—is the central bank's lender-of-last-resort function meaningful if narrowly construed (that is, if it fails to reach the shadow banking system)?

TO BE NOTED: From Macroblog:

"A new accord?

As days go in the U.S. Treasury market, Wednesday was a rough one. Bloomberg News described the day's developments as follows:

"The difference in yields between Treasury two- and 10-year notes widened to a record on concern surging sales of U.S. debt will overwhelm the Federal Reserve's efforts to keep borrowing costs low. …

"The unprecedented government borrowing has created concern about a rise in consumer prices. Policy makers have expanded the Fed's balance sheet to $2.2 trillion while excess reserves at U.S. banks have increased to $896.3 billion.

" 'Inflation is in the headlight of many investors,' wrote Andrew Brenner, co-head of structured products and emerging markets in New York at MF Global Inc., in a note to clients today."

By cosmic coincidence, I was reading that story in Tokyo as I prepared to chair a session at the Bank of Japan's 2009 International Conference on Financial System and Monetary Policy Implementation in which Marvin Goodfriend (Carnegie-Mellon professor and former Richmond Fed policy adviser) presented his thinking on keeping the central bank's inflation objectives firmly in hand at a time of rapidly rising government debt and large increases in the Fed's balance sheet. Professor Goodfriend's case is laid out in a paper titled "Central Banking in the Credit Turmoil: An Assessment of Federal Reserve Practice" (which was also presented at a conference devoted to research on the interactions between monetary and fiscal policy—that is, government spending and tax—co-sponsored by Princeton University's Center for Economic Policy Studies and Indiana University's Center for Applied Economics and Policy Research). Goodfriend pulls no punches:

"The 1951 'Accord' between the United States Treasury and the Federal Reserve was one of the most dramatic events in U.S. financial history. The Accord ended an arrangement dating from World War II in which the Fed agreed to use its monetary policy powers to keep interest rates low to help finance the war effort. The Truman Treasury urged that the agreement be extended to keep interest rates low in order to hold down the cost of the huge Federal government debt accumulated during the war. Fed officials argued that keeping interest rates low would require inflationary money growth that would destabilize the economy and ultimately fail.

"The so-called Accord was only one paragraph, but it famously reasserted the principle of Fed independence so that monetary policy might serve exclusively to stabilize inflation and the macroeconomic activity. …

"The enormous expansion of Fed lending today—in scale, in reach beyond depository institutions, and in acceptable collateral—demands an accord for Fed credit policy to supplement the accord on monetary policy. A credit accord should set guidelines for Fed credit policy so that pressure to misuse Fed credit policy for fiscal purposes does not undermine the Fed's independence and impair the central bank's power to stabilize financial markets, inflation, and macroeconomic activity."

Goodfriend's "new accord" amounts to asserting a set of principles that would reinforce price stability as the central goal of monetary policy, set the Fed down the road of extricating itself from the extraordinary credit market interventions of the past year-and-a-half, and join the central bank and Treasury in common cause toward the goal of doing everything possible to make sure that the Fed and Treasury don't go there again.

The paper was provocative, but it also raised a couple of fundamental questions. In particular, what is the degree of autonomous fiscal risk-taking appropriate to allocate to a central bank? If such powers are granted, how often and under what conditions ought those powers be exercised? And how far should the powers reach? If, as Goodfriend states, "the central bank's power to stabilize financial markets, inflation, and macroeconomic activity" requires lender-of-last-resort interventions—and hence pure credit policy interventions—what does that imply about the appropriate scope of monetary and regulatory authorities going forward? If the "shadow banking system" is the de facto banking system of the modern era—as Yale University's Gary Gorton argued in a paper presented at the Atlanta Fed's annual Financial Markets Conference held earlier this month—is the central bank's lender-of-last-resort function meaningful if narrowly construed (that is, if it fails to reach the shadow banking system)?

These, really, are first-order questions. On to the debate.

By David Altig, senior vice president and research director of the Atlanta Fed"

it is hard to paint a very positive portrait of the labor market in the near term

From Macroblog:

"Layoffs: The new problem?

Across the United States and Europe there was a wave of layoff announcements this week, with more than 70,000 job cuts announced on Monday alone. Another 11,500 job cuts were announced on Tuesday, bringing the total to a little more than 200,000 layoffs announced during the first month of the year (announced layoffs January 2009). Also, the U.S. Bureau of Labor Statistics (BLS) reported Wednesday that job losses in December 2008 associated with mass layoff events (those that involve at least 50 initial claims for unemployment insurance) were up 55 percent versus a year earlier. During January, layoffs have spread to more industries and to companies from Microsoft to Starbucks to the world's largest manufacturer of construction equipment, Caterpillar, all of whom announced layoffs this week.

While layoffs have received quite a bit of attention, they were only part of the story of labor market problems in 2008—which makes the accelerating layoff reports especially bad news.

According to the latest data from the BLS Job Openings and Labor Turnover Survey (JOLTS), the layoff rate (as a percent of total employment) increased from 1.3 percent at the start of the recession in December 2007 to 1.6 percent in November 2008. Over the same period, the rate at which workers quit their jobs declined from 1.8 percent to 1.4 percent—likely a result of uncertain job prospects. On net, the overall rate of job separation toward the end of 2008 was similar to what it was at the beginning of the year. The total number of separations stood at about 4.3 million in November 2008, compared to 4.4 million in December 2007.

While the rate of total separations was relatively steady during 2008, a more notable change can be seen in the hiring rate (as a percent of total employment), which declined from 3.4 percent to 2.6 percent. The level of hiring is estimated to have been about 3.5 million in November 2008, compared with 4.7 million in December 2007.

The chart below highlights the rapid decline in hiring relative to layoffs.

Not only have firms been letting people go, they apparently have taken down the help wanted signs at an even faster rate. As a result, the unemployed have fewer employment options, and this development has exacerbated the duration of unemployment. From the BLS household survey, in December of 2008 the average duration of unemployment was 19.7 weeks, compared with 16.5 weeks in December of 2007. This lengthening in the duration of unemployment is also reflected in the Department of Labor weekly claims data released yesterday that showed the four-week average number of continuing claimants for unemployment insurance at 4.63 million during the week of January 16, compared to 2.65 million in mid-December 2007 (see the chart below).

Unfortunately, the growing indication is that "furlough, wage reductions, hiring freezes and shorter hours simply did not do enough" to deal with weak business conditions. Barring a pick-up in job creation—which is unlikely given the recent pattern of continuing claims for unemployment insurance—it is hard to paint a very positive portrait of the labor market in the near term.

By Menbere Shiferaw and Sandra Kollen, senior economic analysts at the Atlanta Fed"

Me:

Previewing your Comment

My own view is that, starting in late November, businesses starting shedding jobs proactively:

http://www.reuters.com/article/GCA-CreditCrisis/idUSTRE50P5OS20090126

"It's hard to estimate when markets will bottom and then how long they'll be there," Cutler said in an interview. "The management team has been through multiple recessions, and knows you have to attack cost structure very early. If you don't attack them early, you can never get ahead of them."

Is there any way that I can gauge this thesis?

Posted by: Don the libertarian Democrat | January 31, 2009 at 10:47 PM

"In fact, the investment/net worth ratio is currently at a postwar low."

Bad news for another of my proposals. Namely, targeted tax cuts for investment. From Macroblog:

"Will tax stimulus stimulate investment?

On Monday, the form of potential fiscal stimulus, 2009-style, took a step forward detail-wise. From the Wall Street Journal:

“President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses(ODDLY, THAT'S THE SAME AMOUNT AS MY PROPOSAL FOR THESE TWO TAX CUTS ), a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs( I WANT TO USE IT AS AN INCENTIVE TO ATTACK THE FEAR AND AVERSION TO RISK, WHICH I BELIEVE TO BE THE MAIN PROBLEM NOW.).

“The size of the proposed tax cuts—which would account for about 40% of a stimulus package that could reach $775 billion over two years( MY FIGURE IS $700 Billion )—is greater than many on both sides of the aisle in Congress had anticipated.”

The plan appears to make concessions to both economic theory—which suggests that consumers will save a relatively large fraction of temporary increases in disposable income—and recent experience—which seems to suggest that what works in theory sometimes works in practice. Again, from the Wall Street Journal:

“Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills( ISN'T THAT SPENDING? ) or saved the cash( I HOPE SOME PEOPLE DO. JUST NOT EVERYBODY. ) rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.”( I THINK THAT THE TAX HAS TO BE PHASED OUT TO ENCOURAGE SPENDING SOONER RATHER THAN LATER.)

As for the business tax package:

“… a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

“A second provision would entice firms to plow that money back into new investment( THIS IS WHAT I WOULD FAVOR ). The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.”

A relevant question here is really quite similar to the one we ask when the tax cuts are aimed at households: Will the extra cash be spent? This graph provides some interesting perspective:

Relative to net worth (of nonfarm nonfinancial corporate businesses), private fixed investment has been in consistent decline since the second quarter of 2006. (The level of fixed investment has declined in each quarter, save one.) In fact, the investment/net worth ratio is currently at a postwar low. ( IS HOUSING INCLUDED? )

Why? A couple of hypotheses come to mind. (1) Firms are extremely pessimistic about the outlook and see relatively few worthwhile projects in which to commit funds.( TRUE ) (2) Credit markets are so impaired that the net worth of firms—a critical variable in mainstream models of the so-called “credit channel” of monetary policy—is supporting increasingly smaller levels of lending.( TRUE ) (3) Nonfinancial firms, like financial firms, are deleveraging and hence not expanding( TRUE ). ALL OF THESE ARE PROBABLY TRUE TO SOME EXTENT, BUT WHEN I LOOK AT THE GRAPH, IT SEEMS THAT INVESTMENT STARTED GOING DOWN DURING THE TECH BUBBLE YEARS AND CONTINUED IN THE HOUSING BUBBLE YEARS. I'M WONDERING IF THERE HASN'T BEEN A MASSIVE AMOUNT OF MONEY INVESTED IN STOCKS AND HOUSING AS OPPOSED TO, SAY, MANUFACTURING. SEE BELOW.

Of course, even if one of these hypotheses is true, it need not be the case that marginal dollars sent in the direction of businesses will go uninvested. But it makes you wonder.( I STILL FAVOR MY IDEA. THE GRAPH ISN'T CONCLUSIVE. )

By David Altig, senior vice president and research director at the Atlanta Fed"

Here's Casey Mulligan:

"TESTING THE THEORY WITH DATA FROM 2008

Another application of this logic is to the residential sector: does residential spending increase or decrease nonresidential spending? Here it is easy to see the importance of supply -- see the figure below.

When housing boomed, nonresidential construction spending fell (despite the fact that the housing boom was increasing the prices of construction labor and materials) -- almost dollar for dollar!

When housing crashed, nonresidential construction spending ROSE (despite the fact that the housing crash was reducing the prices of construction labor and materials), about 15 cents on the dollar. Note that, according to the NBER, some of the nonresidential increase occur ed during a recession.

Another fascinating property of this episode is that the shocks to spending are on the order of magnitude (100s of billions of dollars) of the kinds of fiscal stimuli being recommended by some economists.

When interpreting what is above, we need to recognize that a large sector is omitted -- the non-construction sector. For this reason, the calculations above underestimate of the aggegate supply effect of housing spending on nonresidential spending (Take, for example, accountants. A housing boom pulls accountants into work for construction businesses, which leaves fewer accountants to work for non-construction businesses.). But they also underestimate the aggregate demand effect, because the housing construction workers are taking their paychecks and spending some of it on non-construction items. In any case, the supply effect is easy to see -- the housing construction boom did not take place with resources that would have otherwise been unemployed and the housing bust did not release resources entirely into unemployment."

So, I'm wondering if the Tech and Housing Bubbles diverted money away from other types of investment. If so, we might want to rethink subsidizing the purchases of houses ( I'm for a general housing subsidy for low-income people. ) It would seem to me, interpreting Mulligan's points for my own purposes, that now would be an especially felicitous time to encourage investment in sectors that have been recently shunned.

"Still, in current circumstances a glimmer of hope is better than nothing."

From Macroblog, some good news:

"Good news in income growth?

One of my New Year’s resolutions is to be more consistent in responding to questions and comments from the loyal readers of macroblog. Though it remains the case that time constraints prohibit a response to all worthy queries, we’re still listening. Next year we’ll endeavor to give a shout back just a little more often.

In that spirit, I received an interesting inquiry from reader Robert Schumacher:

A cursory examination of the monthly trends in real disposable income in light of the NBER official business cycles suggests to me that a sustained rise in disposable personal income (at least three if not four months) signals the end of the recession is at hand. In that real disposable income rose in October and November how are we to interpret this amidst the dire economic forecasts for the coming year?

It does seem, as Robert suggests, that a sustained rise in real disposable income is characteristic of a typical recession’s end. Using a graphical device from a few posts back, here’s a look at the trajectory of disposable income up to and after December 2007 (the start date of the current recession according to the NBER Business Cycle Dating Committee), compared with the average experience of the previous seven recessions dating from 1960:

As in the previous post, “time 0” represents the peak of a business cycle, or the month a recession begins. The average length of US recessions from 1960 through 2001 was 10.7 months, so the line indicating 10 months from the peak roughly coincides to the end of the average recession over this period.

On average, Robert’s conjecture looks right on track( I AGREE ). In the typical case, growth in real disposable income stalls and then begins to pick up three or four months before recession’s end. If you smooth through the spike associated with the stimulus package of late spring, income growth was roughly flat through August but has increased since (and at a reasonably good clip). That would seem to portend well for all of us—and I assume it is all of us—hoping for a sooner rather than later end to the current contraction.

The picture is equally encouraging if we look at the income series preferred by the Business Cycle Dating Committee, which subtracts out transfers (that is, payments made to the public by the government):

That’s all encouraging, but there is a caveat: Individual results may vary. Here are the comparisons for the long-lived (16-month) recessions of 1973–75 and 1981–82:

In these two recessions—which are arguably better benchmarks than the average at this point—income measures were not such reliable harbingers of expansion( NOTHING IS WRITTEN ).

Still, in current circumstances a glimmer of hope is better than nothing. ( I AGREE )

By David Altig, senior vice president and director of research at the Federal Reserve Bank of Atlanta

"Trade-related credit is issued primarily by banks via “letters of credit,” the purpose of which is to secure payment for the exporter."

Galina Alexeenko and Sandra Kollen with a fascinating post on Macroblog about letters of credit:

"Now that the mystery has been solved concerning whether we are in recession or not, our attention can turn to monitoring the conditions that might signal the contraction’s end. A nice assist in this endeavor comes from the “Credit Crisis Watch” at The Big Picture, which includes an extensive list of graphs summarizing ongoing conditions in credit markets.

In case that list is not extensive enough for you, allow us to add one more item to the list: the condition of trade finance. International trade amounts to about $14 trillion and, according to the World Trade Organization (WTO), 90 percent of these transactions involve trade financing. Trade-related credit is issued primarily by banks via “letters of credit,” the purpose of which is to secure payment for the exporter. Letters of credit prove that a business is able to pay and allow exporters to load cargo for shipments with the assurance of being paid. Though routine in normal times, the letter of credit of process is yet another example of how transactions between multiple financial intermediaries introduce counterparty risk and the potential for trouble when confidence flags."

The Letter Of Credit is proof that there will be payment when the goods shipped are received at their destination.

"This is how it works: Company A located in the Republic of A wants to buy goods from Company B located in B-land. Company A and B draw up a sales contract for the agreed sales price of $100,000. Company A would then go to its bank, A Plus Bank, and apply for a letter of credit for $100,000 with Company B as the beneficiary. (The letter of credit is done either through a standard loan underwriting process or funded with a deposit and an associated fee). A Plus Bank sends a copy of the letter of credit to B Bank, which notifies Company B that its payment is available when the terms and conditions of the letter of credit have been met (normally upon receipt of shipping documents). Once the documents have been confirmed, A Plus Bank transfers the $100,000 to Bank B to be credited to Company B.

In general, exporters and importers in emerging economies may be particularly vulnerable since they rely more heavily on trade finance, and in recent weeks, the price of credit has risen significantly, especially for emerging economies. According to Bloomberg, the cost of a letter of credit has tripled for importers in China, Brazil, and Turkey and doubled for Pakistan, Argentina, and Bangladesh. Banks are now charging 1.5 percent of the value of the transaction for credit guarantees for some Chinese transactions. There have been reports of banks refusing to honor letters of credit from other banks and cargo ships being stranded at ports, according to Dismal Scientist".

This has obviously slowed down trade.

"These financial market woes are clearly spilling over to “global Main Street.” The Baltic Dry Index, an indirect gauge of international trade flows, has dropped by more than 90 percent since its peak in June as a result not only of decreased global demand but also availability of financing that demand, according to Dismal Scientist.

In the words of the WTO’s Director-General Pascal Lamy, “The world economy is slowing and we are seeing trade decrease. If trade finance is not tackled, we run the risk of further exacerbating this downward spiral.” Since about 40 percent of U.S. exports are shipped to developing countries, the inability of the importers in those countries to finance their purchases of U.S.-made goods can’t help the U.S. exports sector, which is already suffering from falling foreign demand as the global economy slows."

This is a serious problem.

"At VoxEU, Helmut Reisen sums up the situation thus:

“As a mid-term consequence of the global credit crisis, private debt will be financed only reluctantly and capital costs are bound to rise to incorporate higher risk. Instead, solvent governments and public institutions will become the lenders of last resort.”

That process has begun. In the last 12 months, according to the WTO, export credit agencies have increased their business by more than 30 percent, with an acceleration since the summer. The increase in this activity, the WTO reports, is being backed by governments of some of the world’s largest exporters, such as Germany and Japan.

Most recently, to support exports of products from the United States and China to emerging economies, both countries decided on December 5 to provide a total of $20 billion through their export-import banks. The program will be implemented in the form of direct loans, guarantees, or insurance to creditworthy banks. Together, the United States and China expect that these efforts will generate total trade financing for up to $38 billion in exports over the next year.

The sense one gets from The Big Picture charts is that at least some hopeful signs have emerged in developed-economy credit markets. Going forward, progress in markets directly related to trade flows between developed and emerging economies may well be an equally key indicator of how quickly we turn the bend toward recovery."

Interesting.

"I’ll take the opportunity to step back and take in the current recession in a somewhat broader context"

Here's another take on the unemployment stats, from David Altiq on Macroblog:

"The recession in pictorial context

If your head had not yet been turned by economic events, today’s startlingly weak employment report probably did the trick. Rather than repeat all the negative superlatives you are likely to hear, I’ll take the opportunity to step back and take in the current recession in a somewhat broader context. One way to look at this is to examine the trajectory of employment relative to December 2007 levels (when this recession began) and compare it with the average trajectory of relative employment in other recessions:

In the graph above “time 0” represents the peak of a business cycle, or the month before a recession begins (December 2008 for the current recession). “Average” refers to the average experience in the seven previous recessions since 1960 (1960-61, 1969-70, 1973-75, 1980, 1981-82, 1990-91, and 2001). To facilitate comparison across recessions, I have normalized the level of employment at the peak of the business cycle to one. As noted, then, each point represents the level of employment relative to the peak: numbers below one indicate that the number of nonfarm jobs was below the number that existed as the economy entered recession.

Before the November job report, the overall employment picture had been fairly unexceptional compared to the average recessionary experience. That changed, as I guess will happen when a half-million job loss statistic arrives. As of today, a milder than average recession has turned into a somewhat deeper than average recession, at least in terms of employment."

Okay. We were in a fairly straightforward recession until now, when we've gone into a deeper recession than on average.

"Does this mean we are heading off the map in terms of past experience? It is hard to tell by just focusing on the average experience of the previous seven downturns. The previous two recessions—1990–91 and 2001—lasted only eight months. Assuming that we remained in recession through November—and I don’t think that conjecture will draw much debate—the current episode is already a year in duration. A more apt comparison might therefore be the “bad” recessions of recent memory, the 1973–75 and 1981–82 episodes, which both lasted sixteen months.

Here, for your viewing displeasure, are those comparisons:

Not surprisingly, in the last two recessions, which were relatively short-lived, the employment situation had already stabilized twelve months after the onset of the downturn. So there may not be much comfort in noting that the employment losses are not yet out of line with experiences of those episodes (especially the 1990-91 version). The trajectories suggested by the relatively long-lived, more severe recessions of 1973-75 and 1981-82 are almost certainly more sensible comparisons at this point. And, as bad as it is right now, we are still a fair distance from the pace of relative employment losses in those episodes.

Okay. And?

"The story is similar if we adopt the vantage point of the unemployment rate:

It is not yet clear whether the acceleration in job loss is a new trend or the lingering impact of a very bad few months, of which the worst is passing. It's always important to monitor new data and anecdotal reports to determine which way the wind is truly blowing. But today's report raised the stakes on that activity by a considerable amount."

It really does seem too soon to tell.