A classic bank run, you say? Hmm, where have I heard that before?

From Econbrowser:

"More papers on the credit crunch

Links to some interesting papers that I recently read.

The first comes from a conference on financial markets held at the start of this month at the University of Illinois in Chicago. Last fall, V.V. Chari, Larry Christiano, and Pat Kehoe received a lot of attention (e.g., Tabarrok, Avent, Economist, Kwak, Bonddad, and Thoma [1], [2], [3],) for noting that aggregate lending by banks was in fact increasing during the period in which many analysts were describing it as sharply curtailed. At the Chicago conference, Federal Reserve Bank of Boston economists Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, and Judit Montoriol-Garriga argued that those aggregate numbers conceal some very significant compositional trends, namely, previously existing lines of credit were being drawn on by borrowers and a sharply increased fraction of lending was consumed by securities originally intended for securitization but which banks were forced to hold on their own books.

Another interesting conference was held two weeks later at the Federal Reserve Bank of Atlanta, from which I found the paper by Gary Gorton quite interesting. (You can also find it discussed by Falkenblog, Cowen, Kling, and Klein). Gorton views the recent problems as an ongoing banking panic. Here are some excerpts:

A banking panic means that the banking system is insolvent. The banking system cannot honor contractual demands; there are no private agents who can buy the amount of assets necessary to recapitalize the banking system, even if they knew the value of the assets, because of the sheer size of the banking system. When the banking system is insolvent, many markets stop functioning and this leads to very significant effects on the real economy....

The current crisis has its roots in the transformation of the banking system, which involved two important changes. First, derivative securities have grown exponentially in the last twenty-five years, and this has created an enormous demand for collateral, i.e., informationally-insensitive debt. Second, there has been the movement of massive amounts of loans originated by banks into the capital markets in the form of securitization and loan sales. Securitization involves the issuance of bonds ("tranches") that came to be used extensively as collateral in sale and repurchase transactions ("repo"), freeing other categories of assets, mostly treasuries, for use as collateral for derivatives transactions and for use in settlement systems.... [R]epo is a form of banking in that it involves the "deposit" of money on call (as repo is short-term, e.g., mostly over night) backed by collateral. The current panic centered on the repo market, which suffered a run when "depositors" required increasing haircuts, due to concerns about the value and liquidity of the collateral should the counterparty "bank" fail....

Securitized asset classes, e.g., mortgages, credit card receivables, auto loans, may be examples of relatively informationally-insensitive debt, created by the private sector without government insurance....

A "systemic shock" to the financial system is an event that causes such debt to become informationally-sensitive, that is, subject to adverse selection because the shock creates sufficient uncertainty as to make speculation profitable. The details of how that happens are discussed below, but in summary, fear of the resulting lemons market can cause the (inefficient) collapse of trading in debt and a stoppage of new credit being issued.

A classic bank run, you say? Hmm, where have I heard that before? But I think there's more that needs to be said about the regulatory environment that is supposed to prevent this kind of thing.

Gorton's paper might offer some support for those who think that we just got stuck on the bad side of a structure with multiple possible equilibria. An alternative and more pessimistic perspective is developed in a recent note by Federal Reserve Bank of San Francisco economists Reuven Glick and Kevin Lansing. Glick and Lansing view the problem as more structural and fundamental, resulting from an unsustainable run-up of household debt. Their analysis was also highlighted by Thoma and Bloomberg.

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Technorati Tags: macroeconomics, economics, Federal Reserve, bank panic, credit crunch

Posted by James Hamilton "

"September 01, 2007

Comments on Housing and the Monetary Transmission Mechanism

Here are the comments that I delivered this morning at the Fed Jackson Hole conference.

Governor Mishkin has done a nice job of categorizing the various channels by which the consequences of monetary policy might be transmitted to the economy. I'd like to take a step back and reflect on what are the instruments of monetary policy, the transmission of whose effects we're discussing.

The instrument of monetary policy that we tend to think of first is the time path of short-term interest rates. It's natural to start there, because it's easy to quantify exactly what the Fed is doing.

But another instrument of monetary policy that I think needs to be discussed involves regulation and supervision of the financial system. This is inherently a messier question. It's harder to quantify the effects, and many of the issues I'm going to be raising today may be outside the current regulatory authority of the Federal Reserve itself. Indeed, one way you can view the history of our financial system is that a certain type of problem becomes recognized, we develop regulations to deal with it, and then new parallel institutions evolve, outside that regulatory framework, where the same kind of problem arises in a new setting.

Although the regulatory question is messier to address, I think we'd all agree there have been periods historically where it played a key role in determining the course of events. The most recent experience might be the 1980s, for which you all know the story.¹ As a result of a series of bad luck and bad decisions, a significant number of U.S. banks and savings and loans at the time ended up with a position of negative net equity. But that did not prevent them from being able to borrow large sums at favorable rates, thanks to deposit insurance. The decision problem for an entity in that situation has a clear solution-- with the lower part of the distribution truncated, you want to maximize the variance of the investments you fund with that borrowing. That recklessness in lending was a factor aggravating both the boom and the subsequent bust of that episode. Fortunately, through a combination of good luck and good policies, we were able to correct the resulting mess in a way that avoided the more severe problems that some of us were anticipating at the time.

Why do I suggest that there might be something similar going on in the current environment? I'm basically very puzzled by the terms of some of the mortgage loans that we've seen offered over the last few years-- for example, mortgages with no downpayment, negative amortization, no investigation or documentation of the borrowers' ability to repay, and loans to households who had demonstrated problems managing simple credit card debt.

The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run, and potentially applies to any institution whose assets have a longer maturity than its liabilities. The problem arises when the losses on the institution's assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent.

In the traditional story, the institution we were talking about was a bank, its long term assets were loans, and its short term liabilities were deposits. In the current situation, the institution could be a bank or investment fund, the assets could be mortgage-backed securities or their derivatives, and the short-term credit could be commercial paper. The names and the players may have changed, but the economic principles are exactly the same. How much of a worry this might be depends on the size of specific potential losses for Institution X relative to its net equity, and the volume of short-term loans that could potentially be disrupted as a result.

This is not just a theoretical possibility. My understanding is that this is exactly what happened to Germany's IKB Deutsche Industriebank on August 9 to set off the tumult in global short-term capital markets.²

Governor Mishkin discusses the potential role of real estate prices in the monetary transmission mechanism. I am seeing that not as an issue in its own right, but instead as a symptom and a propagation mechanism of the broader problem. It is a symptom in the sense that, if loans were extended to people who shouldn't have received them, real estate prices would have been bid up higher than they should have been. And it is a propagation mechanism in the sense that, as long as house prices continued to rise, all sins were forgiven. Even a completely fraudulent loan would not go into default when there's sufficient price appreciation, since the perpetrator is better off repaying the loan in order to enjoy the capital gain.

The problem is that, as this process gets undone, both effects operate in reverse. A credit crunch means that some people who should get loans don't receive them, depressing real estate prices, and as prices fall, some loans will become delinquent that otherwise might not. If such fundamentals are indeed contributing factors on the way up and the way down, the magnitude of the resulting decline in real estate prices, and their implications for default rates, could be much bigger than the reassuring numbers Mishkin invites us to remember based on the historical variability of these series. What worries me in particular is, if we see this much in the way of delinquencies and short-term credit concerns in the current economic environment, in which GDP has still been growing and house price declines are quite modest, what can we expect with a full-blown recession and, say, a 20% decline in average real estate values?

Now, the question that all this leads me to ask is why-- why did all this happen? Why were loans offered at such terms? I'm not sure that I have all the answers, but I am sure that this is the right question. And if you reject my answers, I hope it's because you have even better answers, and not because you dismiss the question.

It seems the basic facts highlighted in Green and Wachter's paper yesterday might be a good place to begin. Since 1990, U.S. nominal GDP has increased about 80% (logarithmically). Outstanding mortgage debt grew 50% more than this, raising the debt/GDP ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed by Fannie and Freddie grew 75% faster than GDP, while mortgages held outright by the two GSEs increased 150% more than GDP. The share of all mortgages held outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% in 2006, which includes $170 billion in subprime AAA-rated private label securities. The fraction had been as high as 20.5% in 2002.³. It is hard to escape the inference that expansion of the role of the GSEs may have had something to do with the expansion of mortgage debt.

Source: Green and Wachter (2007).

This acquisition of mortgages was enabled by issuance of debt by the GSEs which currently amounts to about $1.5 trillion. Investors were willing to lend this money to Fannie and Freddie at terms more favorable than are available to other private companies, despite the fact that the net equity of the enterprises-- about $70 billion last year-- represents only 5% of their debt and only 1.5% of their combined debt plus mortgage guarantees. If I knew why investors were so willing to lend to the GSEs at such favorable terms, I think we'd have at least part of the answer to the puzzle.

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I'm thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, "the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default." And the Fed says, "oh yes we would." And the market says, "oh no you wouldn't."

It's a game of chicken. And one thing that's very clear to me is that this is not a game that the Fed wants to play, because the risk-takers are holding the ace card, which is the fact that, truth be told, the Fed does not want to see the GSEs default. None of us do. That would be an event with significant macroeconomic externalities that the Fed is very much committed to avoid.

While I think that preserving the solvency of the GSEs is a legitimate goal for policy, it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs' assets and liabilities, and making sure the net equity is sufficient to ensure that it's the owners, and not the rest of us, who are absorbing any risks. So here's my key recommendation-- any insitution that is deemed to be "too big to fail" should be subject to capital controls that assure an adequate net equity cushion.

While I think the answer to our question may begin here, it certainly doesn't end, as indeed, thanks to Lockhart, the growth of mortgages held outright by the GSEs in 2006 was held in balance, and we simply saw privately-issued mortgage-backed securities jump in to take their place, with their share of U.S. mortgages spiking from 8.6% in 2003 to 17.4% in 2005. One might argue that the buyers of these private securities may have made a similar calculation, insofar as the same aggregate conditions that keep Fannie and Freddie afloat would perhaps also be enough to keep their noses above water. Or perhaps Professor Shiller is right, that psychologically each investor deluded himself into thinking it must be OK because he saw everybody else doing the same thing. Or maybe they were more rationally thinking, "the Fed wouldn't let us all go down, would it?" And the Fed says, "oh yes we would." And once again, regulation, not selecting an optimal value for the fed funds target, has to be the way you want to play that game.

If these bad loans were all a big miscalculation, perhaps that is something the Fed might consider addressing as a regulatory problem as well. The flow of accurate information is absolutely vital for properly functioning capital markets. I have found myself frustrated, in looking through the annual reports of some of the corporations and funds involved in this phenomena, at just how difficult it is to get a clear picture of exactly where the exposures are. I think the accounting profession has let us down here, which you might describe as a kind of networking equilibrium problem. But if the Federal Reserve were to develop and insist on certain standards of accounting transparency for its member institutions, that might help to be a stimulus to get much more useful public documentation for everybody.

It also might be useful to revisit whether Fed regulations themselves may be contributing to this misinformation. Frame and Scott (2007) report that U.S. depository institutions face a 4% capital-to-assets requirement for mortgages held outright but only a 1.6% requirement for AA-rated mortgage-backed securities, which seems to me to reflect the (in my opinion mistaken) assumption that cross-sectional heterogeneity is currently the principal source of risk for mortgage repayment. Perhaps it's also awkward for the Fed to declare that agency debt is riskier than Treasury debt and yet treat the two as equivalent for so many purposes.

Of course I grant the traditional argument that regulation necessarily involves some loss of efficiency. But to that my answer is, it's worth a bit of inefficiency if it enables us to avoid a full-fledged financial crisis. I'd also point out that, if our problems do indeed materially worsen, the political calls for regulation will become impossible to resist, and much of the cures recommended by the politicians would create dreadful new problems of their own-- that too is part of the historical pattern we've seen repeated many times. For this reason, I think it would be wise for the Federal Reserve to be clear on exactly what changes in regulatory authority could help prevent a replay of these developments, and preposition itself as an advocate to get these implemented now. Such steps will also be necessary, I think, to restore confidence in the system, if the situation indeed worsens from here.

Now, I should also emphasize that understanding how we got into this situation is a different question from how we get out. Tighter capital controls by themselves right now would surely make the matter worse, and allowing an expansion of the GSE liabilities may be as good a short-term fix as anybody has. But I do not think we should do so without seeing clearly the nature of the underlying problem, and certainly cannot think that by itself expansion of GSE liabilities represents any kind of long-run solution.

Finally, in closing, suppose that I'm wrong about all of this. Suppose that the developments I've been talking about-- the appearence of loan originators in every strip mall, anxious to lend to anyone, and other parties just as anxious to buy those loans up-- suppose that it is all a response to the traditional monetary instrument, the manipulation of the short-term interest rate. After all, a 1% short-term rate, 6% 30-year mortgage rate, and 13% house price appreciation, such as we saw in 2004, is plenty of incentive to borrow and repay. I used to believe that this was sufficient to account for all that we were seeing, and many of you perhaps still think that way. But if it were the case that all these institutional changes are just a response to interest rates, it means that the lags in the monetary transmission process are substantially longer than many of us had supposed. If people were still buying houses in 2006 as a result of institutions that sprung up from the conditions in 2004,it means that, if we thought in 2004 that overstimulation could easily be corrected by bringing rates back up, then we would have been wrong. And likewise, suppose you believe that the pain we're seeing now, and may continue to see for a matter of years, until the new loan originators all go out of business, and recent buyers are forced out of their homes, is simply a response to a monetary tightening that ended a year ago. If so, then if we think today that, if things get really bad, we can always fix things by rapidly bringing interest rates back down-- well, then, once again, we'd be wrong.

---

Footnotes

1. See for example Kane (1989) and Keeley (1990). Return to text

2. Wall Street Journal, August 10, 2007, p. A1. Return to text

3. Sources: Office of Federal Housing Enterprise Oversight, Enterprise Share of Residential Mortgage Debt Outstanding: 1990 - 2007Q1, and Lockhart (2007). Return to text

---

References

Frame, W. Scott, and Lawrence J. White. 2007. "Charter Value, Risk-Taking Incentives, and Emerging Competition for Fannie Mae and Freddie Mac," Journal of Money, Credit, and Banking, 39, pp. 83-103.

Green, Richard K., and Susan M. Wachter. 2007. "The Housing Finance Revolution."

Kane, Edward J. 1989. The S&L Insurance Mess: How Did It Happen? (Washington: Urban Institute Press).

Keeley, Michael C. 1990. "Deposit INsurance, Risk, and Market Power in Banking," American Economic Review, 80, pp. 1183-1200.

Lockhart, James A. III. 2007. Housing, Subprime, and GSE Reform: Where Are We Headed?

Shiller, Robert J. 2007. "Recent Trends in House Prices and Home Ownership."

Posted by James Hamilton"

"September 06, 2007

Borrowing short and lending long

Here I elaborate on the description of the nature of current problems in financial markets that I offered at the Fed's Jackson Hole conference last week.

A traditional bank is in the business of taking the funds it receives from its depositors and investing them in projects with higher rates of interest. If that was all that is involved, however, the system would be highly unstable, because it's always possible that the bank could lose money on its long-term investments if interest rates rise or worsening economic conditions lead some of its borrowers to default. In such a situation, if the customers all decide they want their money back, there wouldn't be enough to pay them all.

The way this problem is solved is to have the capital that the bank lends come not just from its depositors but also in part from the owners of the bank. These owners should have invested some of their own money to start the bank and reinvested some of the profits of the bank to allow it to grow. The capital that comes from the owners rather than depositors is known as the bank's net equity. The idea is that if the bank takes a loss on its investments, that loss comes out of net equity, and there's still money to pay off all the people who deposited money in the bank.

And what if the losses are bigger than the net equity? Then we're back to the unstable equilibrium, in which each depositor has an incentive to be the first one to get his or her money back, the situation for a classic bank run. Depositors may not be sure which banks have adequate net equity and which don't, so some will be trying to get their money out of banks that are really in good shape. As a result of the bank run, however, those previously solvent institutions will have to sell off their long-term assets, perhaps at a significant loss if they have to be unloaded at fire-sale prices in a panicked market. The result of this may be that the bank panics themselves create new insolvencies, and the problem cascades into a worsening situation.

Historical experience teaches us that this is a highly undesirable scenario, and can create significant economic hardship for people who are completely innocent bystanders. For this reason, we have developed institutions to regulate the banking system, one key goal of which is to ensure that banks always retain sufficient net equity to be able to weather such storms.

What has happened over the last decade is that a variety of new institutions have evolved that play a similar role to that of traditional banks, but that are outside the existing regulatory structure. Rather than acquire funds from depositors, these new financial intermediaries may get their funds by issuing commercial paper. And instead of lending directly, these institutions may be buying assets such as mortgage-backed securities, which pay the holder a certain subset of the receipts on a larger collection of mortgages that are held by the issuer. Although the names and the players have changed, it is still the same old business of financial intermediation, namely, borrowing short and lending long.

There are a variety of new players involved. The principals could be hedge funds or foreign or domestic investment banks. Others could be conduits or structured investment vehicles, artificial entities created by banks, perhaps on behalf of clients. The conduit issues commercial paper and uses the proceeds to purchase other securities. The conduit generates some profits for the bank but is technically not owned by the bank itself and therefore is off of the bank's regular balance sheet.

This system has seen an explosion in recent years, with the Wall Street Journal reporting that conduits have issued nearly $1.5 trillion in commercial paper. Their thirst for investment assets may have been a big factor driving the recklessness in mortgage lending standards, as a result of which much of the assets backing that commercial paper have experienced significant losses.

Without an adequate cushion of net equity for these new financial intermediaries, and with tremendous uncertainty about the quality of the assets they are holding, the result is that those who formerly bought the commercial paper are now very reluctant to renew those loans, a phenomenon that PIMCO's Paul McCulley described at the Fed Jackson Hole conference as a "run on the shadow banking system." I heard others at the conference claim that there might be as much as $1.3 trillion in commercial paper that will be up for renewal in the next few weeks, with great nervousness about what this will entail.

In some cases, these intermediaries have lines of credit with conventional investment banks on which they will be drawing heavily, which will cause these off-balance-sheet entities to quickly become on-balance-sheet problems. Their losses may severely erode the net equity of the institution extending the line of credit. How big a mess will this be? I don't think anybody really knows for sure.

In my remarks at Jackson Hole, I basically suggested that we should be thinking about both the causes and potential solutions to the current problem not just in terms of choosing an "optimal" level for the fed funds target interest rate, but also in terms of seeking regulatory and supervisory reforms, the ultimate goal of which would be to ensure that any financial institution whose failure would exert significant negative externalities on the rest of us should be subject to net equity requirements, so that most of the money the players in this game are risking is their own.

I also recommended that we need reforms to make the whole system more transparent. I think the accounting profession has let us down, in that it is very difficult to look at the annual reports of some of the institutions involved and determine what exactly the exposures are. In theory, competitive market pressures are supposed to result in incentives for private auditors to ensure accurate and informative reports. But I think there is a networking equilibrium issue here in which it is very hard for one auditor to try to change the rules if nobody else does, even if getting everybody to change at once would unambiguously improve social welfare. I recommended that the Federal Reserve could itself be a catalyst for such a change by revisiting the reporting requirements on its member institutions.

---

Technorati Tags: macroeconomics, housing, Federal Reserve, bank run, economics, bank conduits, shadow banking system

Posted by James Hamilton"

Me:
Previewing your Comment
"The concern that I think we should be having about the current situation arises from the same economic principles as a classic bank run, and potentially applies to any institution whose assets have a longer maturity than its liabilities. The problem arises when the losses on the institution's assets exceed its net equity. Short-term creditors then all have an incentive to be the first one to get their money out. If the creditors are unsure which institutions are solvent and which are not, the result of their collective actions may be to force some otherwise sound institutions to liquidate their assets at unfavorable terms, causing an otherwise solvent institution to become insolvent." I call this a Calling Run, and agree with you. But my notion of this came from Irving Fisher's classic paper "The Debt-Deflation Theory Of Great Depressions", and Debt-Deflation is what frightened me, not a contained run on some kinds of investments. Was this your worry as well? In other words, the fear was a run that spread outside of its purview. Posted by Don the libertarian Democrat

That, too, is a disappointment for those who are waiting for increased consumption spending to lift us out of recession

TO BE NOTED: From Econbrowser:

Where's my recovery, dude?

A couple of disappointments in this week's data.

New claims for unemployment insurance have peaked just before the end of each of the last half-dozen recessions.

Black line: 4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Shaded areas correspond to recessions as judged by the National Bureau of Economic Research.

Unfortunately, the Labor Department reported today that seasonally adjusted new claims for unemployment insurance rose by 32,000 for the most recent available week. That bumps the 4-week average to 630,000, up 6,000 from its value the previous week, though the average is still below its peak of 659,000 reported April 9. That the downward trajectory will resume next week is far from clear.

Black line: seasonally adjusted weekly new claims for unemployment insurance from January 1 through May 14, 2009. Blue line: 4-week average.

We also received the news yesterday that monthly sales for retail and food services fell 0.4% in April, the second consecutive monthly drop. That, too, is a disappointment for those who are waiting for increased consumption spending to lift us out of recession.

Source: FRED.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton "

could prove to be a significant limiting factor on how much the Fed can hope to achieve from monetary stimulus

TO BE NOTED: From Econbrowser:

"Inflation and relative prices

There are persuasive reasons why we'd be better off today with an inflation rate higher than what we've seen over the last six months. But while a uniform expansion that raised all wages and prices by the same amount would be helpful, what the Fed could actually achieve in the present situation may be something less desirable.

When academic economists talk about inflation, we often think in terms of a single-good economy in which the concept refers unambiguously to an increase in the dollar price of that good. But in the real world, in any given month some prices rise and others fall, and we can only measure inflation in terms of the broad central tendency behind those individual price changes.

A recent research paper by Columbia Professor Ricardo Reis and Princeton Professor Mark Watson suggests that real-world measured inflation may behave very little like the textbook ideal. Reis and Watson introduce the hypothetical concept of a pure inflation shock as something that changes every price by x(t) percent, where in any given quarter t the magnitude x(t) is the same number for every item in the economy. Reis and Watson show how such a shock can be measured for any given quarter by observing the behavior of separate components of the PCE deflator. Their principal finding is that this concept of pure inflation in fact plays very little role in quarterly changes in broad price indexes such as the GDP deflator or the consumer price index, accounting for only 15-20% of measured inflation. The authors instead find that changes in relative prices are much more important than pure inflation for determining what happens to the broad CPI. For example, the measured deflation over the last 6 months is heavily influenced by falling energy prices.

If you think that the Federal Reserve is responsible for more than 15-20% of the variation in the CPI, the implication is that part of its influence comes from changes it causes in relative prices. But changes in relative prices-- such as the huge run-up in energy prices in the first half of 2008-- can be much more destabilizing than the textbook pure inflation.

I would therefore think that the Fed might be somewhat concerned by the surge in commodity prices over the last few weeks. The graph below plots the prices of 11 commodities since the Fed's announcement of quantitative targets on March 18. Gold is the only one of these commodities that hasn't gone up in price, with the average of these commodities up 13% over the last two months.

Prices of assorted commodities normalized at March 17, 2009 = 100. Data source: WSJ commodity cash prices, via Webstract.

Some increase in relative commodity prices is certainly to be expected if we are indeed about to see a recovery in real economic activity. But this is a trend the Fed needs to watch closely from here, and could prove to be a significant limiting factor on how much the Fed can hope to achieve from monetary stimulus.

Because I for one do not think it's a good idea to call for a replay of the 2008:H1 commodity market show.

---

Technorati Tags: macroeconomics, commodity prices, economics, Federal Reserve, deflation, inflation

Posted by James Hamilton"

That brings the 4-week average down for the third consecutive week and puts it 3.3% below the peak reached April 9

TO BE NOTED: From Econbrowser:

"April 30, 2009

Further progress for initial claims for unemployment insurance

The Labor Department reported today that initial claims for unemployment insurance fell by 14,000 during the most recent available week. That brings the 4-week average down for the third consecutive week and puts it 3.3% below the peak reached April 9.

Black line: seasonally adjusted new claims for unemployment insurance, weekly since January. Blue line: average of 4 most recent weeks as of each date.

That ongoing drop in the 4-week average is noteworthy because in each of the last 5 recessions, once the new claims number began declining from its peak value reached during the recession, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks.

Black line: 4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Vertical lines: first week of the first month of a business cycle expansion as subsequently dated by the National Bureau of Economic Research.

Reasoning as in my last discussion of these data, one can try to judge how meaningful the latest numbers might be as follows. If we leave out the 1970 recession, there are 230 weeks in which the NBER declared the economy to have been in recession during the 5 recessions of 1974, 1980, 1982, 1990, and 2001. In 22 of these weeks, we saw as big a drop as we've seen this month, namely, the 4-week average dropped by more than 3.3% over a 3-week period. Of these 22 favorable readings, 11 turned out to be part of the final move out of recession, while in the other 11, new claims turned back up to reach a subsequent higher peak. Thus, if all you had to go on was the data on new unemployment claims and its behavior in previous recessions, you might conclude that there's a 50% chance that an economic recovery will have started by the beginning of June.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton"

Though I grant it takes a little imagination to see that in the graph above

TO BE NOTED: From Econbrowser:

"April 29, 2009

Good economic news?

Today's GDP numbers were about what I was expecting. Although economic activity continued its sharp decline, if we continue to follow the script, things should improve.

The Bureau of Economic Analysis reported today that U.S. real GDP fell at a 6.1% annual rate in the first quarter of 2009. That's enough to push our Econbrowser Recession Indicator Index up to 99.5%, its highest value since 1980:Q2. This index uses the latest GDP numbers to form a retrospective impression of the economy's status as of one quarter earlier (2008:Q4). We will declare the recession to be over when the index falls back below 33%.

The plotted value for each date is based solely on information as it would have been publicly available and reported as of one quarter after the indicated date, with 2008:Q4 the last date shown on the graph. Shaded regions represent dates of NBER recessions, which were not used in any way in constructing the index, and which were sometimes not reported until two years after the date.

Leading the retreat in real GDP was a 9.5% drop (quarterly rate) in nonresidential fixed investment. This was enough all by itself to subtract 4.7% from the annual GDP growth rate. There was a comparable drop in residential fixed investment, which subtracted another 1.4% from the implied annual GDP growth rate. The collapse in nonresidential fixed investment was what we expected, given the usual cyclical pattern of plunging business fixed investment in the later stages of an economic downturn. The drop in housing surprised me somewhat. If new home construction does no better than simply hold steady at its current abysmally low rate, the sector will stop making negative contributions to the growth rate.

Because imports are subtracted from GDP, falling imports made a big positive contribution to GDP growth, much of which was taken away by plunging exports. But it would be quite wrong-headed to summarize these twin developments solely in terms of their net implications for U.S. GDP. The simultaneous drop in imports and exports signals an accelerating collapse in world trade, which I see as the single most troubling detail of today's report.

On the bright side, inventory liquidation subtracted 2.8% from the quarter's annual real GDP growth rate, meaning that real final sales were substantially better than GDP. Most importantly, consumption rebounded from the depressed levels of 2008:Q4.

That last development is particularly key, since the historical pattern is for consumption to begin the recovery in the later phases of the recession, even as nonresidential fixed investment is headed down.

Average cumulative change in 100 times the natural log of real GDP or its respective component beginning from the business cycle peak for the 10 recessions between 1947 and 2001. Horizontal axis denotes quarters after the peak.

If you want to see that pattern of recession and recovery blown up on a bigger scale, you can look just at the downturn of 1981-82:

Cumulative change in 100 times the natural log of real GDP or its respective component beginning in 1981:Q3. Horizontal axis denotes quarters after 1981:Q3.

Here's how these series have behaved so far this time:

Cumulative change in 100 times the natural log of real GDP or its respective component beginning in 2007:Q4. Horizontal axis denotes quarters after 2007:Q4.

If this is all unfolding according to historical pattern, that's a source of comfort, because we saw how those earlier recessions ended. If consumption continues to grow, and if residential fixed investment has finally bottomed, then the 2009:Q2 decline in GDP should be milder than Q1, and positive growth by the end of the year could be in store.

Though I grant it takes a little imagination to see that in the graph above.

---

Technorati Tags: GDP, recession probability, recession indicator index, macroeconomics, economics

Posted by James Hamilton"

once new claims number began declining from its peak value, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks

TO BE NOTED: From Econbrowser:

"Initial claims for unemployment insurance

The Labor Department reported today that initial claims for unemployment insurance rose by 27,000 in the most recent available week. Although that's a disappointing development, it's still a small enough increase to allow the 4-week average to fall for the second week in a row. Since that declining 4-week average is one of the few encouraging pieces of news in an otherwise discouraging economic landscape, I wanted to take a closer look at just how significant a statistical signal it really sends.

The interest in the 4-week average of new claims for unemployment compensation results from the observation by Northwestern Professor Robert Gordon that, for each of the last six recessions, once the new claims number began declining from its peak value, the NBER subsequently dated the recovery from that recession as beginning within 8 weeks.

Black line: 4-week average of seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Vertical lines: first week of the first month of a business cycle expansion as subsequently dated by the National Bureau of Economic Research.

Here's a close-up of the behavior of the series so far in 2009, with the raw weekly numbers in black and the 4-week average in blue.

Will the latest downward move prove to be the beginning of a recovery, or will we turn around and head back up to a new high? Let's try to pose this as a statistical question. We're trying to figure out whether the number for the 4-week average that was reported two weeks ago will turn out to be the highest value of this recession. Let s_t equal 0 if week t turns out to come before the peak value for the recession, and s_t = 1 if it turns out we're past the peak. Of course we don't know now which is the case, but if t represents a week from one of the previous 6 recessions, we now know enough to assign a value of either 0 or 1 to that week. There are 278 of those earlier observations on s_t from the recessions of 1970, 1974, 1980, 1982, 1990, and 2001.

The question we'd like to ask statistically is the following. Let's take it as given that we're currently in a recession. Let y_t denote the observed two-week percentage change in the 4-week average as of week t. The latest observation is a 1.8% decline, so the most recent value is y_t = -1.8. We'd like to calculate the probability that s_t = 1 if we've seen a 2-week decline in y_t as big as 1.8%, that is, we'd like to find the value of

From the definition of a conditional probability, this can be found by dividing the joint probability by the marginal probability:

We know the denominator of this fraction by looking at the number of those earlier known recession weeks between 1969 and 2001 for which we observed a 2-week decline in the 4-week average for new claims of 1.8% or more. It turns out that there were 46 weeks as favorable or more so as our most recently available datum:

To get the numerator, we count how many of those favorable declines proved to be the real McCoy. The answer is, 17 of them were part of the eventual trip down and out of the recession, but the other 29 represented temporary relief on a path that would eventually reach a new peak before turning down. The answer to our original question of interest, namely what's the probability we're on our way out of the recession this time, is thus given by

In other words, there's a 63% chance that new unemployment claims will go back above the recent peak before they finally start to head back down.

The key factor that leads to this pessimistic assessment is the fact that we're conditioning on the knowledge that our current week t is definitely still part of the recession, which seems to me an entirely safe bet. Given that we are in a recession, that fact in itself would lead you to expect to see new unemployment claims go up rather than down (as they did in the vast majority of our 278-week earlier sample). The fact that we've seen the average decline for a couple of weeks now isn't enough to get you to change your mind, if you're convinced that as of right now the recession has not yet ended.

What would it take to get you to change your mind? A 2-week drop of more than 3.4% would bring the probability above 0.5. But you'd never get much more confident than that based on this line of reasoning, because you'd always be factoring in the possibility that we'd see a repeat of the big drops in new unemployment claims that were observed in the 1970 and 1974 recessions, which ended up being followed by even bigger increases. The fact we're conditioning on for these calculations-- that we're currently in a recession-- is by itself a strong enough predictor that future unemployment claims are headed higher that you'd never be completely sure the peak is behind us based on just a few weeks worth of decline.

In other words, you'd never be completely persuaded, if the only variable you had to look at was a few weeks of unemployment claims, that a recession is just about to end.

The latest number might turn out to be a green shoot, no question. But the odds are two to one that it's just another dead twig.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton "

it's hard to envision a recovery without an upswing in consumer spending

TO BE NOTED: From Econbrowser:

"Update on the latest economic indicators

Some good news, some bad, in the indicators we follow this week.

First, the bad news. Monthly sales for retail and food services, which had been up a bit in January and February, fell 1.1% on a seasonally adjusted basis between February and March, leaving the first quarter 8.8% below 2008:Q1. That's a particularly discouraging development, since given the cyclical behavior of the other components of GDP, it's hard to envision a recovery without an upswing in consumer spending.

Source: FRED.

On the other hand, new claims for unemployment compensation were reported today to have fallen by 53,000 in the week ending April 11, bringing the 4-week average down by 8,500 from what the revised numbers show to have been the recent peak the week before. If April 4 ultimately proves to be the peak for the entire year, and if this recession behaves like each of the previous 6 recessions, we could expect the NBER eventually to declare that the economic recovery began within 6 weeks of today.

Black line: seasonally adjusted weekly initial claims for unemployment insurance, from Department of Labor via Webstract. Blue line: 4-week average of black line. Vertical lines: first week of the first month of a business cycle expansion as subsequently dated by the National Bureau of Economic Research.

Calculated Risk notes Goldman Sachs economist Seamus Smyth's estimate that a decline of 20,000 in the four-week average signals we've passed the real peak with probability 0.5, and a decline of 40,000 would give us 90% confidence. CR accordingly cautions not to get excited over the 8,500 drop seen so far.

Excited or no, bad news it's not, and the new claims data release was enough to allow the Aruoba-Diebold-Scott Business Conditions Index to climb up to -2.04% on April 11 from the previous assessment of -2.44% for April 4.

ADS BCI for July 1, 2007 through April 11, 2009, as assessed on April 16, 2009. Data source: Federal Reserve Bank of Philadelphia.

---

Technorati Tags: employment, recession, macroeconomics, economics

Posted by James Hamilton"

Why sell crack when taking money from a careless lender is so much easier and more profitable?

TO BE NOTED: From Econbrowser:

"Mortgage fraud

Why sell crack when taking money from a careless lender is so much easier and more profitable?

From the San Diego Union Tribune:

Federal prosecutors indicted 24 people in a massive mortgage fraud scheme that they said was led in part by a gang member from San Diego and netted participants $11 million in profits.

In an indictment unsealed yesterday, prosecutors laid out a wide-ranging racketeering conspiracy that ran from 2005 to 2008 and targeted homes across the county. Among the identified leaders was Darnell Bell, a documented member of the Lincoln Park street gang.

Bell, 38, used his status in the gang to recruit other members for the scheme and "maintain discipline," according to the indictment.

The sweeping conspiracy involved almost every element in the real estate transaction chain. The defendants include a real estate broker, a group of straw buyers, an escrow officer, an appraiser, tax preparers and a notary.

Prosecutors allege the network used fake buyers to purchase homes for more than the asking price, with the defendants pocketing the overage. Lenders were duped into funding mortgages for the inflated price and later suffered losses when the buyers walked away and the property was foreclosed.

The value of the properties involved is estimated at $100 million.

I'm wondering if the lenders were also "duped" into lending this $100+ million without income documentation or down payments.

Posted by James Hamilton at April 12, 2009 07:13 AM"

a rapid lowering of rates could actually exacerbate the magnitude of an economic downturn

TO BE NOTED: From Real Time Economics:

"By Justin Lahart

Reeling from the housing bust and the banking crisis, it’s hard to think that the energy shock — the one that carried the average price of gasoline to a peak of $4.11 a gallon last July — was much more than a minor player in the economic downturn. But there’s the uncomfortable fact previous oil shocks, like the ones that came with the 1973 oil embargo, the 1979 Iranian revolution and the 1990 invasion of Kuwait, were also associated with recessions. And the 2001 recession, too, came on the heels of a run-up in oil prices.

In a paper presented at the Brookings Panel on Economic Activity Thursday, University of Calif.-San Diego economist James Hamilton crunched some numbers on how consumer spending responds to rising energy prices and came to a surprising result: Nearly all of last year’s economic downturn could be attributed to the oil price shock.

As he writes on his blog, that’s a conclusion that he doesn’t quite believe in himself. We’d like to think that, say, the seizing up of the credit markets this fall had something to with the economy falling off the table in the fourth quarter.

But then again, maybe what happened to oil prices had something to do with credit markets seizing up. The housing bubble saw people of lesser means traveling further afield to buy homes. That gave them long commutes that they were able to afford when gas was $2 a gallon, but maybe they couldn’t at $3. Housing in the exurbs got hit hardest, and one reason why is that high gasoline prices made it hard for people to lived in them to keep up with their mortgage payments, and hard for them to sell their homes without taking a steep loss. In some meaningful way, that has to have contributed to mortgage problems.

A more controversial argument on energy’s role in the credit crunch could go like this. Housing prices kept on climbing, but the Federal Reserve – laboring on the idea that it couldn’t identify bubbles and that even if it could, it shouldn’t pop them — didn’t do anything about them. But then rising oil prices started adding to inflationary pressures, so the Fed kept pushing rates higher, left them high even as housing prices collapsed, and was to slow to lower them when the credit crisis got rolling."

And, from Econbrowser:

"Consequences of the Oil Shock of 2007-08

In a follow-up on my earlier post, I'd now like to discuss the second part of my paper, Causes and Consequences of the Oil Shock of 2007-08, which I presented today at a conference at the Brookings Institution. Here I'll review the role that the oil price shock may have played in causing the economic recession that began in 2007:Q4.

My paper uses a number of different models that had been fit to earlier historical episodes to see what they imply about the contribution that the oil shock of 2007-08 might have made to real GDP growth over the last year. The approaches surveyed include Edelstein and Kilian (2007), who examined the detailed response of various components of consumer spending, Blanchard and Gali (2007), who studied the extent to which the contribution of oil shocks has significantly decreased over time, my 2003 paper, which emphasized the role of nonlinearities, and a model-free data summary of the observed behavior of different economic magnitudes following this and previous oil shocks. Although the approaches are quite different, they all support a common conclusion: had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the U.S. economy would not have been in a recession over the period 2007:Q4 through 2008:Q3.

One of the most interesting calculations for me was to look at the implications of my 2003 model. I used those historically estimated parameters to find the answer to the following conditional forecasting equation. Suppose you knew in 2007:Q3 what GDP had been doing up through that date and could know in advance what was about to happen to the price of oil. What path would you have then predicted the economy to follow for 2007:Q4 through 2008:Q4?

The answer is given in the diagram below. The green dotted line is the forecast if we ignored the information about oil prices, while the red dashed line is the forecast conditional on the huge run-up in oil prices that subsequently occurred. The black line is the actual observed path for real GDP. Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.

Solid line: 100 times the natural log of real GDP. Dotted line: dynamic forecast (1- to 5-quarters ahead) based on coefficients of univariate AR(4) estimated 1949:Q2 to 2001:Q3 and applied to GDP data through 2007:Q3. Dashed line: dynamic conditional forecast (1- to 5-quarters ahead) based on coefficients reported in equation (3.8) in Hamilton (2003) (which was estimated over 1949:Q2 to 2001:Q3) applied to GDP data through 2007:Q3 and conditioning on the ex-post realizations of the net oil price increase measure.

The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don't fully believe myself. Unquestionably there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

It is interesting also that the observed dynamics over 2007:Q4-2008:Q4 are similar to those associated with earlier oil shocks and recessions. The biggest drops in GDP come significantly after the oil price shock itself. What we saw in earlier episodes was that the drops in spending caused by the oil price increases resulted in lost incomes and jobs in affected sectors, with those losses then magnifying other stresses on the economy and producing a multiplier dynamic that gathered force over subsequent quarters. The mortgage delinquencies and financial turmoil in the current episode are of course not the specific stresses that operated in earlier downturns, but the broad features of that multiplier process are surprisingly similar to the historical pattern.

My paper concludes:

Eventually, the declines in income and house prices set mortgage delinquency rates beyond a threshold at which the overall solvency of the financial system itself came to be questioned, and the modest recession of 2007:Q4-2008:Q3 turned into a ferocious downturn in 2008:Q4. Whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them, is a matter of conjecture. Regardless of how we answer that question, the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession.

---

Technorati Tags: oil, oil prices, oil shocks

Posted by James Hamilton at April 2, 2009 07:27 PM"

"A more conventional policy tool would be monetary policy. A number of observers
suggested that the very rapid declines of short-term interest rates in 2008:Q1 fanned the
flames of commodity speculation, with negative real interest rates encouraging investments
in physical commodities (e.g., Frankel, 2008). In January 2009, Federal Reserve Chair Ben
Bernanke offered the following retrospective on that debate:
The [Federal Open Market] 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,
41
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.
Bernanke seemed here to be taking the position that since the Fed got the long run
correct (ultimately there would be a significant downturn in both the economy and commodity
prices, with strong disinflationary pressure), the short-run consequences (booming
commodity prices in 2008:H1) were less relevant. On the other hand, if it is indeed the
case that the spike in oil prices was one causal factor contributing to the downturn itself,
there are concerns to be raised about ignoring those short-run implications. The evidence
examined here is consistent with the claim that if a slower easing of interest rates in 2008:H1
had succeeded in mitigating the magnitude of the oil price run-up, the result could well
have been a better outcome in terms of the 2008:H1 real GDP growth rate. Although the
Fed is not accustomed to think in such terms— that a rapid lowering of rates could actually
exacerbate the magnitude of an economic downturn— I think there is some reason to take
such a possibility seriously in this case.
But while the question of the possible contribution of speculators and the Fed is a very
interesting one, it should not distract us from the broader fact: some degree of significant
oil price appreciation during 2007-08 was an inevitable consequence of booming demand and
42
stagnant production. It is worth emphasizing that this is fundamentally a long-run problem,
which has been resolved rather spectacularly for the time being by a collapse in the world
economy. However, the economic collapse will hopefully prove to be a short-run cure for the
problem of excess energy demand. If growth in the newly industrialized countries resumes at
its former pace, it would not be too many more years before we find ourself back in the kind
of calculus that was the driving factor behind the problem in the first place. Policy-makers
would be wise to focus on real options for addressing those long-run challenges, rather than
blame what happened last year entirely on a market aberration."

What we need in the current situation is a central bank that is a bulwark of stability.

TO BE NOTED: From Econbrowser:

"The Fed's new balance sheet

My previous post reviewed the profound changes in the balance sheet of the U.S. Federal Reserve over the last 18 months. Here I comment on some of the concerns that the new Fed balance sheet raises for the conduct of monetary policy.

I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.

Assets of the Federal Reserve, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward. Apart from that general unease, I have a particular concern about the motivation for the Term Asset-Backed Securities Loan Facility, whose goal is to generate up to $1 trillion of lending for businesses and households by catalyzing a revival of loan securitization. I grant that securitization was an enormously successful device for funneling vast sums into sundry loans. For example, securitization successfully turned 80% of quite shaky subprime loans into Aaa-rated assets. To put that in perspective, only five U.S. companies currently have the ability to issue Aaa-rated debt. So yes, a device that transformed weak loans into Aaa-rated debt was marvelously successful at attracting capital from all over the world into U.S. private lending.

Ratio of total mortgage debt (from Table L.2 of Flow of Funds Accounts) to nominal GDP (from BEA Table 1.1.5).

But the whole premise behind those Aaa ratings-- that securitization could isolate a "safe" component of a pool of fundamentally risky loans-- was deeply flawed. It is impossible to diversify away aggregate or systemic risk. All that the device did was to mislead investors into thinking they were protected from those nondiversifiable risks and push those risks onto the taxpayers and the Fed. Before we decide that securitization is the road out of our present difficulties, I would like a detailed and convincing explanation of why the past mistakes are not going to be repeated again.

A second concern I have with the new Fed balance sheet is that it has seriously compromised the independence of the central bank. To my knowledge, every hyperinflation in history has had two key ingredients: (1) budget deficits that could not be resolved politically, and (2) a central bank that assumed the obligations that the fiscal authority could not.

In the U.S. today, there is little question in my mind that repaying the projected deficits with tax increases or spending cuts will be extremely difficult politically. Each additional trillion dollars would roughly require doubling the personal income tax rate on all Americans for one year, something I cannot see the political process delivering. There is enormous pressure in the current situation to defer solutions and look for temporary fixes with off-balance-sheet measures. The reason that the Fed is sought as a partner for the Treasury in all these new actions is because the Fed is perceived to have deeper pockets than the Treasury. This is not a situation that a self-respecting central bank should let itself get into.

My third concern is that the new Fed balance sheet has handicapped the Fed's ability to fulfill its primary mission, which I see as promoting a stable and predictable low rate of inflation. Which of the Fed's new assets would it sell off when it needs to absorb back in the huge volume of reserves it has recently created? The Fed's hoped-for scenario is that the reserves won't need to be called back in until the situation has stabilized and the facilities are no longer needed. But I am concerned instead about the possibility of a dramatic shift in the perceptions of foreign lenders, in which case inflationary pressures could emerge in a situation that is far more chaotic than the one we currently face.

I recommend instead that the Fed should be buying Treasury Inflation-Protected Securities in the current situation. Tim Iacono says that's like the Mafia buying "protection" from itself. But my point is that TIPS represent an asset that would gain in value at a time the Fed needs to sell them, meaning that the logistical ability of the Fed to drain reserves quickly in such circumstances is without question.

What we need in the current situation is a central bank that is a bulwark of stability. A profound lack of confidence in the U.S. government itself would make our current problems look like a walk in the park. If the Fed had the means and the credibility to deliver a stable and low inflation rate, I believe that would go a long way to solving our current problems.

But it's not clear the Fed has either the means or the credibility."

Plan B is for the Fed to borrow directly from the public

TO BE NOTED: From Econbrowser:

"Money creation and the Fed

A lot of people have seen this picture of the recent behavior of the monetary base and wondered what it means.

Figure 1. Adjusted monetary base. Source: FRED.

To understand the explosion in the monetary base since September, let's begin with a little background. The Federal Reserve has the ability to purchase assets or make loans with funds (money) that are created by the Fed itself. To buy a billion dollars worth of assets, the Fed doesn't show up with new cash in a wheelbarrow. Instead the Fed pays for any assets it purchases or loans it extends by crediting the funds that the recipient bank has in an account with the Fed, known as reserve deposits. A bank can later withdraw those deposits in the form of green currency, if it chooses, and that's the point at which an armored truck from the Fed would be involved with physical delivery of cash.

The monetary base is essentially the sum of (1) the currency that's been withdrawn from private banks and is being held by the public, (2) the currency that's sitting in the vaults of private banks that could potentially be withdrawn by the banks' customers if they wanted, and (3) banks' reserve deposits, which you could think of as electronic credits for currency that the banks could ask for from the Fed any time the banks choose. Historically, newly created reserve deposits have usually shown up pretty quickly as currency withdrawn by banks and then by the public. Choosing a pace at which to allow that supply of currency to grow so as to accommodate the increased currency demands from a growing economy without cultivating excessive inflation is one of the main responsibilities of the Fed.

Figure 2 below plots the assorted "factors absorbing reserve funds" from the Fed's H41 release during the halcyon period from 2003 to the middle of 2007. At that time, currency held by the public was by far the biggest component in the liabilities side of the Fed's balance sheet, with the currency supply increasing 20% over these 5 years and with temporary seasonal bumps to accommodate the annual Christmas surge in currency demand. Reserve deposits (the sum of the "reserves" and "service" components in Figure 2) were quite minor relative to total quantity of currency in circulation.

Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 7, 2003 to June 27, 2007. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

With this increase in newly created money, the Fed was over this period acquiring assets primarily in the form of short-term Treasury securities, which holdings grew 25% over this 5-year period. The Fed at that time used short-term repurchase agreements as a device for adjusting the supply of reserves on a temporary basis. Note that for each date the height of the components in Figure 3 below (essentially the asset side of the Fed's balance sheet) is exactly equal, by definition, to the height of the liabilities portrayed in the previous Figure 2.

Figure 3. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 7, 2003 to June 27, 2007. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

Beginning in September 2007, the Fed began a process of systematically changing the nature of its asset holdings. Over the course of the next year, the Fed sold off over $300 billion in Treasury securities (about 40% of its holdings of Treasury securities), and replaced them with $150 billion in direct bank lending in the form of term auction credit, $60 billion in loans to foreign central banks in the form of liquidity swaps, and $100 billion in repurchase agreements, used now not for temporary adjustments but instead as a device to create a market for MBS by accepting alternative assets as collateral.

Figure 4. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to August 27, 2008. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

Because the Fed funded those measures through August 2008 by selling off its holdings of Treasuries, there was little effect on either currency in circulation or the monetary base through that time.

Figure 5. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to August 27, 2008. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

Beginning in September of 2008, the Fed embarked on a huge expansion in its lending efforts and holdings of alternative assets. The biggest items among assets currently held are $469 billion in term auction credit, $328 billion in currency swaps, $241 billion leant through the CPLF, and $236 billion in mortgage-backed securities now held outright.

Figure 6. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

Where did the Fed get the resources to do all this? In part, it asked the Treasury to borrow on its behalf, represented by the pale yellow region in Figure 7 below, and a sum that last week amounted to a quarter trillion dollars. Note that magnitude is not part of the monetary base drawn in Figure 1. Some of the Fed expansion has shown up as additional currency held by the public, which made a modest contribution to the explosion of the monetary base seen in Figure 1. But by far the biggest factor was a 100-fold increase in excess reserves, the green region in Figure 7. These excess reserves mean that for the most part, banks are just sitting on the newly created reserve deposits, holding these funds idle at the end of each day rather than trying to invest them anywhere.

Figure 7. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 3, 2007 to March 25, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

That idleness, as I read the situation, was something the Fed initially actually wanted, and deliberately cultivated by choosing to pay an interest rate on excess reserves that is equal to what banks could expect to obtain by lending them overnight. As long as banks do just sit on these excess reserves, the Fed has found close to a trillion dollars it can use for the various targeted programs.

But what would happen if those electronic credits start to be redeemed for actual cash? Then we would have a concern, and the Fed would need to call the reserves back in by selling assets or failing to renew loans. But that presents a potential problem, as noted by Charles Plosser, President of the Federal Reserve Bank of Philadelphia:

It is true that a number of the Fed's new programs will unwind naturally and fairly quickly as they are terminated because they involve primarily short-term assets. Yet we must anticipate that special interests and political pressures may make it harder to terminate these programs in a timely manner, thus making it difficult to shrink our balance sheet when the time comes. Moreover, some of these programs involve longer-term assets-- like the agency MBS. Such assets may prove difficult to sell for an extended period of time if markets are viewed as "fragile" or specific interest groups are strongly opposed, which could prove very damaging to our longer-term objective of price stability.

Last Monday's joint statement by the Treasury and the Fed indicated that the plan is for the worst of the Fed's assets (reported as "Maiden Lane" and part of the "AIG" sums in Figure 4) to be taken over by the Treasury, and Plosser for one wants the Treasury to take all the non-Treasury assets off the Fed's balance sheet. But as the Fed has declared its intention to raise its MBS holdings to $1.25 trillion it seems the current plan calls for more, not less of non-Treasury assets. And the following clause in the joint Fed-Treasury statement suggests that perhaps the Fed intends this, like most of the previous balance sheet changes, to not be allowed to impact total currency in circulation:

the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves.

John Jansen (hat tip: Tim Duy) construes that clause to mean that the Fed is going to request the ability to borrow directly as well as for exemption of any borrowing done by the Treasury on behalf of the Fed from the congressional debt ceiling. Also via Tim, FRB San Francisco President Janet Yellen offers this elaboration:

As the economy recovers, the Fed will eventually have to reduce the quantity of excess reserves. To some extent, this will occur naturally as markets heal and some programs consequently shrink. It can also be accomplished, in part, through outright asset sales. And finally, several exit strategies may be available that would allow the Fed to tighten monetary policy even as it maintains a large balance sheet to support credit markets. Indeed, the joint Treasury-Fed statement indicated that legislation will be sought to provide such tools. One possibility is that Congress could give the Fed the authority to issue interest-bearing debt in addition to currency and bank reserves. Issuing such debt would reduce the volume of reserves in the financial system and push up the funds rate without shrinking the total size of our balance sheet.

In other words, if the Fed decides that, as a result of inflationary pressures, it needs to undo some of the expansion in its liabilities at a time when it is not prepared to unwind its asset positions, Plan B is for the Fed to borrow directly from the public.

Which brings me back to the original question. Does the explosive growth of the monetary base in Figure 1 imply uncontrollable inflationary pressures? My answer: not yet, but stay tuned."