"Their mission is to provide liquidity to the system by acting as lender-of-last-resort "

Casey Mulligan:

"Flight to Quality( FLIGHT TO SAFETY ) -- Cause or Effect?

Professor Lucas is a strong advocate.

I agree that there is a flight to quality( I AGREE ). Professor Lucas says that one way that people attempt to buy safe securities is to spend less on consumption goods. That makes sense -- but the same logic implies that people should work harder (earn more) as another means to accumulate those securities. The facts show that people are working less.( WHY ? COULDN'T IT HAVE TO DO WITH EMPLOYERS CUTTING BACK? ) Barro and King (1984) explained it best -- the basic puzzle of recessions (this one included) is that consumption and leisure move in opposite directions. Wealth effect and intertemporal substitution effect explanations of recessions (Professor Lucas' story is one example) imply that they move together.

That's why I believe that the "flight to quality" is a symptom( HERE I AGREE ) rather than a cause.

Professor Lucas arrives at the conclusion that the Fed should print money. Despite the arguments above, I agree that such a Fed policy would do more help than harm( I AGREE )."

Now Lucas in the WSJ:

"The Federal Reserve's lowering of interest rates last Tuesday was welcome ( TRUE ), but it was also received with skepticism( THAT'S FINE ). Once the federal-funds rate is reduced to zero, or near zero, doesn't this mean that monetary policy has gone as far as it can go? This widely held view was appealed to in the 1930s to rationalize the Fed's passive role as the U.S. economy slid into deep depression.

It was used again by the Bank of Japan to rationalize its unwillingness to counteract the deflation and recession of the 1990s. In both cases, constructive monetary policies were in fact available but remained unused( TRUE ). Fed Chairman Ben Bernanke's statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending( TRUE ).

There should be no mystery about what he has in mind. Over the past four months the Fed has put more than $600 billion of new reserves into the private sector, using them to discount -- lend against -- a wide variety of securities held by a variety of financial institutions. (The addition is to be weighed against September 2007's total outstanding level of reserves of about $50 billion.)

This action has been the boldest exercise of the Fed's lender-of-last-resort function( I AGREE THAT THIS IS WHAT IT IS ) in the history of the Federal Reserve System. Mr. Bernanke said that he is prepared to continue or expand this discounting activity as long as the situation dictates( I AGREE WITH HIM ).

Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a "flight to quality"( FLIGHT TO SAFETY ) that is very much analogous to the "flight to currency"( I AGREE. IT'S LIKE A BANK RUN. HOWEVER, I SEE IT AS A FLIGHT TO EXPLICIT GUARANTEES FROM IMPLICIT GUARANTEES ) that crippled the economy in the 1930s. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety( TRUE. IT'S BOTH. ). Individuals have tried to do this by selling other securities, but without an increase in the supply of "quality" securities these attempts do nothing but drive down the prices of other assets( TRUE ). The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession( TRUE ). Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending( TRUE. STILL THE FLIGHT TO SAFETY ).

When the Fed wants to stimulate spending in normal times, it uses reserves to buy Treasury bills in the federal-funds market, reducing the funds' rate. But as the rate nears zero, Treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of "quality" assets.

A dead end? Not at all. The Fed can satisfy the demand for quality by using reserves -- or "printing money" ( GO FOR IT )-- to buy securities other than Treasury bills. This is the way the $600 billion got out into the private sector.

This expansion of Fed lending has not violated the constraint that "the" interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months. The yield on short-term governments is now about the same as the yield on cash: zero. But the spreads between governments and privately-issued bonds are large at all maturities. The flight to quality means exactly that many are eager to trade private paper for non-interest bearing (or low-interest bearing) reserves and with the Fed's help they are doing so every day( TRUE, ALTHOUGH IT SOUNDS FOOLISH ).

Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced "bargains" on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lender-of-last-resort. We don't care about the quality of the assets the Fed acquires in doing this( WE DO CARE ). We care about the quantity of its liabilities( OK ).

There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.( I'D PREFER SIMPLY PUTTING MONEY OUT AND LEAVING IT )It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These seem to me important virtues( THAT'S A GOOD POINT )."

More or less, I agree.

"The defaults sparked a deleveraging, and the deleveraging destroyed the confidence which was keeping asset prices aloft. "

Felix Salmon discusses the notion of Brad DeLong's missing $17 Trillion:

"But really all finance is a confidence game, and just as Madoff dwarfs Voysey, so do total stock-market losses (in the tens of trillions of dollars) dwarf Madoff's. So long as investors had faith in Voysey, or Madoff, or stocks, everything worked fine. It was only when they tried to take their money out in quantity that things imploded.

Edward Hadas calls this "the noble lie":

The noble lie is the foundation on which all banking is built -- the ability of a bank's depositors and borrowers both to consider the same funds as their own. It's a lie because no bank, no matter how well capitalised, can always let each depositor cash every account...
The fiction of potentially unlimited withdrawal is not limited to bank accounts. Holders of the more advanced financial instruments -- bonds, shares and derivatives -- cannot all sell at once. If more than a few try, the market price drops sharply. If there is a stampede for the exit, the market disappears entirely.

"Stampede for the exit", of course, is also known under its more wonkish name: "global deleveraging". If everybody's selling and nobody wants to buy, what you thought of as wealth -- that number at the bottom of your brokerage statement, whether you have an honest broker or not -- can evaporate with astonishing speed."

I don't think this is a lie. Since it works, it's true. Also, not everyone has rushed to get their money out. But I do agree that it's a loss of confidence. But the loss of confidence was in the power of the government to solve this crisis. Underlying this system was trust, but, ultimately, trust in the government.

This trust in government still exists where it has some determinate meaning, which is why people who have FDIC insured accounts aren't pulling their money out, why increasing the FDIC insurance amount was a good idea, why the Fed paying interest on reserves has led banks to leaving their money there, and why the Flight To Safety landed in US Treasuries. There are other areas as well where the government guarantees are still believed and are effective. In other words, people only trust the banks to the extent that the government is guaranteeing them. This also explains why the Noble Lie isn't a lie: The government has the ability to make everyone whole. The consequences and conditions might be painful and rough, but the government can do this ( One can imagine limits to this statement, but we are very far away from it being operative here, which is why these government guarantees are still taken seriously. )

"Which I think is the answer to Brad DeLong's question of how on earth $20 trillion of wealth has been lost, when total loan defaults are only on the order of $2 trillion. The defaults sparked a deleveraging, and the deleveraging destroyed the confidence which was keeping asset prices aloft."

I agree, but it's a loss in the confidence of government to adequately deal with this crisis. Here we can say that it has become obvious that not everyone will be made whole or even reasonably well compensated. Some people are going to have to take real losses. This loss of faith in the power of government to keep the losses to a minimum is akin to a loss of faith in a creed or mode of life, especially since there was nothing even resembling an alternative. It feels like a loss of faith in a creed after which there are no alternative creeds that can take its place.

"For example: if there's just one person willing to pay $950 for my Google stock, then that's how much it's worth. But if that marginal buyer goes away, and there's a general sentiment that people would rather have cash than Google stock, the price can fall precipitously without much if any news. DeLong tries to model the preference for cash over Google stock as a rise in such things as "liquidity discount" and "risk discount", but that's not how it works in the real world: few people ever bought Google stock because they did the math and decided that the risk-adjusted present value of future dividends was $950. (Especially since Google doesn't pay a dividend.)"

I disagree. There are methods to determine a stock's worth, which, while not without flaws, are very useful. But, in a panic, that worth is worthless.

"Sure, DCF jockeys exist, but they don't tend to be price-setters. Brad DeLong, who's done a lot of original research on the equity risk premium, is basically in that camp: he buys stocks because he has faith in his own analysis. But most of us aren't that clever: we just buy stocks out of some combination of greed and fear (that we won't have enough money to live on, decades hence, if we don't invest our money in ways which make it grow substantially)."

Okay.

"In times of turmoil, we start worrying less about not having enough money in 20 years, and more about not having enough money in 20 weeks. (What if I lose my job? What if my investments fall further?) So we sell our investments."

Sometimes foolishly.

"Can this be modelled as an increase in the liquidity discount? Maybe, but in that case Brad has already answered his own question:

As long as we love our children as ourselves (and most of us do) and as long as we have access to and can credibly pledge collateral for financial transactions (and we can) the magnitude of the liquidity discount should be roughly equal to the technologically and organizationally driven rate of labor productivity growth divided by the intertemporal elasticity of substitution. The technologically and organizationally driven rate of labor productivity growth is a fairly steady 2 percent per year. The intertemporal elasticity of substitution is in the range from 1/2 to 1.

The intertemporal elasticity of substitution might normally be close to 1, but it sure isn't there right now -- not for those of us without tenure, anyway. It came down a lot in the summer of 2007, when the commercial paper market first started seizing up, and it's even lower now. Ask any hedge fund manager dealing with massive redemptions -- it might not be rational to buy with a long time horizon and then suddenly decide to liquidate, but this is not a rational market, and it hasn't been for some time."

This is true.

"There's also a strong feedback loop here. In normal markets, the more that prices fall, the more people want to buy. In financial markets, during a time of crisis, the more that prices fall, the more people want to sell. The intertemporal elasticity of substitution isn't a constant: it's a variable, which falls along with the market. And the people who don't adjust their discount rate fast enough to new realities end up, like Bill Miller, getting crushed."

This is basically the fear and aversion to risk and accompanying flight to safety.

"Especially if you're buying financials and other confidence stocks, you need a lot of other people to be buying them too, otherwise they have a tendency to go to zero. More generally, whenever lenders lose confidence in a company and refuse to refinance its debt, shareholders are likely to find themselves severely diluted at best, and quite possibly wiped out entirely."

Financial Stocks have suffered, like the Bush Administration, from a general feeling that they are being led by incompetent leaders, if not by criminals.

"It's entirely reasonable to draw a distinction between Mr Voysey and Bernie Madoff -- the men with the ignoble lies -- and the more noble lies underlying the stock market. But deleveraging is no respecter of nobility. Which is why all of us are now suffering, not just those who invested with Bernie."

They're both guilty, but one has committed a more heinous crime than the other. However, neither should be let off. Prosecuting some people who have committed crimes is a good way to restore confidence in government.