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."

“We could have known better that foreign investors were not prepared for Lehman to collapse.”

From Real Time Economics:

By David Wessel

In the first — and not likely to be the last — lengthy behind-the-scenes account from veterans of the Bush administration, Phillip Swagel, who was assistant Treasury secretary for economic policy from December 2006 until January 2009, offers his take in a 50-page essay to be presented later this week at the Brookings Panel on Economic Activity. Swagel, who has an economics Ph.D. from Harvard, will teach at Georgetown’s McDonough School of Business in the fall. Swagel says academic economists think the government has more power than it does. “A lesson for academics is any time the word ‘force’ is used as a verb (‘the policy should be to force banks to do X or Y’), the next sentence should set forward the section of the U.S. legal code that allows such… action.” (Read the full paper.)

Among his points:

• The Treasury predicted in May 2007 that “we were nearing the worst of it in terms of foreclosure starts” and the problem would subside after a peak in 2008. “What we missed is that the regressions didn’t use information on the quality of the underwriting of subprime mortgages in 2005, 2006 and 2007,” Swagel said — Federal Deposit Insurance Corp. staff pointed that out at the time.
• The ill-fated 2007 Treasury proposal to create a privately funded entity — called MLEC, or Master Liquidity Enhancement Conduit – to buy up toxic assets from the banks was developed by the Treasury’s Office of Domestic Finance and shared with market participants without involvement from other Treasury senior staff. “The MLEC episode looked to the world and to many within Treasury like a basketball player going up in the air to pass without an open teammate in mind — a rough and awkward situation,” he said. He notes, though, that some elements of MLEC are present in the Obama administration’s Public Private Investment Partnership plan to joint venture with big money investors to buy loans and securities “though with the (huge) advantage of being able to fund the purchases through low cost government financing and with taxpayers assuming much of the downside risk.”
• On the housing front, the Paulson Treasury staff did develop, though it never proposed, a plan to offer a federal subsidy to lenders willing to lower interest rates to reduce monthly payments for at-risk borrowers. A similar plan eventually was embraced by the Obama administration. Federal Reserve staff wanted to do more than the Paulson Treasury to aid homeowners who were underwater — that is, with mortgages greater than the value of their homes. “Among the White House staff in particular, but also within Treasury… there was no desire to put public money on the line to prevent additional foreclosures,” Swagel said. “The cynical way of putting this was that spending public money on foreclosure avoidance would be asking taxpayers to subsidize people living in McMansions they could not afford with flat screen televisions paid out of their home equity line of credit.” Swagel argued that — at least in late 2007 and early 2008 — there wasn’t much congressional interest in voting to spend money on foreclosures. “There were constant calls for Treasury and the administration to do more on foreclosure prevention, but this was just rhetoric.” Housing policy, he added, was “essentially static” until Congress passed the $700-billion Troubled Asset Relief Program, and the FDIC offered ways to tap that fund to avoid foreclosures, proposals that the Treasury considered badly flawed.
• Treasury staff had “distinctly mixed feelings” about Secretary Paulson’s move towards “hardening the heretofore-implicit” government guarantee of Fannie Mae and Freddie Mac’s debt in July 2007. “Treasury Departments across administrations had sought to remove the implicit guarantee, not to harden it….[M] any people expressed to me their misgivings about what looked like a bailout in which GSE bondholders and shareholders won and taxpayers . It was hard to disagree,” he said. Paulson soon shared those misgivings and immediately set Treasury staff to work on the next step, the August move to put the companies in conservatorship.
• The surprises to the Treasury on Monday, September 15, after Lehman Brothers filed for bankruptcy, were two-fold: “the breaking of the buck by the Reserve Fund [a money market fund] and the reaction of foreign investors to the failure of Lehman.” Swagel says it was impossible for the Treasury to anticipate that the Reserve Fund had so much Lehman paper, but, “We could have known better that foreign investors were not prepared for Lehman to collapse.”
• “Saving AIG was not what anyone wanted, but at the time it seemed the only possible course of action….There was little time to prepare for anything but pumping in [government] money — and at the time only the Fed had the ability to do so for AIG.”
• Paulson, on Sept. 18, set out three principles for Treasury staff: (1) He wanted any policies to be readily understood by markets. (2) Actions should be decisive and overwhelming,” in contrast to the July Fannie and Freddie move. (3) “Actions must have the explicit endorsement of Congress,” as opposed to continued to rely exclusively on the Fed.
• Paulson “truly meant” to the use the $700 billion in TARP money to buy assets from the banks, not to buy shares in the banks, because he saw it as “a fundamentally bad idea to have the government involved in the ownership of banks.” He changed is mind when markets deteriorated and “he well understood that directly adding capital to the banking system provided much greater leverage.” The initial plan was to offer a matching program under which Treasury would invest a dollar for every dollar private investors kicked in, but that didn’t prove possible. Swagel, responding to critic, argues that the terms of the capital had o be generous because “there is no authority in the U.S. to force a private institution to accept government capital.”
• As late the last week in October 2008, Treasury staff were still planning to conduct “reverse auctions” to buy assets from the banks, but about then it became clear that “the economy had deteriorated and the tide of public opinion had begun to turn against the TARP, so much so that there were real doubts as the whether Congress would release the second stage of the TARP funds at all.” (Congress had insisted on doling out the $700 billion in two chunks.)
• To get access to the money, Swagel says, the Treasury knew it needed “a well-developed set of programs” and needed “to be able to explain what it was doing…never our strength.” So a decision was made in late October and announced by Paulson on Nov. 12 to abandon asset purchases. “Paulson knew that canceling the auctions would make it seem as if he was switching course yet again… He was willing to take the criticism… to keep the resources available for more capital injections.” But the program to invest the second $350 billion in the banks was never developed as events — namely the woes of Citigroup and U.S. auto companies — got in the way.

Paulson is writing his own account of the crisis, which he hopes to publish before year-end.

A spokeswoman for Paulson said he was traveling and couldn’t be reached for comment. In a recent interview with The Wall Street Journal and Dow Jones News Wires, Paulson said figuring out how to stretch the government funds was always a key challenge of managing the TARP. “It was clear to us that as much money as $700 billion is, it wasn’t enough by itself to directly purchase enough illiquid assets,” he said."

Me:

• Don the libertarian Democrat wrote:

I found the paper fascinating. A few points:
“The Fed can lend,
however, against collateral to its satisfaction, so in principle the Fed could have lent
against Lehman’s unencumbered assets—essentially what it did with AIG. This would
not have saved the Lehman—indeed, it would have concentrated losses on the rest of the
firm—but it is possible that such lending could have provided time for a more orderly
dissolution of the firm (indeed, there are estimates that the disorderly bankruptcy reduced
the recovery value of the firm by billions of dollars). The feeling at Treasury, however,
was that Lehman’s management had been given abundant warning that no federal
assistance was in the offing, and market participants were aware of this and had time to
prepare. It was almost as if Lehman management was in a game of chicken and
determined not to swerve.”
1) The point is that saving Lehman would have allowed a more orderly unwinding, and, yes, the added losses were substantial.
2) Lehman assumed an implicit guarantee on a bailout, and acted as though they did. This should have been known, as later bailouts have shown that this was a widely understood part of the underlying basis of the financial system; namely, implicit government guarantees.
“The events together led to a run on money market
mutual funds, and this in turn caused commercial paper markets to freeze. If left
unstopped, this would have led issuers of commercial paper to turn to their backup lines
of credit—meaning that banks would have needed to massively fund these lines
simultaneously under circumstances that were never contemplated and then hoard capital
against those lines. As discussed by Ivashina and Scharfstein (2008), banks in the fall of
2008 did fund these lines as companies drew on them as a precautionary measure, but this
played out over time rather than all at once.
From the Treasury perspective, there appeared to be a broad run on the financial system.”
Yes, a Calling Run resulted, the beginning of Fisher’s Debt-Deflation Spiral. Since Bears had supposedly been saved to forestall a Calling Run, why the decision not to intervene here?
I have more points, but I’ll take up no more space.

The session will focus on the Obama administration’s push to overhaul financial regulations and thorny issues like executive compensation

TO BE NOTED: From Real Times Economics:

"By WSJ Staff

Listed below are the CEOs of several of the largest banks meeting with President Barack Obama on Friday, according to a White House press release. The session will focus on the Obama administration’s push to overhaul financial regulations and thorny issues like executive compensation.

Jamie Dimon, JP Morgan Chase
Ken Chenault, American Express
John Koskinen, Freddie Mac
Ronald Logue, State Street
Robert Kelly, BONY-Mellon
Rick Waddell, Northern Trust
James Rohr, PNC
Lloyd Blankfein, Goldman
John Mack, Morgan Stanley
Vikram Pandit, Citi
John Stumpf, Wells Fargo
Cam Fine, Independent Community Bankers
Edward Yingling, ABA
Richard Davis, US Bank
Ken Lewis, Bank of America

If the regime were administered in a way that appeared to be based on politically-motivated favoritism or hostility, it would risk being undermined

TO BE NOTED: From Real Time Economics:

"Floating Proposals

The Federal Reserve sent a private memo to Capitol Hill on March 23 that it described as “technical assistance” as Congress decides how to create a mechanism for winding down a systemically important –- but failing -– financial company.

Fed officials wrote in the unsigned letter that the resolution authority must exist “outside of the bankruptcy code in order to allow the resolving agency to be responsive to the circumstances of the specific financial crisis that motivated use of the regime.” But it says the process “must still operate in a manner that respects the rule of law and that is perceived as such (emphasis not added). If the regime were administered in a way that appeared to be based on politically-motivated favoritism or hostility, it would risk being undermined.”

One major difference between the Fed’s proposal and a new one from Treasury is that the Fed says the Treasury should be able to seize a company and then put it into a conservatorship run by the Federal Deposit Insurance Corp., the Securities and Exchange Commission, a new federal insurance regulator, or the Commodity Futures Trading Commission. A Treasury proposal suggests that the only agency that would be allowed to take a large, financial company into receivership would be the FDIC."

The erosion in market discipline distorts market behavior and can give firms an incentive to grow

From Real Time Economics:

"By Phil Izzo

In a speech today before community bankers, Federal Reserve Chairman Ben Bernanke didn’t address the furor over AIG bonuses directly. However, he did speak to “unpleasant” choices that the government has had to make in rescuing financial firms. Bernanke has spoken previously about his angry reaction to the necessity of the AIG bailout, saying on CBS’s “60 Minutes” that the issue led him to slam down the phone “more than a few times.” Here are some excerpts from his speech:

Many of you likely are frustrated, and rightfully so, by the impact that the financial crisis and economic downturn has had on your banks, as well as on the reputation of bankers more generally. You may well have built your reputations and institutions through responsible lending and community-focused operations, but nonetheless, you now find yourselves facing higher deposit insurance assessments and increasing public skepticism about the behavior of bankers–outcomes that you perceive were largely caused by the actions of larger financial institutions. Many of you managed your businesses prudently and shunned more exotic instruments and activities. And many of your customers–households and businesses–avoided excesses and are able to meet their financial commitments on a timely basis.

No doubt this frustration has been heightened by the problems caused by financial firms that are too big or too interconnected to fail. Indeed, the too-big-to-fail issue has emerged as an enormous problem, both for policymakers and for financial institutions generally. Creditors of a firm perceived as too big to fail have less incentive to monitor and restrict the firm’s risk-taking through adjustments to the price at which they lend money to the firm. If left unaddressed, this weakening of market discipline creates an unlevel playing field for smaller institutions, which may not be able to raise funds as cheaply, even if their individual risk profiles are better, or at least no worse, than those of their larger competitors. The erosion in market discipline distorts market behavior and can give firms an incentive to grow–either internally or through acquisitions–in order to be perceived as too big to fail.

Government rescues to prevent the failure of major financial institutions also have required large amounts of public resources. These actions have involved extremely unpleasant and difficult choices, but given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets, and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.

…

Supervisors must pay close attention to compensation practices that can create mismatches between the rewards and risks borne by institutions or their managers. As the Federal Reserve and other banking agencies have noted, poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization. Management compensation policies should be aligned with the long-term prudential interests of the institution, be tied to the risks being borne by the organization, provide appropriate incentives for safe and sound behavior, and avoid short-term payments for transactions with long-term horizons."

Me:

• Don the libertarian Democrat wrote:

“The erosion in market discipline distorts market behavior and can give firms an incentive to grow–either internally or through acquisitions–in order to be perceived as too big to fail.”

It’s good to see that the implicit government guarantees are finally being addressed.

in theory he has a point

From Real Time Economics:

"ECB Official Responds to Krugman Criticism

Posted by WSJ Staff

ECB executive board member Lorenzo Bini Smaghi published a letter in the Italian newspaper La Repubblica today challenging Paul Krugman’s recent contention that euro zone governments and the ECB aren’t doing enough to prop up the struggling economy. The following is the full text of the letter translated from the original Italian.

To the Editor.

In a recent article in the International Herald Tribune, Professor Paul Krugman states that Europe may have made a mistake in adopting the euro ten years ago. His point, he claims, is corroborated by the euro area’s apparent institutional inability to react to the severe crisis we are facing at present, an inability which, he claims, may have disastrous results.

The claims made in the article are in no way supported by empirical evidence. I don’t want to bother the readers with too many figures and statistics, but we should also avoid gross inaccuracies.

Let’s get the facts straight, starting with the question of fiscal policy, an area in which – according to Krugman – Europe has failed, more so than the United States, to enact an effective recovery policy. This conflicts with recent IMF calculations, which show that the fiscal stimulus in European countries is wholly comparable to that seen in the United States, particularly when taking into account measures to cushion the effect of automatic stabilisers, which, by contrast with the United States, are a major factor in Europe. For instance, for the period 2009-10, discretionary measures adopted in Germany total 3.5% of GDP, compared with 3.8%in the United States. In some European countries, such as Italy, the size of such stimulus measures is relatively limited owing to the high levels of debt, but in other countries the total fiscal stimulus is larger than in the United States.

The perception that more has been done in the United States probably stems from the extensive financial measures adopted in support of the US banking system. It should be pointed out, however, that the US banking system was in greater need of such measures than the European banking system. When overall stimulus measures are considered in relation to the situation, the differences are indeed fairly limited.

As regards monetary policy, the degree of stimulus can be better measured by comparing market interest rates, rather than official interest rates. Such a comparison shows that European rates are more or less in line with those observed in the United States, and are even lower in some cases. For example, 6 and 12-month interbank interest rates in Europe are slightly lower than their US equivalents. Furthermore, real interest rates – i.e. net of inflation – are markedly lower in Europe than in the United States, and retail interest rates on mortgage lending and lending to non-financial corporations are of a comparable magnitude, if not somewhat lower in Europe.

As regards action taken by the central bank, following the initial liquidity injection of in excess of €90 billion in August 2007, the ECB’s balance sheet has steadily grown, increasing by approximately €600 billion to reach a level of 16% of GDP (compared with 13% of GDP for the US Federal Reserve). There is a major difference, however: the ECB lends to the banking system against collateral, thereby reducing the risks for European taxpayers.

According to Krugman, the fact that the ECB does not have a government behind it which can cover any losses accounts for its being overly cautious. However, this assumption implies that the taxpayer should bear the burden – through inflation – of the difficulties experienced by the banking system. I’m not so sure that this is what US citizens want, and it is certainly not what people in Europe want.

To sum up, Krugman’s argument is that it is better to have only one decision-maker in a crisis, rather than 16 governments which need to coordinate their actions, as is the case in the euro area. In theory, this seems reasonable. But it doesn’t explain how the most fateful decision of all – the decision to allow a systemically important bank to fail in the midst of a financial crisis – was taken by a single decision-maker, while the 16 euro area governments have managed to avoid making such a large mistake. Neither does it explain how euro area governments have managed to agree on measures aimed at bank recapitalization, at guarantees to bank liabilities and on principles for removing toxic assets from banks’ balance sheets, decisions which have become a point of reference for all the countries of the G20.

Krugman concludes that countries such as Spain would have been better off without the euro. Again, in theory he has a point, since devaluing one’s currency might seem attractive in the current circumstances. In practice, however, when global trade grinds to a halt and the financial market is in distress, the depreciation of a currency can trigger a loss of market confidence in the country, which can further aggravate the economic and financial crisis. This is what happened in Italy in 1992-93, for example. Krugman should travel to those European countries which do not yet have the euro and would really like to introduce it as soon as possible; he would not fail to notice that the reality is very different from textbooks economic theory.

Nobody can claim that Europe is perfect; quite the opposite. We should continue to strengthen economic integration and the coordination of financial and economic policies. We just need to build on what we already have, in particular the euro.

Lorenzo Bini Smaghi
Member of the Executive Board of the European Central Bank"

Me:

• Don the libertarian Democrat wrote:

Someone once said that the main benefit to having a currency was to have something that could be debased with benefit. I think that when Lorenzo says that Spain would be better off debasing in theory, he means that they would if they could. Since Spain is spending quite a bit more on its stimulus without debasing, isn’t the only real alternative for the other countries to subsidize Spain?

today’s data show solid lending growth at record low contract rates

TO BE NOTED:

"Fed Data Show Banks Are Lending

You thought banks weren’t lending, right? A quarterly survey of banks by the Federal Reserve, released Tuesday, contradicts that notion.

The survey is the Survey of Terms of Business Lending, in which banks are asked to disclose details on commercial and industrial loans they make during a week in time. In this case, it was for the week of Feb. 2-6.

Michael Feroli, an economist at J.P. Morgan Chase, who has an eagle eye for interesting Fed data, crunches the numbers and draws these conclusions:

“Contrary to recent rhetoric that claims banks aren’t lending to businesses, today’s data show solid lending growth at record low contract rates. During the survey week, banks extended $95.6 billion in credit to businesses, an increase of 13% from the same quarter last year. Moreover, much of the recent decline in policy rates has passed through to rates facing businesses: the average rate for C&I loans in the first quarter was 2.34%, the lowest since the series began in 1997.”

The report seems to fly in the face of weekly Fed reports which show outstanding commercial and industrial loans on bank balance sheets have contracted since October. Mr. Feroli says outstanding loans might be contracting because some businesses are paying off their debts, especially as they shrink their inventories."

TO BE NOTED:

E.2 SURVEY OF TERMS OF BUSINESS LENDING, FEBRUARY 2-6, 2009                                 For immediate release
6. Commercial and industrial loans by date pricing terms were set and commitment status            March 17, 2009

Date pricing terms were set and commitment status	Weighted- average effective loan rate4 (percent)	Amount of loans ($ millions)	Average loan size ($ thousands)	Weighted- average risk rating3	Weighted- average maturity/ repricing interval2 (days)	Percent of value of loans
						Secured by collateral	Subject to prepayment penalty	Prime based
All commercial banks
1. During survey week	1.81	49,341	1,586	3.0	53	28.6	44.5	7.3
2. Not under commitment	1.39	21,372	1,438	3.1	42	36.6	73.8	5.6
3. Informal commitment	1.79	20,924	1,892	2.4	53	9.3	26.7	4.1
4. Formal commitment	3.12	7,044	1,358	3.5	86	62.1	8.4	21.9
Before survey week9
5. Up to 90 days	3.48	14,369	824	3.6	95	28.2	22.7	19.2
6. 91 to 365 days	2.95	12,435	304	3.1	141	61.0	16.8	44.6
6. More than 365 days	2.48	19,460	914	3.2	136	38.6	22.9	28.9
Domestic banks
8. During survey week	3.33	9,959	349	3.0	182	57.7	14.7	35.1
9. Not under commitment	2.72	4,635	329	2.5	167	38.1	16.7	25.2
10. Informal commitment	4.71	2,102	222	2.9	321	89.5	4.6	39.3
11. Formal commitment	3.33	3,222	649	3.6	111	65.0	18.5	46.5
Before survey week9
12. Up to 90 days	3.56	11,028	640	3.7	115	29.9	7.2	24.0
13. 91 to 365 days	3.17	9,886	244	3.2	145	72.7	9.7	55.2
14. More than 365 days	2.55	10,852	569	3.2	124	54.1	18.9	40.8
Large domestic banks
15. During survey week	2.43	7,010	678	2.9	91	43.4	17.0	31.1
16. Not under commitment	2.06	3,806	580	2.3	85	27.6	16.5	20.6
17. Informal commitment	3.32	753	312	3.2	165	78.4	4.2	60.0
18. Formal commitment	2.73	2,451	1,799	3.6	76	57.0	21.7	38.7
Before survey week9
19. Up to 90 days	3.47	10,499	938	3.7	96	27.0	7.5	22.2
20. 91 to 365 days	3.04	8,704	310	3.2	159	71.2	10.8	52.7
21. More than 365 days	2.46	10,018	690	3.2	116	54.6	20.3	38.7
Small domestic banks
22. During survey week	5.49	2,949	162	3.1	397	91.7	9.2	44.4
23. Not under commitment	5.73	829	110	3.3	543	86.2	17.6	46.5
24. Informal commitment	5.49	1,349	191	2.7	408	95.8	4.8	27.8
25. Formal commitment	5.21	771	214	3.4	221	90.4	8.0	71.3
Before survey week9
26. Up to 90 days	5.24	529	88	3.4	486	87.6	2.7	58.0
27. 91 to 365 days	4.18	1,182	95	3.3	43	83.7	2.1	73.5
28. More than 365 days	3.65	834	184	3.2	220	47.5	1.6	66.0
Foreign banks
29. During survey week	1.42	39,382	15,242	3.0	21	21.3	52.0	.3
30. Not under commitment	1.02	16,737	21,493	3.2	7	36.1	89.6	.2
31. Informal commitment	1.47	18,822	11,889	2.3	24	.3	29.2	.2
32. Formal commitment	2.95	3,823	17,231	3.4	65	59.6	.0	1.1
Before survey week9
33. Up to 90 days	3.20	3,341	15,293	3.4	30	22.6	73.8	3.5
34. 91 to 365 days	2.07	2,549	6,771	2.7	128	15.5	44.5	3.9
35. More than 365 days	2.39	8,608	3,857	3.1	150	19.1	28.0	13.9

...  The number of loans was insufficient to provide a meaningful value.

---

Summary statistics	All commercial banks	Domestic banks	Large domestic banks	Small domestic banks	Foreign banks
Average reported prime rate	3.34	3.35	3.27	3.68	3.21
Standard error of loan rate4	.09	.12	.14	.13	.16

The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

From the WSJ:

"Secondary Sources: Greenspan’s Defense, Depression, Looting

A roundup of economic news from around the Web.

• Greenspan Defense: On the Journal’s opinion pages, former Federal Reserve Chairman Alan Greenspan says the central bank wasn’t responsible for the housing bubble. “There are at least two broad and competing explanations of the origins of this crisis. The first is that the “easy money” policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess. The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.”
• What Is Depression?: Calculated Risk looks at what would need to happen for this recession to become a depression. “Some people argue the duration of the economic slump defines a depression - and the current recession is already 15 months old. That is longer than the recessions of ‘90/’91 and ‘01. The ‘73-’75 recession lasted 16 months peak to trough, and the early ’80s recession (a double dip) was classified as a 6 month recession followed by a 16 month recession (22 months total). Those earlier periods weren’t “depressions”, so if duration is the key measure, the current recession still has a ways to go… Even though the current recession is already one of the worst since 1947, it is only about 1/3 of the way to a depression (assuming a terrible Q1). To reach a depression, the economy would have to decline at about a 6.6% annual rate each quarter for the next year… I still think a depression is very unlikely. More likely the economy will bottom later this year or at least the rate of economic decline will slow sharply. I also still believe that the eventual recovery will be very sluggish, and it will take some time to return to normal growth.”
• Looting: David Leonhardt of the New York Times looks at a 1993 paper titled “Looting” by George Akerlof and Paul Romer, and he sees parallels to the current crisis. ““Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem. Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame. But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem. Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess. He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.”

Compiled by Phil Izzo"

Me:
11:26 am March 11, 2009

• • • Don the libertarian Democrat wrote:

    “The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.”

    You’ve got it. This is the main cause of the crisis, even though it’s practically impossible to get people to see this. Maybe this post will help.

The Financial Times writes that some clarity for the pricing of toxic assets might spell bad news for hopes of valuing these instruments.

From Real Time Economics:

"Secondary Sources: Valuing Toxic Assets, Budget, Animal Spirits

A roundup of economic news from around the Web.

Valuing Toxic Assets: The Financial Times writes that some clarity for the pricing of toxic assets might spell bad news for hopes of valuing these instruments. “At long last, one shard of reality has just emerged to piece this gloom. In recent weeks, bankers at places such as JPMorgan Chase and Wachovia have been quietly sifting data trying to ascertain what has happened to those swathes of troubled CDO of ABS. The conclusions are stunning. From late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS.) Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi. The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.”

Budget: Peter Orszag has returned to the blogosphere in his new role as OMB director and makes the case for transparency in the budget. “You probably won’t agree with everything in the Budget. But at the very least, it’s honest, laying down a fair marker as to where we are now. And I sincerely believe that the first step in arriving at a plan to move forward is to reach agreement on the place from which we are starting. This Budget is not an end-point. It is a beginning. I invite you to return to this blog to read more about our continued efforts to return prosperity to the economy, discipline to the federal budget, and efficiency to our government.” Separately, Stan Collender says that under the metrics used by the Bush administration the budget deficit would have been about $1.3 trillion instead of $1.7 trillion.

Animal Spirits: Writing for the Financial Times, Samuel Brittan says that the emphasis on so-called animal spirits has been overdone. “Citizen A cuts down on his purchases of widgets. Company B that makes the widgets cuts down staff, who in turn reduce their spending. Sales collapse in the local supermarket, putting yet more people on to the dole. Thus we drive ourselves into a slump, which has little to do with what some economists call “creative destruction”. It is just a stupid downward spiral that is pushed even further down by media pronouncements about how people should cut their spending. A slump originating in the banking sector has this additional feature. Even if Company B can find another project for which there might be a market, it will not be able to obtain working capital, at other than moneylenders’ rates, because banks are unwilling to lend. As for long-term loans for new ventures, it can forget them. This stylized picture is instinctively grasped much better by the proverbial taxi drivers and barmen who inform many journalists of the popular mood than it is by many academics, senior officials and top politicians. The economist who first got the process right in a big way was, of course, Lord Keynes. Yet there is now a campaign by some who regard themselves as his followers to play down the British economist’s analysis of effective demand in favour of something they call “animal spirits”.”

Compiled by Phil Izzo"

Me:

The FT post was right. Investors have been buying the TAs. The people that own them don’t like the price that they would receive for them. There’s a huge gap between bid and ask, subsidized by the belief that the government will intervene enough to allow these assets to appreciate. If they do not or would take years and years to do so, we have been wasting an enormous amount of time and money delaying the liquidation of these losses at fire sale prices. Unfortunately, this also holds true for the housing market. At best, we can help create a more orderly and efficient process of people eating these losses. As far as I’m concerned, these delays are not helping.

Comment by Don the libertarian Democrat - February 27, 2009 at 11:00 am

How to determine the fair price of insurance in an environment where there are no sensible market prices?

From Real Time Economics:

"An Insurance Complement to TARP II

By Ricardo J. Caballero

The basic principles underlying Secretary Geithner’s sketch of a financial stabilization plan are the right ones: To stabilize the financial system without nationalization; to jump start frozen financial markets by reducing the perceived tail risk from private investments; and to reduce the risk, especially systemic risk, being held by banks and other leveraged financial institutions. Politics require that a “good deal for the taxpayers” is added to these principles, but the truth is that the best deal for the taxpayers, once one considers the endogenous response of the economy, is anything that works to stabilize the financial system, almost regardless of how many short-term transfers the financial institutions may receive.

It is true that the recent announcements are lacking specific details, and perhaps revealed that the Treasury’s economic team overestimated people’s ability to distill the good news in an abstract message of principles when in panic mode. But there is good news in them, as they reflect a much deeper understanding of the fundamental uncertainty problem ravaging insurance and credit markets than commentators and politicians have. It is time for all of us to focus on facilitating their difficult task and to try to fill some of the gaps.

My preferred (part of a) solution is to provide universal insurance for the assets that are currently clogging the balance sheets of banks and other financial institutions. There are two issues often raised in the context of an insurance arrangement of this kind: How to determine the fair price of insurance in an environment where there are no sensible market prices? And, how to prevent financial institutions from selectively insuring their worst assets without disclosing them as such?

Fortunately, once the policy decision is made that these key systemic institutions will survive no matter what, these problems have a relatively easy solution. The great advantage of dealing with long-lived institutions holding a large number of assets is that there is no need to resolve the thorny issue of the insurance price and the quality of the assets right now. We can wait for the passage of time and a return to normality to determine whether their assets were worse than the representative asset in the corresponding asset class. Concretely, I would suggest that:

The price of the insurance should be set at pre-crisis levels for the corresponding asset class. If there is a sense that these assets were over-rated to begin with, then we should adjust the prices accordingly (for example, use AA pre-crisis insurance prices for overly-rated AAA assets).

This arrangement should be coupled with tight monitoring of the insured institutions and with retroactive fines a few years down the road to those institutions (and their management) whose assets underperform relative to their asset class.

A key aspect of this insurance arrangement is that it is aimed mainly at removing the aggregate risk from the balance sheet of financial institutions, although it does so asset-class by asset-class, so it considers the different portfolio composition of different financial institutions. Moreover, since these institutions have a large number of assets within each asset-class, one can rely on the law of large numbers to net out idiosyncratic accidents.

One potential criticism to this mechanism is that it does not resolve an adverse selection problem faced by potential equity investors: Since banks that choose to lie now will be eventually punished retroactively, then how can investors be reassured that the bank they are choosing to recapitalize is not lying? My reaction to this valid concern is twofold: First, my sense is that at this point in time the main risks are aggregate rather than of this kind. Thus, if enough aggregate uncertainty is removed from their balance sheets, the banks will not need, for the time being, much new capital. Second, the aggregate insurance arrangement need not work in isolation, but it can be implemented very quickly and be used as a stopgap. It can then be followed by the much slower process of getting onto the books of the banks to build more public trust. Moreover, by proceeding in this sequence, the stress tests do not put the burden of further negative aggregate shocks on the banks balance sheets, and hence further reduce the need for nationalizations and other remedies that have brought great distress to equity markets and taxpayers wealth in recent days.

I view this insurance proposal as complementary to and in the spirit of Secretary Geithner’s two-step proposal. On one hand, the former appears to have two advantages over the latter: First, it is simpler and faster to implement since it is done in one step, instead of having to go through a bad bank and then enticing the private sector to buy these assets. My sense is that the non-banks private sector will require more insurance than the banks themselves, since they will be exposed to an additional layer of adverse selection as they will be buying assets from the banks. Second, it immediately raises the tangible capital of the distressed financial institutions, without further need for capital injections. On the other hand, the two-step approach also has two advantages over the single-step insurance proposal: It addresses, more directly, the illiquidity problem in underlying asset markets, and it provides a channel to inject resources into the harder-to-get-to shadow financial system.

Clearly, there is no single dominant strategy to deal with the current crisis, but whatever we do, it is central that we focus on the whole system and on the role played by uncertainty. Standard recipes used to deal with isolated problems in a bank or two can easily backfire. Nationalizations and related measures are fine solutions in partial equilibrium, but they are recipes for disaster in an environment where systemic risk and uncertainty are at the core of the problem.

Mr. Caballero is the Ford International Professor of Economics at MIT"

Me:

“we focus on the whole system and on the role played by uncertainty”

I’m still wondering how we price this crisis insurance. It seems that either the premiums will be onerous, or they will be seen to be insufficient. It seems to add uncertainty, since no one knows for sure how much will actually be covered. Unless you’re assuming that the government will cover everything in the end anyway. What am I missing?

Comment by Don the libertarian Democrat - February 17, 2009 at 6:25 pm