — tend to be a stabilizing presence in markets that they invest in. The argument was generally made about sovereign funds, but it presumably applied at least in part to central banks as well. They have a somewhat shorter time horizon than sovereign fund, but they also presumably care a bit more about financial stability.

Alas, there is now one clear case where an abrupt shift in central bank purchases destabilized a market.

Central banks stopped buying Agency bonds in August and never resumed their purchases. The US Treasury now says that Agency bonds are “effectively” guaranteed — and they certainly have more Treasury backing than in the past. But that wasn’t enough to convince the world’s central banks. They now want nothing less than a full guarantee.( FLIGHT FROM IMPLICIT GUARANTEES TO EXPLICIT GUARANTEES BEGAN BEFORE LEHMAN. FANNIE/FREDDIE? )

The latest (year-end) data from the New York Fed on foreign central banks’ custodial holdings shows that the magnitude of the shift out of Agencies and into Treasuries in the later part of the year. Central banks went from buying $250-300b of Agencies a year (judging from the growth of their FRBNY portfolio) to net sellers of Agencies in a rather short period of time( FLIGHT TO SAFETY ).

The 3 month change in the Fed’s custodial holdings is even more dramatic, and leaves no doubt that central banks have been large set sellers of Agencies. The Fed’s custodial holdings of Treasuries rose by $250 billion over the last three months of 2008 while the Fed’s custodial holdings of Agencies fell by $150 billion. Try annualizing these numbers. In the fourth quarter, central banks were buying Treasuries at a $1 trillion annual pace and selling Agencies at a $600 billion annual pace.

It seems hard to argue against the proposition that a sudden increase in central bank’s risk aversion( EXACTLY. THE FEAR AND AVERSION TO RISK AND ACCOMPANYING FLIGHT TO SAFETY ) has contributed to the distress in a key part of the US market.

Central bank reserve managers’ core concern, of course, isn’t stabilizing the US debt market. It is making sure that they have enough liquid assets to meet their own country’s liquidity needs. It used to also be to make a bit of profit on the country’s– before it swung to making sure that they didn’t take credit losses. The net result, though, was a lot of pressure on the Agency market in the fourth quarter — and a lot of central bank demand for Treasuries just when private demand for Treasuries also soared. Suddenly risk adverse reserve managers sold what was cheap and bought what was dear, magnifying( YES ) rather than dampening market moves.

This experience should also to some way toward settling another debate: are central banks’ purchases and sales big enough to impact prices in large, liquid markets?

Many argued that the Treasury market was so deep and so liquid that it could absorb even large central bank sales without too much trouble. Central banks (net) purchases were large relative to the Treasury’s (net) sales, but they weren’t that large relative to total Treasury market turnover. That led many to argue that if central bank sales ever pushed a bond away from its fundamental value, private buyers would step in — preventing any large move in price.*

The Agency market isn’t a perfect analogue to the Treasury market. But it is quite large — the outstanding stock of Fannie and Freddie bonds (counting Fannie and Freddie guaranteed MBS) is over $5 trillion. Agency issues aren’t quite as homogenous as Treasury issues, but they don’t differ that much from each other either. Both Freddie and Fannie have lots of outstanding bonds in the market — and, at least until recently, the Agency market was also considered to be fairly liquid. It still doesn’t seem to have been able to absorb the big swing in central bank demand.

Agency spreads widened significantly when central banks pulled back (the expansion in the supply of debt with an implicit if not explicit guarantee also played a role …). They only came back in when the Fed indicated it would start buying Agencies …( YES )

And it sure seems like the enormous increase in central bank demand for Treasuries is one — though certainly not the only — reason why Treasury yields are so low right now( YES ). The obvious risk here is that the US government will infer too much from the fact that Treasury yields collapsed even as Treasury issuance soared. The current surge in central bank demand for Treasuries is unlikely to be sustained, if for no other reason than global reserve growth has slowed and central banks have a finite supply of Agencies to sell. I personally think this risk is manageable, as I expect a meaningful rise in US savings (an a fall in investment) will free up domestic funds for the Treasury (or start to flow into the banks, allowed the Fed to scale back its loans to the banks and scale up its Treasury holdings). But it is a risk.

In one key respect though, central banks have remained a stabilizing force: they abandoned the Agency market, not the dollar market. This underscores an important point, one that I wish I had recognized earlier. Central bank reserve managers can influence the US market in two very different ways:

a) By shifting out of one asset and into another asset. Selling Agencies and buying Treasuries for example. Or selling equities to buy Treasuries. ( GOOD POINT )

b) By shifting out of the dollar ( GOOD POINT )

A country like China that is effectively pegged to the dollar can shift the composition of its US portfolio around without putting much pressure on the dollar or its peg. Moving from Agencies to Treasuries is consequently a fairly low cost option for China. Sure, China gives up a bit of yield( FOR AN EXPLICIT GUARANTEE ). But it doesn’t have to abandon its exchange rate regime. It is an option that China can exercise at a low cost to itself.

Moving away from the dollar, by contrast, would require adjustment in China - not just adjustment in the US … and that hasn’t been something that China has been willing to do( THIS I ATTRIBUTE TO SAVER COUNTRY FEAR OF CHANGING THE CURRENT SYSTEM. ).

* The argument could also be made in reverse. If central bank purchases drove a bond’s price up too much, private investors would sell — so the bond’s price (and yield) wouldn’t move away from its “fundamental” value. That led some to argue that central bank purchases couldn’t have much of an impact on say the Treasury market."

The more I look at this post, and compare it to the VIX, it's obvious that the Fannie/Freddie event was key. Somehow, the government's handling of this spooked investors and caused the beginning of the Flight To Safety.

"if they start to view the pound as Europe’s equivalent of an Agency bond …"

Brad Setser on the wild ride of the dollar recently:

"Only a few days ago, so it seems, it took about $1.25 to buy a euro. Now it takes closer to $1.45 (it was more earlier today, but the dollar subsequently rallied). And — as Macro Man notes — the dollar’s move pales relative to the recent slide in the pound. Not so long ago a pound bought 1.5 euros. Now it buys a euro and change. The Anglo-Saxon currencies haven’t had a good two week run.

Both the US and the UK ( 1 ) had housing and finance centric economies. Both have ( 2 ) significant external deficits. And both are ( 3 ) inclined to use monetary and fiscal policy aggressively to combat a downturn.

But with global trade collapsing, the euro’s rise can not be all that comfortable for members of the eurozone. It isn’t clear that any one wants a stronger currency right now ( THIS MEANS THAT THEIR EXPORTS WILL BE MORE EXPENSIVE IN OTHER COUNTRIES, AND THEY DON'T WANT TO LOSE EXPORT BUSINESS DURING AN ECONOMIC DOWNTURN ). Currencies though are relative prices — and can go up or down amid a global contraction. In theory, everyone could ease monetary policy equally without changing the relative value of any currencies ( THIS WOULD KEEP THE DOLLAR HIGHER ). In practice things rarely work out as neatly ( EXACTLY ).

Dr. Krugman, I would assume, hopes that the euro’s rise puts more pressure on Germany to join a coordinated European fiscal stimulus — with good reason. Germany’s export machine relies on global and European demand. That demand is falling (watch Russian imports for example). And if the euro’s rally is sustained, Germany will soon face an additional headwind. So too will the less competitive members of the eurozone. They are in an even more difficult position if Germany doesn’t lead a coordinated European reflation. ( GERMAN EXPORTS WILL BE TOO EXPENSIVE )

Four other thoughts:

1) Until fairly recently, all the European currencies tended to move in tandem against the dollar. That meant their cross-rates were stable. And it meant that the euro wasn’t as strong as it seemed. The euro was strong against the dollar and the yen, but not against the pound, the Swedish krona, the Norwegian krona and similar currencies. Right now the euro is rising against all the smaller European currencies — not just against the dollar.

2) Japan is starting too worry about yen strength, not surprising. Renewed intervention seems like a possibility if the yen continues to rise. That shouldn’t be a surprise. Japan tends to intervene heavily when the interest different between the yen and dollar goes away, reducing private market demand for dollars.

3) China has to be pleased by the euro’s rally. Dollar strength translated into RMB strength — and a rising RMB when Chinese exports were slowing (and likely now falling) made Chinese policy makers uncomfortable. There was even talk of moving to a real basket peg — which would have meant that RMB would depreciate against the dollar when the dollar was strong. But I rather doubt that China now wants to appreciate against the dollar to offset the dollar’s renewed weakness against the euro. Right now China is happy to see the dollar and thus the RMB weaken( THAT WAY THEIR EXPORTS DON'T GET MORE EXPENSIVE FOR US ) …

4) Central banks have been big buyers of the pound over the past few years. Reserves were growing, and the pound’s share was rising. Central banks liked its yield( PAID HIGHER INTEREST ) — and the fact that it an easy alternative to both the dollar and the euro. By my count, central bank inflows often were large enough to cover the UK’s current account deficit. Central banks reserves are shooting up, but if they “rebalance” their portfolios they should be big buyers of pounds now — as they need to hold more pounds to keep the pound’s share of their portfolio up as the pound’s value slides.

I’ll be interested to see if they do so — or if they start to view the pound as Europe’s equivalent of an Agency bond …( AND NOT BUY IT AS TOO RISKY )

Notice the Chinese Contradiction:

1) They don't want the dollar to weaken so that they can export to us

2) That's happening because we're printing money

3) Yet, they tell us not to borrow too much from them, and they don't want to spend too much

Problem: On 3, it has to be one or the other

Either we borrow more and they save more

or

we save more and they spend more

"Yet, in response to this crisis, the Federal Reserve reacted like Bagehot on steroids. "

Via the WSJ, Richard Fisher of the Dallas Fed:

"Again, some historical context. The basic manual for a central bank’s response to a panic was written in the early 19th century by two Englishmen, Walter Bagehot and Henry Thorton. Bagehot’s prescription to counter a panic was as follows: “The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man’ whenever the security is good.” He wrote of how, during the Panic of 1825, the Bank of England “lent by every possible means and in modes … never adopted before.” Also bearing in mind the advice of Thorton, who in 1802 wrote that “it is by no means intended to imply that it would become the (Central) Bank to relieve every distress which the rashness of (financiers) may bring upon themselves…. The relief should neither be so … liberal as to exempt those who misconduct their business … nor so scanty and slow as deeply to involve the general interests. These interests, nevertheless, are sure to be pleaded by every distressed person whose affairs are large, however indifferent or ruinous may be their state.”

Central bankers are generally considered the most laconic genus of the human species. Yet, in response to this crisis, the Federal Reserve reacted like Bagehot on steroids. We have not quite lent “to this man and that man.” But beginning with the announcement on December 12 of last year of our term auction facility, we have reached deep into our tool kit to “lend by every possible means and in modes … never adopted before.” We have been neither “scanty” nor “slow.” In rapid order, the Federal Reserve has stretched out the terms with which we lend to bankers; accepted new forms of collateral; broadened access to our lending window to securities dealers and one particular insurance company—AIG—whose failure was deemed by the Federal Reserve Board to present a risk to the financial system; opened a window for financing commercial paper; backstopped money market mutual funds; and, recognizing that we are inextricably interwoven with a global economy, established swap lines to help meet the dollar-funding needs of 14 central banks, ranging from the European Central Bank and the Bank of England to the Banco de México and the Singapore Monetary Authority, the total of which now aggregates to hundreds of billions of dollars. And our staff and policymakers have provided substantial intellectual input into activities of other regulators, such as the FDIC and the Treasury, as they develop innovative means and modes of recapitalizing the banking system, dealing with the mortgage crisis and restoring economic growth."

I'm fine with a lot of this, although not all their moves, and I endeavor to follow Bagehot.

But Bagehot also tried to put in rules and terms to avoid these kinds of crises. Let's use Bagehot on steroids to reduce the chances of this or a similar event occurring again.

"concern that central bank demand may not rise as fast as Treasury supply."

Interesting Brad Setser post. Read him for all the facts, which he is amazing at marshaling and making coherent. Also read the comments, they're often quite incisive, and Brad Setser replies, which is great:

"Nonetheless, central banks are unlikely to match the extraordinary pace of reserve growth that characterized much of 2007 and 2008. That though doesn’t necessarily imply that US Treasury rates will have to rise dramatically to induce private investors to absorb the increase in Treasury supply. Not so long as economic climate remains so bad. Yesterday’s data was awful. And the recent fall in consumption suggests that Americans will soon start saving a bit. Their appetite for risky assets has already fallen. That means more demand for safe assets. Investors who reached for yield in the boom times got burned; many may play it safe.

Consequently, whileCalculated Risk worries about fall in Chinese demand for Treasuries, I worry more that China’s steps to stimulate its economy won’t be vigorous enough. Right now, demand for the world’s goods seems to be falling fast . Demand for safe financial assets is not. And Treasuries — judging from their yields — are still considered safe. At the margin, I would rather see China step up its imports of goods and services than continue its current pace of Treasury purchases."

I'm thinking that banks will have to raise interest rates to attract capital from investors, but not if the government bails them out. On the other hand, I can see the reasoning that would keep government interest rates lower. All of this, for me, is only short term. I'm the only person worrying, not about deflation, but inflation. I find the effects of the crosscurrents here quite amazing. Thank God for blogs like Setser's and Calculated Risk.

Also notice this in my continuing Lehman brief:

"Indeed, the total increase in Treasuries in the market between August 2007 and August 2008 — i.e. before Lehman’s default triggered the current crisis and the huge surge in Treasury borrowing — has been quite large. Think $425b from the Fed’s balance sheet (an outright fall of $305b, and another $115b increase in securities lent out over that time frame) and roughly $400b of new Treasury issuance (see the monthly statements of the public debt)."

"This led me to correctly predict that as the housing bust picked up steam in the U.S., the trade deficit would peak as a percent of GDP."

From Calculated Risk, an interesting chart:

"Perhaps we have seen a Virtuous Cycle as depicted in the following diagram:

Click on graph for larger image in new window.Starting from the top ... lower interest rates have led to an increase in housing prices. And those higher housing prices have led to an ever increasing equity withdrawal by homeowners. ... it is reasonable to assume that a large percentage of this equity withdrawal has flowed to consumption, increasing both GDP and imports over the last few years. ... it appears mortgage equity withdrawal has been a meaningful contributor to the ever widening trade and current account deficits.

To finance the current account deficit, foreign Central Banks (CBs) have been investing heavily in dollar denominated securities. Some analysts have suggested that these investments have lowered interest rates by between 40 bps and 200 bps (Roubini and Setser: "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006")

If these analysts are correct, and foreign CB intervention is lowering treasury yields, then this has also lowered mortgage interest rates ... and the cycle repeats. The result: a Virtuous Cycle with higher housing prices, more consumption and lower interest rates.

As a result of the rapidly increasing housing prices, we are now seeing significant speculation, excessive leverage and poor credit quality of new homebuyers; all the signs of an overheated market. ... What happens if the housing market cools down? "

It's very informative, and there's a counterclockwise one as well called the Vicious cycle.

It's truly informative as to the what and why, but not the who. Here's my comment:

Don the libertarian Democrat writes:

Are there any human agents in these cycles, or is this like a mechanism? At what point do individual human decisions pass over from possible to inevitable in this schema, or do humans even matter? Or only the movement of money and other financial products?
Don the libertarian Democrat | Homepage | 11.01.08 - 10:52 pm | #