double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other

TO BE NOTED: From The Growth Blog:

"The Financial and Economic Crisis and the Developing World: Where We Are and Where We Are Going

By Michael Spence

Created 04/14/2009 - 16:46

The financial system in the USA and much of Europe had a heart attack in September 2008. As in the case of a real heart attack, the highest priority has gone to the emergency response and to stabilizing the patient. Once that is done and the crisis is abating and even to some extent as it is going on, it will be important (economically and politically) for some to focus on two related issues: What created the rising risk of an attack? And what combination of actions post-crisis will reduce the risk of a repeat in the future.

There are related issues. Are there lessons in the current crisis (and past ones) or is each one sufficiently idiosyncratic so that reregulating with reference to the past does little to limit the potential future damage. Globally, what is the appropriate tradeoff between risk reduction on the one hand and higher costs of capital and lower growth on the other? Is the financial sector different from most others in that when it malfunctions, the rest of the economy malfunctions along with it, and if so should it be treated differently? Will investors learn from this crisis to a point that much of the “re-regulation” will come from adjusted investor behavior and risk assessment procedures? Or are there inherently large divergences between private and social objectives that need to be aligned through regulatory and oversight structures? Are the answers the same for domestic economies and financial systems and for the global aggregate, or are they fundamentally different?

In climate change there are issues of mitigation (prevention or risk reduction) and adaptation. Good policy is a mix of the two. Corner solutions are unlikely to be the right answer. A similar issue arises in the present case. Whether or not regulation and oversight are adequate depends upon the risks and the consequences of financial instability and distress and the latter depends on the existence and effectiveness of response mechanisms. We will need to talk about both in a coordinated way.

The Crisis of September 2008

Credit locked up, interbank lending stopped, and the payments systems' started to malfunction in the US and much of Europe. The TED spread (The interest rate differential between t-bill rates and LIBOR) and related measures of risk at the heart of the financial, payments and credit system rose from its normal 100 basis points to between 4 and 5 hundred basis points. Asset prices declined rapidly, balance sheets in the financial sector further deteriorated and the household sector experienced a massive wealth loss, triggering a reduction in consumption. The double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other accelerated and has only recently shown evidence of deceleration.

The financial crisis quickly became an economic problem and then a crisis. Asset price declines (equities globally lost $25-30 trillion or more in a four month period) and very tight credit caused investors and consumers to become extremely cautious, causing consumption to fall and the real economy to turn downward. There was no near-term bottom and few brakes to slow the downward momentum.

A complete credit lock-up (and a depression-like scenario in which businesses that rely on credit simply fail) was averted through rapid action by central banks using a growing variety of programs to increase liquidity or directly supply credit, thereby circumventing the normal channels that were damaged and not functioning. The balance sheet of the Fed more than doubled in size from less than a trillion to more than two trillion and with recent commitments is on its way to 3 trillion dollars.

There were two further issues of central importance. First, the markets in a variety of securitized assets stopped functioning. The shadow banking system through which a substantial portion of credit is provided in the US, froze up. Second, because of a combination of leverage and damaged assets, there was and is a potentially large solvency problem in a significant number of large and systemically important institutions. The solvency and related transparency issues continue to be with us today.

The effects on the developing world were immediately felt, though the awareness of the magnitude increased over time. The two important channels were aggregate demand (globally), and the availability and cost of credit and financing. A third channel, rapid shifts in relative prices apart from credit spreads, were important but on balance beneficial.

The financial channel was dramatic. Credit tightened pretty much instantly in the developing world as capital either rushed back to the advanced countries or stopped flowing out, to deal with damaged balance sheets and capital adequacy problems in the advanced countries. The currencies of all major developing countries except for China depreciated against the dollar. Developing countries with reserves used them to stabilize the net capital flows and to partially restore credit and financing. Trade financing dried up and other capital flows diminished or disappeared. The IMF intervened in several cases while financing and bilateral swap arrangements of a variety of kinds were made by the US and China. Credit remains tight and high priced and there is a continuing need for additional financing on a broad front. The IMF did not have the resources in the fall of 2008. Expanding those resources significantly was part of the G20 agenda. At the G20 summit in early April, an important commitment was made to expand IMF resources by over $1 trillion to restore the availability of trade and other forms of finance on an interim basis to developing countries that need it.

The second channel was aggregate demand and trade. As aggregate demand in the advanced countries dropped for the aforementioned reasons, global aggregate demand fell and with it trade: exports and imports. The trade data show a stunning drop in exports, considerably more than in aggregate demand. In many developing countries that rely on external demand and exports as an engine of growth, the immediate negative effect was lower growth, reduced employment and reduced consumption triggering the usual domestic recessionary dynamics.

Globally, the intent is to counter this loss of aggregate demand with coordinated fiscal stimulus programs in the advanced countries and in developing countries to the extent it can be done without jeopardizing fiscal sustainability. The latter capacity varies considerably across countries. There is dissension in the G20 as to what the right order of magnitude is. There are also issues of free riding and protectionism. It is understandable that citizens in various countries facing fiscal deficits and large future debt service obligations prefer to have the benefits of a stimulus program land domestically.

I have described this incentive structure elsewhere as akin to a prisoner’s dilemma with the non-cooperative dominant strategies being either stimulus with some protectionism or free-riding depending on the size and openness of the economy. One can think of that portion of the G20 effort, the part devoted to openness, as attempting to shift policies away from the non-cooperative Nash equilibrium. Evidently, from data on increases in protectionist measures, this will be only partially successful, but partial success is probably much better than no effort at all. Realistically we may not have the option of choosing the first best, coordinated stimulus with openness, but rather have to be satisfied with an effort at coordinated stimulus with some protectionism, as opposed to openness with feeble stimulus commitments.

More generally there is confusion and disagreement about the role of government in the context of a crisis. I have written at somewhat great length about this issue here [1]. This disagreement complicates the politics of timely and effective intervention and has to be factored into the risk assessments for policy makers and private investors and consumers alike. One thing is clear. Government has become a major player in the financial system and the economy. In the financial system it has morphed from regulator to regulator and participant. Predictability of government action has therefore become a major determinant of risk.

The third channel was relative price changes. The dramatic spike in commodity prices (especially food and energy) was reversed. This ameliorated a twin challenge in most developing countries of dealing with the impact of the commodity price spike on the poor and on inflation. Beyond that, at the country level, those who have gained and lost depends on whether a particular country is a net importer or exporter of commodities.

The commodity price spike and fall brought into focus an important policy issue. Large relative price swings have very important distributional consequences across countries and across subsets of the population within countries. These need to be addressed as part of creating a better managed and more stable global economic system that people will support. [for further reference, see part IV of the Commission on Growth and Development: The Growth Report [2]].

Where Are We Now?

On the real economy side, in the advanced countries and globally, growth has gone negative or slowed dramatically. Global growth is projected to be negative in 2009 for the first time since World War II. Trade has collapsed. While there are some signs that the downward momentum may be slowing, the real economies have not bottomed out and are unlikely to do so in 2009 and perhaps well into 2010.

The advanced countries financial systems have shown some recent signs of improvement, though they are still functioning on life support. There are signs that credit is easing and risk spreads are declining somewhat from very high levels. But that is certainly because the government and central banks have a major and expanding role in the financial system. It is too early to say that the system is starting to return to normal. In the US, the Fed and the Treasury have launched a series of initiatives designed to restart the markets in securitized assets, clarify values, remove the transparency fog surrounding the balance sheets of major financial institutions, and as necessary recapitalize banks and other systemically important institutions, probably by becoming a major (or the sole) owner of some of them. Progress on this front from a policy point of view is relatively recent and it is too early to tell the extent to which they will be sufficient to jump start the sequential healing process and a return to normal functioning.

The US savings rate is rising, a part of the disorderly unwinding of global imbalances. Asset prices remain volatile and it is too early to tell if they have stabilized. It is clear however, that the financial system and the real economy will not return to their previous configurations. Even absent major and likely changes in regulation and oversight, there will be a “new normal”. Global growth in the future will be driven by a different portfolio of saving and investment rates and levels across countries.

The Growth Commission Workshop Meeting And Supplementary Report On The Financial And Economic Crisis

The Commission on Growth and Development is meeting one more time in late April in conjunction with a two day workshop, to consider issues related to the financial and economic crisis and its aftermath. The intent is to produce a special report, additional to the Commission report [3] which came out in May 2008. This special report will likely deal with three broad sets of issues.

One set has to do with post-crisis, the challenge of creating more effective regulatory and oversight structures (domestically and internationally) that reduce the risk of instability and the likelihood that the instability spreads quickly to the entire global system. A second set of issues has to do with crisis response. Are there ways when instability and malfunction occur, to limit the damage and disrupt the transmission channels? Further, can some of this capability be created in advance so that it can be deployed quickly? There is obviously a third issue: are the conditions needed to bring the patient back to health and prosperity being met? And if not, what else do we need to do?

The Commission anticipates that there will be a process overseen by the G20 designed to develop proposals for a different global financial architecture, regulatory and oversight structure. Our intention is to have the augmented Commission report contribute to that process with particular attention to the needs and interests of developing countries, some of whom are represented in the G20 itself and most of whom are not.

As we approach the workshop and the Commission meeting and discussion of these issues, we invite broader comment, input and discussion on the BLOG.

Like many members of the Commission and participants in the workshop, I have been thinking and writing about the financial and economic crisis under the headings of causes, crisis dynamics and policy responses, and post crisis reform. A link to my articles will be published on this blog, and I look forward to your comments."

its failure could have triggered a 1930s-style global financial and economic meltdown, with catastrophic implications for production, incomes,and jobs

TO BE NOTED: From the Fed:

Chairman Ben S. Bernanke
At the Morehouse College, Atlanta, Georgia
April 14, 2009

Four Questions about the Financial Crisis

I am pleased to have the privilege of speaking today to the students and faculty of Morehouse College, the only all-male historically black institution of higher learning in the United States. It is sufficient to note that Martin Luther King, Jr., was a graduate of Morehouse. Yet a roster of distinguished alumni that also includes former Atlanta Mayor Maynard Jackson, former U.S. Surgeon General David Satcher, and filmmaker Spike Lee testifies to the success of your stated mission of "producing academically superior, morally conscious leaders for the conditions and issues of today."

My remarks today will focus on the ongoing turmoil in financial markets and its consequence, the global economic recession. The financial crisis, the worst since the Great Depression, has severely affected the cost and availability of credit to both households and businesses. Credit is the lifeblood of market economies, and the damage to our economy resulting from the constraints on the flow of credit has already been extensive. With recent job losses exceeding half a million per month, this year's college graduates are facing the toughest labor market in 25 years. In the communities in which you and I grew up, many families are trying to cope with lost employment and depleted savings or are facing foreclosure on their homes. Firms have shut factories and cancelled construction projects. States and municipalities are scrambling to find the funding to provide critical services. And although we naturally tend to be most aware of conditions in the United States, we should not overlook the impact that the crisis is having virtually everywhere in the world, particularly on many citizens of countries that struggle economically even when the global economy is doing well.

In the midst of all of these concerns, many Americans have recently celebrated Easter or Passover. As you may know, a highlight of the traditional Passover meal occurs when the youngest child asks four questions, the answers to which tell the history of the Jews when they were slaves in Egypt and during their exodus to the Promised Land. In the spirit of the holiday, today I will pose and answer four important questions about the financial crisis. Of course, my answers will have to be brief, but we will have more time for additional questions at the conclusion of my prepared remarks.

How Did We Get Here?
The first question I would like to address is: How did we get here? What caused our financial and economic system to break down to the extent it has? Not surprisingly, the answer to this question is complex, and experts disagree on how much weight to give various explanations. In my view, however, to tell the story fully--and, in particular, to understand its international scope--we need to consider how global patterns of saving and investment have evolved over the past decade or more, and how those changes affected credit markets in the United States and some other countries.

At the most basic level, the role of banks and other financial institutions is to take the savings generated by households and businesses and put them to use by making loans and investments. For example, financial institutions use the funds they receive from savers to provide loans that help families buy homes or allow businesses to finance inventories and payrolls. Financial markets, such as the stock and bond markets, perform a similar function, as when a firm raises funds for a new factory by selling a bond directly to investors. When the financial system is working as it should, it allocates funds both prudently (that is, with proper attention to risk) and efficiently (to the most productive uses).

Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today's dollars.

Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well( NB DON ). Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain. One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of this lending was poorly done( NB DON ), involving, for example, little or no down payment by the borrower or insufficient consideration by the lender of the borrower's ability to make the monthly payments. Lenders may have become careless because they, like many people at the time, expected that house prices would continue to rise--thereby allowing borrowers to build up equity in their homes--and that credit would remain easily available, so that borrowers would be able to refinance if necessary. Regulators did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation.

Mortgage markets were not the only ones caught up in the credit boom. The large flows of global saving into the United States drove down the returns available on many traditional long-term investments, such as Treasury bonds, leading investors to search for alternatives. To satisfy the enormous demand for investments both perceived as safe and promising higher returns, the financial industry designed securities that combined many individual loans in complex, hard-to-understand ways. These new securities later proved to involve substantial risks--risks that neither the investors nor the firms that designed the securities adequately understood at the outset.

The credit boom began to unravel in early 2007 when problems surfaced with subprime mortgages( NB DON )--mortgages offered to less-creditworthy borrowers--and house prices in parts of the country began to fall. Mortgage delinquencies and defaults rose, and the downturn in house prices intensified, trends that continue today. Investors, stunned by losses on assets they had believed to be safe, began to pull back from a wide range of credit markets, and financial institutions--reeling from severe losses on mortgages and other loans--cut back their lending. The crisis deepened last September, when the failure or near-failure of several major financial firms caused many financial and credit markets to freeze up. Stock prices fell sharply as investors lost confidence in the financial sector and became gloomy about economic prospects. Declining stock values, a teetering financial system, and difficulties in obtaining credit triggered a remarkably rapid and deep contraction in global economic activity and employment, a contraction that has persisted through the first months of 2009. Both the ongoing financial crisis and economic contraction have posed major challenges to economic policymakers.

What Is the Fed Doing to Address the Situation?
Those challenges bring me to my second question: What has the Federal Reserve been doing to address the economic and financial crisis?

The Fed's mandate from the Congress is to promote maximum sustainable employment and stable prices. In addition, the Fed is expected to contribute to financial stability by acting to contain financial disruptions and prevent their spread outside of the financial sector. Thus, we have been serving as a first responder to the crisis.

The Fed's basic policy tool for influencing economic activity and inflation is its ability to control very short-term interest rates--specifically, the federal funds rate, which is the rate that banks pay each other for overnight loans. Lower interest rates can be used to stimulate private-sector borrowing and spending at times like the present when the economy is suffering from a lack of demand. In September 2007, shortly after the turbulence in financial markets began and signs of economic weakness started to appear, the Federal Open Market Committee (FOMC), the body that determines the Federal Reserve's monetary policy, began to aggressively reduce the federal funds rate. By the spring of 2008, we had cut that interest rate from 5-1/4 percent to 2 percent, a highly proactive policy that helped to cushion the economy from some of the effects of the financial turmoil. But, as I mentioned a moment ago, the intensification of the financial crisis in the fall of 2008 led to a further significant deterioration in the economic outlook. The FOMC responded with additional interest rate cuts, and since December, our policy interest rate has been essentially zero. In addition, the FOMC has made clear that it expects economic conditions to warrant holding the federal funds rate low for an extended period.

However, given the ongoing problems in credit markets, conventional monetary policy alone is not adequate to provide all the support that the economy needs. The Fed has therefore taken a number of steps to help the economy by unclogging the flow of credit to households and businesses. In doing so, we have demonstrated that the Fed's toolkit remains potent, even though the federal funds rate is close to zero and thus cannot be reduced further.

We have taken a wide range of actions to help restore the flow of credit, of which I will only mention a few of the most important. One set of actions involves making short-term loans to banks and other financial institutions. Banks and other financial intermediaries normally make longer-term commitments--such as residential mortgages and business loans--yet rely on funding that may be relatively short-term, such as customer deposits that can be withdrawn at any time. To have the confidence to commit to longer-term loans and investments, banks must be sure that they will have ample access to funding when necessary. To give this assurance to banks, the Federal Reserve has made clear that it will provide short-term credit to sound financial institutions as needed. Indeed, serving as a lender of last resort to financial institutions is a method that central banks have used for centuries to try to calm financial crises.( NB DON )

To underscore our commitment to providing short-term funding to banks when they need it, we have lowered the interest rate we charge for short-term loans and extended the term of the loans to up to three months. We have also begun to auction funds to financial institutions, thereby allowing the interest rate paid to depend on the level of demand. Importantly, this lending is extremely safe from the point of view of both the Fed and the taxpayer. Not only is our lending short-term and restricted to healthy institutions, but we require that the borrowers pledge, as security, collateral whose value exceeds the amount we are lending. The Fed's lending to financial institutions has helped to ease conditions in a number of key financial markets, reduced important benchmark interest rates (such as the London interbank offered rate, or Libor, to which payments on some mortgages and other types of loans are tied), and increased the willingness of banks to make credit available.

A second strategy the Fed has employed is to use targeted lending to help free up critical credit markets outside of the banking system. A good example of targeted lending is our efforts in the commercial paper market. Commercial paper is a form of short-term debt issued by a variety of businesses to finance their operations; paychecks and payments to suppliers can depend on it. Among the largest investors in commercial paper are money market mutual funds. At the peak of the crisis last fall, many people who had invested in money market mutual funds lost confidence in those funds and withdrew their money( NB DON ); this loss of funding forced money market mutual funds to reduce their own investments, which in turn caused serious problems in the commercial paper market. Through a series of lending programs, and in coordination with steps taken by the Treasury, the Federal Reserve helped restore confidence in both money market mutual funds and the commercial paper market. Over time, withdrawals from money market mutual funds have been replaced by modest net inflows, and borrowers in the commercial paper market have seen significant improvements in the cost and availability of funding.

More recently, the Federal Reserve has also initiated a lending program, with the cooperation of the Treasury, designed to free up the flow of credit to households and small businesses. Among the forms of credit on which the program is currently focused are auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. We are currently reviewing other types of credit for possible inclusion in this program. In all cases, we will be taking the appropriate measures to minimize the risk of loss to the Federal Reserve.

Restoring stability to the market for housing and home mortgages has been a particular area of concern. To address this problem, the Fed has employed a third type of policy tool--namely, buying securities in the open market. The FOMC has approved purchases of well over $1 trillion this year of mortgage-related securities guaranteed by the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. Buying mortgage-related securities helps to drive down the interest rates that consumers pay on mortgages, and, indeed, the rate on a traditional 30-year fixed-rate mortgage has recently fallen to less than 5 percent, the lowest level since the 1940s. Certainly, the housing market remains depressed, but lower interest rates and house prices are making houses more affordable. For example, two years ago, when mortgage rates were higher than 6percent, payments on a mortgage covering 80 percent of the cost of a $215,000 home would have been more than $1,000 per month; today, the price of that same house may have fallen to $170,000, and, at today's mortgage interest rates, the monthly payment would be about $700. Lower mortgage rates are also helping some homeowners refinance their mortgages to reduce their monthly payments.

The Federal Reserve will continue to take the necessary steps to unclog the credit markets and strengthen the economy. We will also continue to work closely with other agencies, such as the Treasury and the Federal Deposit Insurance Corporation (FDIC), each of which has also taken a variety of actions to help stabilize financial markets, as well as with other central banks around the world.

Does the Fed's Aggressive Response Risk Inflation Down the Road?
The multifaceted policy response that I've described has been aggressive. I am confident that such a proactive policy response is well justified by the serious ongoing problems in financial markets and the economy. However, some have raised the third question I will address: Could the Fed's aggressive actions to stabilize the economy today lead to an inflation problem down the road?

I mentioned earlier that the Fed's mandate from the Congress is to foster price stability as well as maximum sustainable employment. The FOMC treats its obligation to ensure price stability extremely seriously. Price stability supports healthy economic growth, for example, by making it easier for households and businesses to plan for the future. In practice, price stability does not require that inflation be literally zero; indeed, although inflation can certainly be too high, it can also be too low. Experience suggests that inflation rates that are close to zero or even negative (corresponding to deflation, or falling prices) can at times be associated with poor economic performance. Cases in point include the United States in the 1930s and the more recent experience of Japan. In their latest quarterly projections of the economy, most members of the FOMC indicated that they would like to see an annual inflation rate of about 2 percent in the longer term. Right now, because of the weakness in economic conditions here and around the world, inflation has been running less than that, and our best forecast is that inflation will remain quite low for some time. Thus, the Fed's proactive policy approach is not at all inconsistent with the goal of price stability in the medium term.

Although inflation seems set to be low for a while, the time will come when the economy has begun to strengthen, financial markets are healing, and the demand for goods and services, which is currently very weak, begins to increase again. At that point, the liquidity that the Fed has put into the system could begin to pose an inflationary threat unless the FOMC acts to remove some of that liquidity and raise the federal funds rate. We have a number of effective tools that will allow us to drain excess liquidity and begin to raise rates at the appropriate time; that said, unwinding or scaling down some of our special lending programs will almost certainly have to be part of our strategy for reducing policy stimulus once the recovery is under way.

We are thinking carefully about these issues; indeed, they have occupied a significant portion of recent FOMC meetings. I can assure you that monetary policy makers are fully committed to acting as needed to withdraw on a timely basis the extraordinary support now being provided to the economy, and we are confident in our ability to do so. To be sure, decisions about when and how quickly to proceed will require a careful balancing of the risk of withdrawing support before the recovery is firmly established versus the risk of allowing inflation to rise above its preferred level in the medium term. However, this delicate balancing of risks is a challenge that central banks face in the early stages of every economic recovery. I believe that we are well equipped to make those judgments appropriately. In addition, when the time comes, our ability to clearly communicate our policy goals and our assessment of the outlook will be crucial to minimizing public uncertainty about our policy decisions.

Why Did the Fed and the Treasury Act to Prevent the Bankruptcy of Some Major Financial Firms?
The final question is as difficult as it is important: Why did the Fed and the Treasury act to prevent the bankruptcy of some major financial firms, such as the investment bank Bear Stearns and the insurance company American International Group, or AIG? We must answer that question not only because the decisions have been controversial, but also because it bears on the steps we need to take as a country if we are to avert a repetition of the crisis.

As a general rule, my strong preference is that any firm that cannot meet its obligations should bear the consequences of the marketplace. But recent circumstances have been truly extraordinary. Consider the situation on September 16 of last year, when the insurance conglomerate AIG faced pressures that threatened to force it imminently into bankruptcy. At that time, the strains in the global financial system were unprecedented and extreme, and the confidence of financial market participants in the system was rapidly eroding. The investment bank Lehman Brothers had filed for bankruptcy the day before, and the mortgage giants Fannie Mae and Freddie Mac, after suffering losses that threatened their solvency, had effectively been taken over by the government just two weeks earlier. As waves of panic and fear washed over the markets, the Fed and the Treasury became very concerned about the stability of a number of other major financial firms.

Large, complex financial institutions tend to be highly interconnected with other firms and markets, and AIG was more interconnected than most. For example, AIG had insured many billions of dollars of loans and securities held by banks around the world, and its failure would have rendered those insurance contracts worthless, imposing large losses on the global banking system. In addition, banks had extended more than $50 billion in credit to the company, much of which would have been lost. Many other serious consequences would have followed from a default by AIG: Insurance policyholders would have faced considerable uncertainty about the status of their policies; state and local governments, which had lent more than $10 billion to AIG, would have suffered losses; workers whose 401(k) plans had purchased $40 billion of insurance from AIG against the risk of loss would have seen that insurance disappear; and holders of AIG's substantial quantities of commercial paper would have also borne serious losses.

But much more important, the disorderly failure of AIG would have put at risk not only the company's own customers and creditors but the entire global financial system. Historical experience shows that, once begun, a financial panic can spread rapidly and unpredictably( NB DON ); indeed, the failure of Lehman Brothers a day earlier, which the Fed and the Treasury unsuccessfully tried to prevent, resulted in the freezing up of a wide range of credit markets, with extremely serious consequences for the world economy. The financial and economic risks posed by a collapse of AIG would have been at least as great as those created by the demise of Lehman. In the case of AIG, financial market participants were keenly aware that many major financial institutions around the world were insured by or had lent funds to the company. The company's failure would thus likely have led to a further sharp decline in confidence in the global banking system and possibly to the collapse of other major financial institutions. At best, the consequences of AIG's failure would have been a significant intensification of an already severe financial crisis and a further worsening of economic conditions. Conceivably, its failure could have triggered a 1930s-style global financial and economic meltdown, with catastrophic implications for production, incomes, and jobs. ( NB DON )

The Federal Reserve and the Treasury agreed that in the environment then prevailing, AIG's failure would have posed unacceptable risks for the global financial system and for our economy. Accordingly, the Federal Reserve, with the full support of the Treasury, made a loan to AIG to prevent its failure. The loan imposed tough terms; in addition, senior management was replaced, and shareholders lost almost all of their investments. However, because the firm avoided a declaration of bankruptcy, creditors of AIG were protected.

In my view, preventing the failure of AIG was the best of the very bad options available, but it nevertheless involved major costs, including financial risks to the taxpayer. The American people also quite correctly see as unfair that AIG was saved from bankruptcy because of the dangers to the system that its failure would have posed, even as many other companies, including nonfinancial and smaller financial firms, have not received the same treatment. Allowing AIG to at least partly avoid the discipline of the marketplace also sets a bad precedent.

For these reasons, it is essential that we make changes to the financial rules of the game to prevent a similar episode from occurring in the future. First, we must ensure that all types of financial institutions, especially large and interconnected ones like AIG, receive strong and effective government oversight. AIG's regulatory oversight was limited, which allowed it to take dangerous risks largely out of sight of federal regulators.

Second, the AIG experience demonstrates that federal regulators urgently need a new set of procedures for dealing with a complex, systemically important financial institution on the brink of failure. Such rules already exists for banks: If a bank approaches insolvency, the FDIC is empowered to intervene as needed to protect depositors, sell the bank's assets, and take any necessary steps to prevent broader consequences to the financial system. However, for an insurance conglomerate like AIG, or for a large financial holding company that owns many subsidiary companies, these rules do not apply. Among other things, a good system for resolving nonbank financial institutions would allow federal regulators to unwind a failing company in ways that minimize disruptions in financial markets. An effective regime would also provide the authorities greater latitude to negotiate with creditors and to modify contracts entered into by the company, including contracts that set bonuses and other compensation for management. More generally, we need significant reforms to financial regulation and financial practices that will reduce the risk of future financial crises like the one we are currently experiencing. The Federal Reserve strongly supports such reform efforts.

Conclusion
The current crisis has been one of the most difficult financial and economic episodes in modern history. Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, homebuilding, and consumer spending, including sales of new motor vehicles. A leveling out of economic activity is the first step toward recovery. To be sure, we will not have a sustainable recovery without a stabilization of our financial system and credit markets. We are making progress on that front as well, and the Federal Reserve is committed to working to restore financial stability as a necessary step toward full economic recovery.

I am fundamentally optimistic about our economy. Among its many intrinsic strengths are universities and colleges like Morehouse, which help talented students gain not only a command of a body of knowledge but also the capacity to think creatively and independently. Institutions like this one train the professionals, entrepreneurs, and leaders who will shape our economy in the future. Today's economic conditions are difficult, but the foundations of our economy are strong, and we face no problems that cannot be overcome with insight, patience, and persistence. The Federal Reserve will certainly do its part to help restore prosperity and opportunity to our economy."

is there a single, predominate cause? I don't think so.

TO BE NOTED: From the Economist's View: A Fair Analysis: I would simply rank them differently than others:

"Who's the Villain in the Crisis?

Is there a single factor, or one predominant factor, that caused the crisis? I've been asked this a lot. Is there something we can point to and say that was the villain, that did it, that's who we should blame? Was it greedy CEOs, Greenspan and the Fed, lying homeowners, real estate agents with bad incentives, Chinese savers, the ratings agencies, the quants, the economists who didn't see it coming, the regulators who failed to regulate, is there a single, predominate cause?

I don't think so. For the crisis to have occurred, there must have been (1) a source of vast amounts of liquidity, (2) a reason for most of that liquidity to go to one sector, the housing sector, rather than being spread around to a variety of industries, and (3) a failure to detect and prevent the bubble from developing in the industry where the excess liquidity found a home.

The source of the excess liquidity is well known, it came from China, the oil producing countries, and low interest rate policy from the Fed. China could have accumulated less reserves, invested them at home, etc., and the US could have pursued a higher interest rate policy (but at what cost to the economy as it was trying to recover from the bursting of the tech stock bubble), that's true, and it might have made the bubble less severe, but were these things, and these things alone, the cause of the bubble?

There's no reason why the excess liquidity could not have been invested in a variety of industries rather than flowing mainly to housing. If that happens, the risks are spread far more broadly, and we don't have such a large bubble, one that endangers the broader economy when it pops. So we have to ask, why did the money flow almost entirely to one industry? It was the false perception that financial innovation could produce higher rewards without increasing risk, there were lots of complex mathematical models around to prove it, and there were ratings agencies to validate the claims. So the combination of excess liquidity with the false promise of higher returns without higher risk caused the money to flow into a particular industry rather than into a wide variety of investment opportunities. It was safe as houses.

But even that wasn't enough to produce a bubble by itself, we have to ask why the checks and balances within the housing sector, both from the market and from regulators, failed to stop the massive flow of money into these assets. The reason is that there were incentive problems all the way through the system. The homeowner gets a non-recourse loan which makes risks mostly one-sided, real estate agents are paid on commission giving them to incentive to maximize the number of houses sold at the highest price they can get, real estate appraisers were in the pocket of the real estate agents (that's obvious when you buy a house), if they don't give the values the agents are looking for, their phone stops ringing. The mortgage brokers were being paid, essentially, on commission and they were able to move these loans off their books - sell them as repackaged securities - so as to remove any long-run interest in the outcome of the loans (so they didn't care what the appraisers said). Their incentive was to sell as many loans as possible with no real concern for quality. Why did people buy these repackaged loans from banks and brokers? Here we come again to the ratings agencies and the poor risk assessment models, the culture within these institutions, moral hazard from implicit or explicit government guarantees, compensation structures, and so on. The incentives at just about every step of the process were to create as many loans as possible with little regard to quality, every check and balance that ought to be in place was missing. The market did not self correct, and regulators clearly fell down on the job, fixing any one of these incentives could have made a big difference by plugging up the pass-through of the excess liquidity from China and the Fed, but the regulators were absent. Whether this is due to incompetence, poorly structured regulatory procedures, or regulatory capture - money talks and nobody wanted to spoil the party - I don't know for sure. But the regulatory failures were clearly broad based.

So I can only narrow the villains down and place them into broad categories, I can't point fingers at any one of them and say you did it, you were the cause of this. The managers at places like AIG were part of the problem, and they surely don't deserve rewards for their performance, that is not the argument here, but they and others like them were only one part of the problems we now have, they didn't cause the problems by themselves. It was a combination of things working together that produced this crisis, that is, excess liquidity, very poorly structured incentives, and incorrect assessment of the risks all came together to produce the problems we are seeing. I wish I could point to a single villain, it would be easier in a many, many ways to be able to do that, but I don't think we can, and doing so runs the risk of delaying the reform that is needed by causing us to focus on only a small set of the larger set of "villains". There's plenty of blame - and reform - to spread around.

Posted by Mark Thoma on Wednesday, March 18, 2009 at 10:08 AM"

This column presents an opinionated synthesis of the key issues and proposals with the aim of focusing and stimulating the debate.

From Vox:

Thomas Philippon
15 February 2009

Proposals for financial regulatory reform are everywhere. This column presents an opinionated synthesis of the key issues and proposals with the aim of focusing and stimulating the debate.

The global crisis has scared the public, captivated policy makers, and fascinated the academic community. A consensus has emerged that the financial system is broken and must be fixed. This column puts forth an opinionated overview of the various reports and proposals for new financial regulations in an attempt to stimulate and focus discussion.

I do not describe the crisis itself since much has already been written about it. Brunnermeier (2008) and Hellwig (2008) provide excellent analysis of the early part of the crisis, the Policy Recommendations from NYU Stern (2009) has a complete coverage, and Blanchard (2008) offers a clear and concise macroeconomic perspective.

Three key reports

I will mostly focus on three reports:

· The “Geneva Report” (Brunnermeier, Crocket, Goodhart, Persaud, and Shin;

· The “G30 Report” by the Group of Thirty, chaired by Paul Volcker; and

· The “NYU-Stern Report” by a group of professors from NYU’s Stern School of which I am one.

These three reports cover most, if not all, areas of financial regulation. I also discuss the capital insurance proposals of Kashyap, Rajan and Stein (2008), and the proposals of Zingales (2008, 2009).

SECTION 1: The failures of current regulations

There is much agreement regarding the shortcomings of current regulations. Let me focus on five specific areas.

Systemic risk. All reports agree that the financial regulatory frameworks around the world pay too little attention to “systemic risk”. For instance, Acharya, Pedersen, Philippon and Richardson (2009) argue that “Current financial regulations seek to limit each institution’s risk seen in isolation; they are not sufficiently focused on systemic risk. As a result, while individual risks are properly dealt with in normal times, the system itself remains, or is induced to be, fragile and vulnerable to large macroeconomic shocks.” Or, as the Geneva Report puts it: “regulation implicitly assumes that we can make the system as a whole safe by simply trying to make sure that individual banks are safe. … a fallacy of composition.”

Pro-cyclical risk taking. All reports agree that current financial regulations tend to encourage pro-cyclical risking taking which increases the likelihood of financial crises, and their severity when they occur. Under current regulations, prolonged periods of low volatility reduce statistical measures of risk and thus encourage excessive risk taking. In bad times, the pendulum swings back producing excessive risk aversion.

Large Complex Financial Institutions (LCFIs). All reports agree that current regulations do not deal adequately with LCFIs, defining LCFIs as “financial intermediaries engaged in some combination of commercial banking, investment banking, asset management and insurance, whose failure poses a systemic risk or `externality’ to the financial system as a whole.” (Saunders, Smith and Walter 2009). All reports also insist on the danger induced by implicit Too-Big-To-Fail guarantees.

Capital requirements. All of the reports struggle with a paradox of financial regulation; capital held to meet minimum requirements cannot be used as a buffer against unexpected losses. As such, fixed capital requirements can only ensure that losses do not immediately make banks insolvent. They might give regulators enough time to intervene, but they are ineffective against systemic risk. The real buffer can only come from equity in excess of the requirements.

Liquidity and maturity mismatch. The traditional view of systemic risk focuses on sequences of bank failures, for example a domino-like spread of counterparty failures. Today’s financial system, where many banks finance their investments in credit markets, faces a different type of systemic risk. As the Geneva Report points out, “a key avenue through which systemic risk flows today is via funding liquidity combined with adverse asset price movements due to low market liquidity.” Acharya and Schnabl (2009) also explain why regulators should take liquidity into consideration when assessing capital adequacy ratios, and Hellwig (2008) insists on the maturity mismatch in vehicles that relied on short term market financing to fund long term assets (real estate assets in particular).

SECTION 2: Propositions for regulatory reforms

The various reports agree broadly on the principles that new regulations should follow – they should be based on rules rather than discretion, and they should address well-identified externalities (see Hart and Zingales, 2008). When it comes to concrete proposals, however, there are fewer practical ideas, and less agreement.

My goal here is not to be exhaustive, focusing rather on the issues that I view as most essential, and on the proposals that are sufficiently spelled out to be evaluated.

Systemic risk. The first step towards regulating systemic risk is to measure it. But how should we do that? In particular, how do we define how much a particular firm contributes to systemic risk? How can we improve Value at Risk (VaR) measures?

There is some good news on the VaR front. There are currently two proposals to incorporate systemic risk into the standard measures. The Geneva report argues for CoVaR, based on the work of Adrian and Brunnermeier (2008), where CoVaR is the VaR of financial institutions conditional on other institutions being in distress. The NYU-Stern report proposes a systemic capital requirement based on the individual firm’s contribution to aggregate tail risk. These two measures have much in common, and are specifically tailored to deal with systemic as opposed to individual risks.

My view is that a combination of systemic and liquidity risk measures proposed by the NYU-Stern and Geneva Reports can considerably improve risk management practices inside financial firms, and, just as importantly, create the basis for a constructive dialogue between these firms and their regulator. At this stage, we need more empirical work to show that the proposed measures can indeed be used to identify institutions that pose systemic risk before a crisis hits.

As far as institutions are concerned, all reports also agree that Central Banks should be explicitly in charge of what the NYU-Stern Report calls “systemic regulations” and the Geneva Report calls “macro-prudential regulation”.

LCFIs, Moral Hazard and the Scope of Regulation. A key problem in improving LCFI regulation is that we do not have a good definition of LCFIs. The Geneva report argues that the best measures are leverage, maturity mismatch, and asset growth. These measures are certainly useful, but it is difficult to argue that they differentiate systemic from individual risks: a firm with high leverage and maturity mismatch would already be classified as individually risky. Saunders, Smith and Walter (2009) argue that LCFIs should be identified based on measures of size in combination with measures of complexity or interconnectedness. The difficulty is that we do not have readily available measures of complexity and interconnectedness.

LCFIs are particularly problematic because they are too-big-to-fail. This is in part because we do not have the procedures to deal with their failures. Altman and Philippon (2009) “advocate the creation of specific Bankruptcy procedures to deal with LCFIs.” Zingales (2008, 2009) argues that we need a “new piece of legislation introducing a new form of bankruptcy for banks, where derivative contracts are kept in place and the long-term debt is swapped into equity.” The G30 report argues that “legislation should establish a process for managing the resolution of failed non depository financial intuitions comparable to the process for depository institutions.” Thus, there is broad agreement on what is needed, but, as far as I am aware, there are few concrete proposals about how to deal with the mind-boggling complexity of the issue. Chapter 11 was deemed too risky for the standard (if large-scale) bankruptcy of General Motors. How far are we, then, from a procedure that we could use to deal with the failure of financial Godzillas such as AIG or Citigroup?

Hedge funds and similar. The reports do not present a consensus on the critical issue of what to do with the largely unregulated sector of hedge funds and private equity. Should we impose systemic regulations to a “group of institutions” if they are interconnected and can collectively pose systemic risks even though they appear individually small? My view is that we should, but I would not know how to start.

Capital requirements and cyclical risk taking. The reports suggest that capital adequacy requirements should incorporate liquidity risk, and that they should be tightened in good times – when systemic risk is building up but has not yet been realized – and should be loosened in bad times when banks need a breathing space to weather the crisis.

I see mostly good news on the liquidity front. The G30 Report proposes “norms for maintaining a sizeable diversified mix of long term funding and an available cushion of highly liquid unencumbered assets.” The NYU-Stern report argues that, in order to limit regulatory arbitrage, “regulation should not be narrowly focused on a single ratio of bank balance-sheet,” and should take into account “liquidity to assets ratio” (measured only through stress-time liquidity). The Geneva report has a well-articulated proposal for regulating liquidity and maturity mismatch (their Chapter 5 is a must-read in my opinion).

Unfortunately, I have not seen as much progress on the issue of cyclical risk taking. As Blanchard (2008) explains, “pro-cyclical capital ratios, in which capital ratios increase either in response to activity or to some index of systemic risk, sound like an attractive automatic stabilizer. […] The challenge is clearly in the details of the design, the choice of an index, the degree of pro-cyclicality.” The Geneva report argues that “macro-prudential regulation should be countercyclical and lean against bubbles,” but does not propose an index against which the cycle should be measured.

The Group of Thirty report is even vaguer, since it simply advocates tighter benchmarks when “markets are exuberant and tendencies for underestimating risk are great.” This hardly sounds like the starting point of a useful regulatory debate. The NYU-Stern report argues that stress tests for systemic risk capital can be used to construct a-cyclical risk measures. This is a more precise and practical idea, but it is not clear that this will be enough to create pro-cyclical regulations.

I very much doubt that we can agree on a set of objective measures of ‘excessive’ credit expansion (let alone bubbles). I think that the best we can expect is a powerful regulator running systemic stress tests based partly on historical data and partly on subjective forward looking scenarios. The critical issue in my view does not lay in the construction of an appropriate cyclical index, but rather in making sure that the regulator is powerful enough to enforce tighter prudential regulations based in part on subjective and debatable interpretations of economic data. The financial industry will not like it, and it has a strong track record of capturing its regulators, so this will not be easy.

Recapitalization during crises. This is probably the most controversial and most interesting topic. In times of crisis, asset values decline, and banks tend to curtail lending and liquidate assets in order to control their leverage. These actions increase systemic risk. It would be more efficient to recapitalize the banks automatically at the first sign of crisis.

An interesting idea is to create recapitalization requirements, in addition to capital requirements. One way to do so is to force levered financial institutions to issue securities that provide automatic recapitalization if the firm’s value decreases. Wall (1989) proposed subordinated debentures with an embedded put option. Doherty and Harrington (1997) and Flannery (2005) proposed reverse convertible debentures. These securities limit financial distress costs ex-post without distorting bank managers’ ex-ante incentives.

In a thought-provoking paper, Kashyap, Rajan and Stein (2008) argue that the idea of automatic recapitalization can be applied to systemic risk. They propose a capital insurance scheme based on systemic risk. Each bank would buy capital insurance policies that would pay off when the overall banking sector is in bad shape. The insurer would be a pension fund or a sovereign wealth fund that would essentially provide fully funded `banking-industry catastrophe insurance’. Kashyap, Rajan and Stein explain that “a bank with $500 billion in risk-weighted assets could be given the following option by regulators: it could either accept a capital requirement that is 2% higher, meaning that the bank would have to raise $10 billion in new equity. Or it could acquire an insurance policy that pays off $10 billion upon the occurrence of a systemic event.”

The issue with this proposal is that it does not provide a link between a firm’s own contribution to aggregate losses and the insurance it must get. The policy pays off $10 billion regardless of the health of the bank at that point. The financial institution still has the incentive to lever up, take concentrated bets, and build illiquid positions which may improve the risk/return profile of the firm but nevertheless increase the systemic risk in the system. The crisis has shown that this is a first order concern. Another limitation of this sort of proposal is that if the crisis is large enough, no amount of private money will ever be enough, and the Fed is always going to be the lender of last resort. The mere existence of a LOLR creates moral hazard unless LOLR services are properly priced ex-ante.

The NYU-Stern report proposes solutions to these problems (Acharya, Pedersen, Philippon and Richardson 2009). One is to make the size of the required insurance policy proportional to the estimated systemic risk capital charge defined above in the section on systemic risk. Another is to specify that the insurance must cover the short fall from a pre-specified target: the bank would have to buy an insurance contract such that its equity is at least $50 billion upon the occurrence of a systemic event. If the bank had only $30 billion, the policy would pay off $20 billion, but if the bank had $55 billion, the policy would pay nothing. The bank would have an incentive to limit its systemic exposure in order to decrease its insurance premium.

The Geneva Report is sceptical: “We doubt whether additional private insurance can then help much on occasions when market and funding liquidity vanishes; the examples of the mono-lines and of AIG confirm our doubts.” The NYU-Stern Report argues that the scheme could be implemented with a mixture of private capital (if only for price discovery) and public capital.

Another important caveat is that capital insurance dominates capital requirements only to the extent that it is expensive to keep equity on banks’ balance. This is indeed the core motivation of Kashyap, Rajan and Stein (2008). But one can take the opposite view, in which case higher equity ratios would be a much simpler solution. Hellwig (2008) puts it eloquently: “At this point, the institutions concerned will protest that equity capital is expensive. I have yet to see a convincing argument showing that this protest is referring to social costs, rather than just the private costs to the bank manager of having to go to outside financiers and having to explain to them what he is doing and why his activities should merit their entrusting him with their money.”

My view is that having some insurance and, perhaps more importantly, some price discovery for the costs of systemic risk would be invaluable. It is therefore worth implementing such a system even if its scale is somewhat limited. I would also argue that an imperfect system is still preferable to ad-hoc LOLR interventions that create incentives for reckless risk taking ex-ante, and leave large liabilities for tax-payers ex-post.

SECTION 3: Conclusion

Let me offer two concluding thoughts.

1. Regarding financial regulations, the devil is in the details – and the successive failures of TARP versions 1.0, 2.0, etc. prove this point more than ever. We have enough agreement on the broad principles of financial regulations, and we need to get down to specifics. I would therefore consider any future report that does not include tables, figures, numbers, equations, and specific proposals to be useless rhetoric.

2. We need to be ready to take a tough stand on future regulations for institutions that are too-big-to-fail.

This issue reminds me of the paradox of free trade. The benefits of free trade are widespread and difficult to grasp, while its costs are concentrated and easily publicized. Public support for free trade is therefore structurally weak. Moral hazard created by implicit guarantees is also widespread and difficult to grasp. It shows up in spreads lowered by a few basis points here and there, in slight distortions of comparative advantages, and in overall weaker governance. But the costs of LCFI failures are large and concentrated. It is therefore tempting for regulators to focus too much on bailouts, and too little on incentives. But this is clearly the wrong policy for the long run. Incentives and accountability must be improved, even if it means fighting a regulatory battle with the industry.

Sir Winston Churchill famously remarked that “Britain and France had to choose between war and dishonour. They chose dishonour. They will have war.” If in the hope of ending the crisis quickly, we choose to bail out the banks without making their managers, shareholders and creditors accountable, then we choose dishonour, and we will have more devastating crises."

Me:

Causes Of This Crisis

On February 16th, 2009 Don the liberta... says:

"Moral hazard created by implicit guarantees is also widespread and difficult to grasp."

It's not that hard to grasp. Through lobbying, the large banks have purchased an insurance policy that implicitly guarantees that they will be bailed out in a financial crisis. Does anyone doubt that now? It is the main cause of this crisis, in that it allowed large and systemically important banks to forgo prudence and take ludicrous risks. The insurance premiums for systemic risk would either be huge or ineffective. The government has to guarantee certain banks to avoid Calling Runs and Bank Runs. Perhaps a Narrow/Limited Banking sector could be put in place that is guaranteed, to be complemented by other financial concerns which are not guaranteed, but cannot cause either Calling or Banks Runs.

You also don't mention Fraud, Mismanagement, Negligence, and Collusion, the second most important cause of this crisis. Do you really believe that subprime loans being handed out at the height of the housing bubble, when prices were at their peak, was completely honest and aboveboard? Please.

Everything You Wanted to Know about Credit Default Swaps--but Were Never Told: A long overdue piece.

From Felix Salmon:

"Extra Credit, Monday Edition

Everything You Wanted to Know about Credit Default Swaps--but Were Never Told: A long overdue piece.

Aid Watch: Bill Easterly's new blog.

Another View: A More Radical Plan for Bank Stability: Peter Solomon's plan sounds like nationalization, even if he doesn't use the word.

CIFG terminates $12 bln in CDS on risky assets: And gets a new set of owners in doing so.

How economists analyze the stimulus: Kling on Murphy and DeLong.

Just Plane Despicable: The NY Post's understandable headline on a story about Citigroup paying $50 million for a new corporate jet -- from France, no less!

Discontinued: Brooks Brothers Folds Fifth Ave Store

Ken Lewis in Black and White: How his dot portrait has evolved this month.

Senate Confirms Geithner as Treasury Secretary: By 60 to 34.

Stock-Surfing the Tsunami: New York magazine rediscovers day-traders. Now with added ETFs!

Get Ready To Block 'N Roll: On the floor of the NYSE. The perfect place to "rock to live music"!"

Here's...well...you know:

The causes of this crisis have nothing to do with CDOs, which are NOT complex. Only the math used to compute default rates is, and it's more of limited use than complex. Can I compute these rates? No. But I can see how the quants do.
The causes are as follows:
1) Government guarantees. These allowed major players to invest in risky investments, which they knew were risky. I showed that you could have found, on the internet, in 2005, how risky all these investments were. Are you telling me that experts couldn't do what I did in 2 hours at home on my PC? Yes, the guarantees were implicit. But does anyone seriously doubt that they were there now?
2) Fraud, negligence, fiduciary mismanagement, and collusion. Rampant. Actual people selling Subprime Loans and other risky assets as safe. Blaming interest rates and pools of foreign money is silly. At most, they enabled fraud, etc.
3) The Bush administration. Many people believed that if anyone could turn a recession into a depression, it was the Bush administration.
4) The debt. We approached this crisis in terrible fiscal shape at the government level, limiting our options dramatically.
Finally, since Lehman, I've been saying that this is a consequence of the S & L Crisis, and the way it was handled. Now, were hearing that we need an RTC, and RTC alumni are giving advice to people on how to get out of this. Although we did close small banks, does anyone else remember where the phrase "Too big to fail" was used previously. Also, we had the same excuses in the S & L Crisis. We couldn't prosecute more people for crimes, even though we suspected as much, because the fraudulent actions mimicked sheer stupidity. Forget the fact that experts, drawing enormous salaries, then claimed to be imbeciles. That's what's happening here. Expect more of these farces in the near future, unless we start focusing on the people involved.

By DonthelibertarianDemocrat Posted: Jan 27 2009 11:35am ET

banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets

From Ricardo Caballero on Vox:

"In a pair of Vox columns, one of the world’s most respected macroeconomists suggests that the consensus view of the crisis’s causes and cures is flawed. This first column focuses on the crisis’s deep causes. Global excess demand for safe assets played a role in building the ‘accident waiting’ to happen. Now, investors’ fears of unknown unknowns – Knightian uncertainty – is why the waiting mountains of cash are not acting as “stabilising speculation”.

This is a financial crisis to remember. The financial losses are measured in trillions of dollars; elite financial institutions have fallen; fear and mistrust( FEAR AND AVERSION TO RISK ) are widespread among investors and lenders; credit markets are not operating except for those with very short maturities; massive and unorthodox policy interventions are an every day occurrence; and we have been, and continue to be, on the verge of a global financial meltdown( A CALLING RUN ).

How did we get into this situation? What should we do to get out of it and to prevent a relapse?

This pair of Vox columns addresses these questions, suggesting that the consensus view of the crisis’s causes and cures is flawed. (These columns are based on a talk at MIT’s 20 January 2009 Economics Alumni dinner in New York City.)

The emerging consensus

There is an emerging consensus on the causes of the crisis which essentially rehashes an old list of complaints about potential excesses committed in the phase prior to the crisis. The sins include uncontrolled global imbalances, unscrupulous lenders( THIS IS TRUE ), and an insatiable Wall Street, all of them lubricated by an ever expansionary Federal Reserve.

It follows from this perspective that the appropriate policy response is to focus on reducing global imbalances, boosting financial regulation( INVESTIGATING AND PROSECUTING CRIME ), bringing down leverage ratios, and adding bubble-control to the Fed’s mandate.

I do not share this consensus view and its policy prescriptions.

The rest of this column develops my view of the crisis’s causes. I start with the pre-crisis phase and then portray the current crisis as primarily a run on all forms of private insurance.

My second column discusses optimal economic policy in this environment.

The pre-crisis phase: Global excess demand for safe assets

For quite some time, but in particular since the late 1990s, the world has experienced a chronic shortage of financial assets to store value. The reasons behind this shortage are varied. They include the rise in savings needs by aging populations in Japan and Europe, the fast growth and global integration of high saving economies, the precautionary response of emerging markets to earlier financial crises, and the intertemporal smoothing of commodity producing economies.

The immediate consequence of the high demand for store-of-value instruments was a sustained decline in real interest rates. Conventional wisdom blames these low rates on loose monetary policy, but this position is difficult to reconcile with facts from the period of the so-called “Greenspan conundrum’’ – when tightening monetary policy had virtually no impact on long rates. In my view, the solution to the apparent conundrum is that low long rates were driven by the large demand for store-of-value instruments, not short-term monetary policy considerations.( A GOOD POINT )

Global imbalances were created by the demand for safe US assets

Low real interest rates are an equilibrium response by which the market creates value out of existing financial assets. Yet another mechanism to increase asset supply is the creation of new assets, including the emergence of the many speculative bubbles that we have seen over the last decade (some of which are legal and some are not – e.g., the NASDAQ bubble and the Madoff scheme, respectively).

Moreover, because of the US’s role as the centre of world capital markets, much of the large global demand for financial assets has been channelled toward US assets. This has been the main reason for the large global “imbalances” observed in recent years. The large current account deficits experienced by the US are simply the counterpart of the large demand for its assets.( OK )

How the subprime mortgage market fits in

Under this perspective, there is a more subtle angle on subprime mortgages than simply being the result of unscrupulous lenders( I'M SORRY. THIS IS A FACT. ). The world needed more assets and the subprime mortgages were helping to bridge the gap. So far so good.

However, there was one important caveat that would prove crucial later on. The global demand for assets was particularly for very safe assets( HERE IS THE PROBLEM WITH HIS THESIS. ) – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety( REALLY? ) became even more pronounced after the NASDAQ crash.

Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky( YES ) subprime assets( WHAT ABOUT THE LOWER CAPITAL REQUIREMENTS? ); the market moved to create synthetic AAA instruments. This consisted of pooling subprime mortgages on the asset side of a Structured Investment Vehicle (SIV), and to tranch (slice) the liability side to generate a AAA component buffered by the now ultra volatile “toxic” residual. The latter was then pooled again into Collateralized Debt Obligations (CDOs), tranched again, and then into CDO-squared, and so on. At the end of this iterative process, many new AAA assets were produced out of some very risky subprime mortgages.( TRUE )

Safe and risky tranches: An accident waiting to happen

The AAA tranches so created were held by the non-levered sector of the world economy, including central banks, sovereign wealth funds, pension funds, etc. They were also held by a segment of the highly-levered sector( THAT WAS THE POINT ), especially foreign banks and domestic banks that kept them on their books, directly and indirectly, as they provided attractive “safe” yields. The small toxic component was mostly held by agents that could handle the risk, although highly levered investment banks also were exposed.( YES )

Much of the focus on the regulatory and credit agency mistakes highlights the fact that the AAA tranch seems to have been too large relative to the “true” capacity of the underlying risky instruments to create such a tranche. While I agree with this assessment, I believe it is incomplete and, because of this, it does not point to the optimal policy response.

Individual default risk vs severe macro risk

Instead, I believe the key issue is that even if we give the benefit of the doubt to the credit agencies and accept that these instruments were indeed AAA from an unconditional probability of default perspective (the only one that counts for credit agencies), they were not so with respect to severe macroeconomic risk.( YES. WE'VE SEEN THAT. )

This created a highly volatile concoction where highly levered institutions of systemic importance were holding assets that were very vulnerable to aggregate shocks. This was an accident waiting to happen.( YES )

The (insurance) crisis: Triple A turns toxic, fear of the unknown spreads

And happen it did. It started without much fanfare sometime in 2006, limited to the housing sector and the associated subprime mortgage market. Eventually, it spread to the financial sector as the securitisation markets supported by these mortgages and other risky loans began to freeze. As this happened, conventional margin and collateral feedback mechanisms amplified the incipient liquidity problem( A CALLING RUN ). Then suddenly, the soundness of the AAA instruments created from risky loans in the previous phase were questioned. In particular, economic agents realised that they didn’t quite understand what was behind these instruments (Caballero and Krishnamurthy 2008a).( NO WAY )

This confusion was the first inkling of something that would later ravage global financial markets. Financial institutions specialise in handling risk but are not nearly as efficient in dealing with uncertainty.

Uncertain versus risk

To paraphrase a recent secretary of defence, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction is not only linguistically interesting, but also has significant implications for economic behaviour and policy prescriptions.

There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner make the dreaded scenarios all the more likely.( OK )

US Treasury’s uncertain response makes things worse

Worsening the situation, until very recently, the policy response from the US Treasury exacerbated rather than dampened the uncertainty problem.( TRUE )

Early on in the crisis, there was a nagging feeling that policy was behind the curve( YES ); then came the “exemplary punishment” (of shareholders) policy of Secretary Paulson during the Bear Stearns intervention, which significantly dented the chance of a private capital solution to the problem( NO. THERE WAS NO PRIVATE CAPITAL SOLUTION. IN FACT. FORGET THE THEORY. ); and finally, the most devastating blow came during the failure to support Lehman( YES ). The latter unleashed a very different kind of recession, where uncertainty( A CALLING RUN ) ravaged all forms of explicit and implicit financial insurance markets.

In the next column I discuss what should be done in light of my analysis of the causes of this financial crisis.

References

Knightian Uncertainty and its Implications for the TARP
Ricardo J. Caballero and Arvind Krisnamurthy
Financial Times, November 24, 2008

Paulson Plan: "Exemplary Punishment" Could Backfire
Ricardo J. Caballero and Pablo Kurlat
Financial Times, The Economists' Forum, Monday, 29 September, 2008

"Musical Chairs.pdf"
Ricardo J. Caballero and Arvind Krishnamurthy
February 2008a

Global Imbalances and Financial Fragility
Ricardo J. Caballero and Arvind Krishnamurthy
December 16, 2008b

Financial Crash, Commodity Prices and Global Imbalances
Ricardo J. Caballero, Emmanuel Farhi, Pierre-Olivier Gourinchas
November 17, 2008 (forthcoming, Brookings Papers on Economic Activity)

Flight to Quality and Bailouts: Policy Remarks and a Literature Review
Ricardo J. Caballero and Pablo Kurlat
October 2008

Collective Risk Management in a Flight to Quality Episode
Ricardo J. Caballero and Arvind Krisnamurthy
Journal of Finance, Vol. 63, Issue 5, October 2008

An Equilibrium Model of "Global Imbalances" and Low Interest Rates

Ricardo J. Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas
American Economic Review 2008, 98:1, pgs 358-393.

On the Macroeconomics of Asset Shortages
The Role of Money: Money and Monetary Policy in the Twenty-First Century
The Fourth European Central Banking Conference 9-10 November 2006, Andreas Beyer and Lucrezia Reichlin, editors. Pages 272-283."

I don't see that he gets near to the roots of the problem. He's defined a kind of paradox: People looking for safe assets wound up with risky assets. No way. The flight to safety occurred in the crisis. The investors were looking for risky assets. They wanted instruments that allowed for more profit with less capital behind it. They were in search of investments that paid more than the safe assets, which were yielding very little. The LTCM debacle had already shown the possibility that a Calling Run could be triggered by a series of seemingly sensible investments. There was no private capital solution to Bear Stearns, unless he means a brokered deal guaranteed and underwritten by the government. There was massive fraud involved at all levels. Everything that we have seen has shown that these big banks have been counting on government help in a crisis, as in the S & L Crisis. There's no evidence at all for a free market approach by them that doesn't involve government guarantees. Finally, Knightian Uncertainty is not very helpful. How do you know that you can't anticipate something until it happens? All this uncertainty talk sounds like throwing up your hands in a panic at the fickleness and vicissitudes of life. It sounds like "I know that I don't know". How old is that truism? He should read Bagehot and Fisher. Fisher explains the problem, and Fisher and Bagehot give the solution. Sad to say, our current crop of economists offer much less wisdom than our earlier ones, including Keynes, because the earlier thinkers dealt with Political Economy, which seems to be a lost art nowadays.

Good (short) video interview with Stanford economist John Taylor on increasing the money supply:

I'm a big fan of John Taylor, but he gets this wrong. Via Paul Kedrosky:

John Taylor on Increasing the Money Supply

Good (short) video interview with Stanford economist John Taylor on increasing the money supply:

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What we had following the mortgage foreclosure run was a Calling Run. The problem with a Calling run is that one of its causes is the inability of various investors to quickly get out of investments with which they could meet their calling requirements. I'm still puzzled why people believe that the government buying these calcified investments would be any easier than anyone else buying them, unless the government unfroze the market by vastly overpaying for the assets. Otherwise, the government doesn't know any more, and probably knows a lot less, than John Paulson, who is said to be buying them now that the government is out the picture. Excuse me if I think that Paulson is a better investor than the government. Paulson's actions tell me that the government would be overpaying for the assets.

In order to buy time for the investors to get out of their investments, the government stepped in to give these investors enough money to make it through this crisis and eventually unwind their investments. Think of AIG. This makes sense. It might even work. My point is that this government intervention should have been at the cost of seizing the businesses saved to be resold into private hands later. Only onerous conditions like this can honor Bagehot's Principles.

But the only way to stop a Calling Run is government intervention, because investors do not believe that anyone but the government can guarantee an orderly unwinding. Without that, it's every investor for its call. The result of that is a Proactivity Run, which we now have anyway, although not as bad as anticipated by some. The result of a prolonged Proactivity Run is very serious social unrest, whether in China, or here. Good luck if it comes to that.

government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period

Chairman Bernanke's speech today:

Chairman Ben S. Bernanke

At the Stamp Lecture, London School of Economics, London, EnglandJanuary 13, 2009

The Crisis and the Policy Response

For almost a year and a half the global financial system has been under extraordinary stress--stress that has now decisively spilled over( YES. THAT'S HOW TO LOOK AT IT. THE TWO ARE SEPARATE EVENTS. ) to the global economy more broadly. The proximate cause of the crisis was the turn of the housing cycle in the United States and the associated rise in delinquencies on subprime mortgages( YES ), which imposed substantial losses on many financial institutions( AND STARTED A CALLING RUN ) and shook investor confidence in credit markets. However, although the subprime debacle triggered the crisis, the developments in the U.S. mortgage market were only one aspect of a much larger and more encompassing credit boom whose impact transcended the mortgage market to affect many other forms of credit( TRUE ). Aspects of this broader credit boom included widespread declines in underwriting standards( LOWER CAPITAL REQUIREMENTS. THE REAL PROBLEM. ), breakdowns in lending oversight by investors and rating agencies( FRAUD, NEGLIGENCE, FIDUCIARY MISMANAGEMENT, AND COLLUSION. ), increased reliance on complex and opaque credit instruments that proved fragile under stress( TOO LITTLE CAPITAL AND HARD TO SELL. ), and unusually low compensation for risk-taking( GOVERNMENT GUARANTEES. ).

The abrupt end of the credit boom has had widespread financial and economic ramifications. Financial institutions have seen their capital depleted by losses and writedowns and their balance sheets clogged by complex credit products and other illiquid assets of uncertain value. Rising credit risks and intense risk aversion( THE MAIN PROBLEM HERE IS THE FEAR AND AVERSION TO RISK. ) have pushed credit spreads to unprecedented levels( THEY ARE NOW COMING DOWN. ), and markets for securitized assets, except for mortgage securities with government guarantees( THAT'S WHY ), have shut down( SOME ARE, IN FACT, BEING BOUGHT BY SMART INVESTORS. ). Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence( THE PROACTIVITY RUN ) and precipitated a sharp slowing in global economic activity. The damage, in terms of lost output, lost jobs, and lost wealth, is already substantial.

The global economy will recover, but the timing and strength of the recovery are highly uncertain. Government policy responses around the world will be critical determinants of the speed and vigor of the recovery( I AGREE ). Today I will offer some thoughts on current and prospective policy responses to the crisis in the United States, with a particular emphasis on actions by the Federal Reserve. In doing so, I will outline the framework that has guided the Federal Reserve's responses to date. I will also explain why I believe that the Fed still has powerful tools at its disposal to fight the financial crisis and the economic downturn, even though the overnight federal funds rate cannot be reduced meaningfully further( ZIRP ).

The Federal Reserve's Response to the Crisis
The Federal Reserve has responded aggressively to the crisis since its emergence in the summer of 2007. Following a cut in the discount rate (the rate at which the Federal Reserve lends to depository institutions) in August of that year, the Federal Open Market Committee began to ease monetary policy in September 2007, reducing the target for the federal funds rate by 50 basis points.¹ As indications of economic weakness proliferated, the Committee continued to respond, bringing down its target for the federal funds rate by a cumulative 325 basis points by the spring of 2008. In historical comparison, this policy response stands out as exceptionally rapid and proactive. In taking these actions, we aimed both to cushion the direct effects of the financial turbulence on the economy and to reduce the virulence of the so-called adverse feedback loop, in which economic weakness and financial stress become mutually reinforcing.

These policy actions helped to support employment and incomes during the first year of the crisis. Unfortunately, the intensification of the financial turbulence last fall led to further deterioration in the economic outlook. The Committee responded by cutting the target for the federal funds rate an additional 100 basis points last October, with half of that reduction coming as part of an unprecedented coordinated interest rate cut by six major central banks on October 8. In December the Committee reduced its target further, setting a range of 0 to 25 basis points for the target federal funds rate.

The 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, 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.( TRUE )

The Fed's monetary easing has been reflected in significant declines in a number of lending rates, especially shorter-term rates, thus offsetting to some degree the effects of the financial turmoil on financial conditions. However, that offset has been incomplete, as widening credit spreads, more restrictive lending standards, and credit market dysfunction have worked against the monetary easing and led to tighter financial conditions overall. In particular, many traditional funding sources for financial institutions and markets have dried up, and banks and other lenders have found their ability to securitize mortgages, auto loans, credit card receivables, student loans, and other forms of credit greatly curtailed. Thus, in addition to easing monetary policy, the Federal Reserve has worked to support the functioning of credit markets and to reduce financial strains by providing liquidity to the private sector. In doing so, as I will discuss shortly, the Fed has deployed a number of additional policy tools, some of which were previously in our toolkit and some of which have been created as the need arose.

Beyond the Federal Funds Rate: The Fed's Policy Toolkit
Although the federal funds rate is now close to zero, the Federal Reserve retains a number of policy tools that can be deployed against the crisis.

One important tool is policy communication. Even if the overnight rate is close to zero, the Committee should be able to influence longer-term interest rates by informing the public's expectations about the future course of monetary policy. To illustrate, in its statement after its December meeting, the Committee expressed the view that economic conditions are likely to warrant an unusually low federal funds rate for some time.² To the extent( SMALL EFFECT ) that such statements cause the public to lengthen the horizon over which they expect short-term rates to be held at very low levels, they will exert downward pressure on longer-term rates, stimulating aggregate demand. It is important, however, that statements of this sort be expressed in conditional fashion( FINE )--that is, that they link policy expectations to the evolving economic outlook. If the public were to perceive a statement about future policy to be unconditional, then long-term rates might fail to respond in the desired fashion should the economic outlook change materially.

Other than policies tied to current and expected future values of the overnight interest rate, the Federal Reserve has--and indeed, has been actively using--a range of policy tools to provide direct support to credit markets and thus to the broader economy. As I will elaborate, I find it useful to divide these tools into three groups. Although these sets of tools differ in important respects, they have one aspect in common: They all make use of the asset side of the Federal Reserve's balance sheet. That is, each involves the Fed's authorities to extend credit or purchase securities.

The first set of tools, which are closely tied to the central bank's traditional role as the lender of last resort, involve the provision of short-term liquidity to sound financial institutions. Over the course of the crisis, the Fed has taken a number of extraordinary actions to ensure that financial institutions have adequate access to short-term credit. These actions include creating new facilities for auctioning credit and making primary securities dealers, as well as banks, eligible to borrow at the Fed's discount window.³ For example, since August 2007 we have( 1 ) lowered the spread between the discount rate and the federal funds rate target from 100 basis points to 25 basis points;( 2 ) increased the term of discount window loans from overnight to 90 days; ( 3 )created the Term Auction Facility, which auctions credit to depository institutions for terms up to three months;( 4 ) put into place the Term Securities Lending Facility, which allows primary dealers to borrow Treasury securities from the Fed against less-liquid collateral; and ( 5 ) initiated the Primary Dealer Credit Facility as a source of liquidity for those firms, among other actions.

Because interbank markets are global in scope, the Federal Reserve has also approved( 6 ) bilateral currency swap agreements with 14 foreign central banks. The swap facilities have allowed these central banks to acquire dollars from the Federal Reserve to lend to banks in their jurisdictions, which has served to ease conditions in dollar funding markets globally. In most cases, the provision of this dollar liquidity abroad was conducted in tight coordination with the Federal Reserve's own funding auctions.

Importantly, the provision of credit to financial institutions exposes the Federal Reserve to only minimal credit risk; the loans that we make to banks and primary dealers through our various facilities are generally overcollateralized and made with recourse to the borrowing firm. The Federal Reserve has never suffered any losses in the course of its normal lending to banks and, now, to primary dealers. In the case of currency swaps, the foreign central banks are responsible for repayment, not the financial institutions that ultimately receive the funds; moreover, as further security, the Federal Reserve receives an equivalent amount of foreign currency in exchange for the dollars it provides to foreign central banks.

Liquidity provision by the central bank reduces systemic risk by assuring market participants that, should short-term investors begin to lose confidence, financial institutions will be able to meet the resulting demands for cash without resorting to potentially destabilizing fire sales of assets( A CALLING RUN. THESE WERE DECENT MOVES. ). Moreover, backstopping the liquidity needs of financial institutions reduces funding stresses( A CALLING RUN. THIS CAN ONLY BE DONE BY THE GOVERNMENT. I DON'T DISAGREE WITH WHAT HE'S TRYING TO DO AT ALL. I AGREE WITH HIM. I SIMPLY DISAGREE ABOUT SOME OF THE MEANS EMPLOYED. ) and, all else equal, should increase the willingness( THE PROBLEM IS THAT THIS HAS TO DO WITH THE FEAR AND AVERSION TO RISK. THE PROACTIVITY RUN WE'RE IN HAS CAUSED THIS TO REMAIN HIGH, EVEN AFTER ALL OF THESE ACTIONS BY THE FED. BUT IT IS GETTING BETTER. ) of those institutions to lend and make markets.

On the other hand, the provision of ample liquidity to banks and primary dealers is no panacea. Today, concerns about capital, asset quality, and credit risk continue to limit the willingness of many intermediaries to extend credit, even when liquidity is ample. Moreover, providing liquidity to financial institutions does not address directly instability or declining credit availability in critical nonbank markets, such as the commercial paper market or the market for asset-backed securities, both of which normally play major roles in the extension of credit in the United States.

To address these issues, the Federal Reserve has developed a second set of policy tools, which involve the provision of liquidity directly( A GOOD IDEA ) to borrowers and investors in key credit markets. Notably, we have introduced facilities to purchase highly rated commercial paper at a term of three months and to provide backup liquidity for money market mutual funds. In addition, the Federal Reserve and the Treasury have jointly announced a facility that will lend against AAA-rated asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. The Federal Reserve's credit risk exposure in the latter facility will be minimal, because the collateral will be subject to a "haircut"( A PENALTY ) and the Treasury is providing $20 billion of capital as supplementary loss protection( THIS WOULD BE A LOSS ). We expect this facility to be operational next month.

The rationales and objectives of our various facilities differ, according to the nature of the problem being addressed. In some cases, as in our programs to backstop money market mutual funds, the purpose of the facility is to serve, once again in classic central bank fashion, as liquidity provider of last resort( LOLR ). Following a prominent fund's "breaking of the buck"--that is, a decline in its net asset value below par--in September, investors began to withdraw funds in large amounts from money market mutual funds that invest in private instruments such as commercial paper and certificates of deposit( A BANK RUN ) Fund managers responded by liquidating assets and investing at only the shortest of maturities. As the pace of withdrawals increased, both the stability of the money market mutual fund industry and the functioning of the commercial paper market were threatened. The Federal Reserve responded with several programs, including a facility to finance bank purchases of high-quality asset-backed commercial paper from money market mutual funds. This facility effectively channeled liquidity to the funds, helping them to meet redemption demands without having to sell assets indiscriminately( A CALLING RUN ). Together with a Treasury program that provided partial insurance to investors in money market mutual funds, these efforts helped stanch the cash outflows from those funds and stabilize the industry.( THIS WORKED, SHOWING THAT A CALLING RUN CAN BE STOPPED BY GOVERNMENT ACTIONS AND GUARANTEES. )

The Federal Reserve's facility to buy high-quality (A1-P1) commercial paper at a term of three months was likewise designed to provide a liquidity backstop, in this case for investors and borrowers in the commercial paper market. As I mentioned, the functioning of that market deteriorated significantly in September, with borrowers finding financing difficult to obtain, and then only at high rates and very short (usually overnight) maturities. By serving as a backup source of liquidity for borrowers( A GUARANTOR ), the Fed's commercial paper facility was aimed at reducing investor and borrower concerns about "rollover risk," the risk that a borrower could not raise new funds to repay maturing commercial paper. The reduction of rollover risk, in turn, should increase the willingness of private investors to lend, particularly for terms longer than overnight. These various actions appear to have improved the functioning of the commercial paper market, as rates and risk spreads have come down and the average maturities of issuance have increased.

In contrast, our forthcoming asset-backed securities program, a joint effort with the Treasury, is not purely for liquidity provision. This facility will provide three-year term loans to investors against AAA-rated securities backed by recently originated consumer and small-business loans( QUALITATIVE EASING ). Unlike our other lending programs, this facility combines Federal Reserve liquidity with capital provided by the Treasury, which allows it to accept some credit risk( TRUE ). By providing a combination of capital and liquidity, this facility will effectively substitute public for private balance sheet capacity, in a period of sharp deleveraging( A CALLING RUN ) and risk aversion( WHAT WE NEED TO DEFEAT ) in which such capacity appears very short. If the program works as planned, it should lead to lower rates and greater availability of consumer and small business credit. Over time, by increasing market liquidity and stimulating market activity, this facility should also help to revive private lending. Importantly, if the facility for asset-backed securities proves successful, its basic framework can be expanded to accommodate higher volumes or additional classes of securities as circumstances warrant( THIS GOVERNMENT GUARANTEE IS NEEDED TO STOP A CALLING RUN. ).

The Federal Reserve's third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed's portfolio. For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. Notably, mortgage rates dropped significantly on the announcement of this program and have fallen further since it went into operation ( TRUE ). Lower mortgage rates should support the housing sector. The Committee is also evaluating the possibility of purchasing longer-term Treasury securities. In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.

These three sets of policy tools--lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities--have the common feature that each represents a use of the asset side of the Fed's balance sheet, that is, they all involve lending or the purchase of securities. The virtue of these policies in the current context is that they allow the Federal Reserve to continue to push down interest rates and ease credit conditions in a range of markets, despite the fact that the federal funds rate is close to its zero lower bound.( TRUE )

Credit Easing versus Quantitative Easing
The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach--which could be described as "credit easing"--resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet( YES ). However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition( QUALITATIVE EASING ) of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally( OK ).

The stimulative effect of the Federal Reserve's credit easing policies depends sensitively on the particular mix of lending programs and securities purchases that it undertakes. When markets are illiquid and private arbitrage is impaired by balance sheet constraints and other factors, as at present, one dollar of longer-term securities purchases is unlikely to have the same impact on financial markets and the economy as a dollar of lending to banks, which has in turn a different effect than a dollar of lending to support the commercial paper market. Because various types of lending have heterogeneous effects, the stance of Fed policy in the current regime--in contrast to a QE regime--is not easily summarized by a single number, such as the quantity of excess reserves or the size of the monetary base. In addition, the usage of Federal Reserve credit is determined in large part by borrower needs and thus will tend to increase when market conditions worsen and decline when market conditions improve. Setting a target for the size of the Federal Reserve's balance sheet, as in a QE regime, could thus have the perverse effect of forcing the Fed to tighten the terms and availability of its lending at times when market conditions were worsening, and vice versa.( OK )

The lack of a simple summary measure or policy target poses an important communications challenge. To minimize market uncertainty( FEAR AND AVERSION TO RISK ) and achieve the maximum effect of its policies, the Federal Reserve is committed( ESSENTIAL ) to providing the public as much information as possible about the uses of its balance sheet, plans regarding future uses of its balance sheet, and the criteria on which the relevant decisions are based.⁴

Exit Strategy
Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve is effectively printing money, an action that will ultimately be inflationary( TRUE ). The Fed's lending activities have indeed resulted in a large increase in the excess reserves held by banks. Bank reserves, together with currency, make up the narrowest definition of money, the monetary base; as you would expect, this measure of money has risen significantly as the Fed's balance sheet has expanded( THEN IT HAS ). However, banks are choosing to leave the great bulk of their excess reserves idle( STILL... ), in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate.( TRUE )

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs( TRUE ). To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities. Indeed, where possible we have tried to set lending rates and margins at levels that are likely to be increasingly unattractive to borrowers as financial conditions normalize. In addition, some programs--those authorized under the Federal Reserve's so-called 13(3) authority, which requires a finding that conditions in financial markets are "unusual and exigent"--will by law have to be eliminated once credit market conditions substantially normalize. However, as the unwinding of the Fed's various programs effectively constitutes a tightening of policy, the principal factor determining the timing and pace of that process will be the Committee's assessment of the condition of credit markets and the prospects for the economy.( GOOD )

As lending programs are scaled back, the size of the Federal Reserve's balance sheet will decline, implying a reduction in excess reserves and the monetary base. A significant shrinking of the balance sheet can be accomplished relatively quickly, as a substantial portion of the assets that the Federal Reserve holds--including loans to financial institutions, currency swaps, and purchases of commercial paper--are short-term in nature and can simply be allowed to run off as the various programs and facilities are scaled back or shut down. As the size of the balance sheet and the quantity of excess reserves in the system decline, the Federal Reserve will be able to return( MORE WILL BE ASKED OF IT NOW ) to its traditional means of making monetary policy--namely, by setting a target for the federal funds rate.

Although a large portion of Federal Reserve assets are short-term in nature, we do hold or expect to hold significant quantities of longer-term assets, such as the mortgage-backed securities that we will buy over the next two quarters. Although longer-term securities can also be sold, of course, we would not anticipate disposing of more than a small portion of these assets in the near term( BECAUSE WE WANT TO MAKE A PROFIT ), which will slow the rate at which our balance sheet can shrink. We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.

Importantly, the management of the Federal Reserve's balance sheet and the conduct of monetary policy in the future will be made easier by the recent congressional action to give the Fed the authority to pay interest on bank reserves. In principle, the interest rate the Fed pays on bank reserves should set a floor on the overnight interest rate, as banks should be unwilling to lend reserves at a rate lower than they can receive from the Fed. In practice, the federal funds rate has fallen somewhat below the interest rate on reserves in recent months, reflecting the very high volume of excess reserves, the inexperience of banks with the new regime, and other factors( A POOR INCENTIVE IN CURRENT CIRCUMSTANCES ). However, as excess reserves decline, financial conditions normalize, and banks adapt to the new regime, we expect the interest rate paid on reserves to become an effective instrument for controlling the federal funds rate.

Moreover, other tools are available or can be developed to improve control of the federal funds rate during the exit stage. For example, the Treasury could resume its recent practice of issuing supplementary financing bills and placing the funds with the Federal Reserve; the issuance of these bills effectively drains reserves from the banking system, improving monetary control. Longer-term assets can be financed through repurchase agreements and other methods, which also drain reserves from the system. In considering whether to create or expand its programs, the Federal Reserve will carefully weigh the implications for the exit strategy. And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster full employment and price stability.( GOOD LUCK )

Stabilizing the Financial System
The Federal Reserve will do its part to promote economic recovery, but other policy measures will be needed as well. The incoming Administration and the Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity. In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system. History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively.

In the United States, a number of important steps have already been taken to promote financial stability, including the Treasury's injection of about $250 billion of capital into banking organizations, a substantial expansion of guarantees for bank liabilities by the Federal Deposit Insurance Corporation, and the Fed's various liquidity programs. Those measures, together with analogous actions in many other countries, likely prevented a global financial meltdown in the fall that, had it occurred, would have left the global economy in far worse condition than it is in today. ( TRUE. ALLOWING A CALLING RUN TO CONTINUE UNTIL IT NATURALLY ENDS WOULD HAVE BEEN A DISASTER, FINANCIALLY AND SOCIALLY. )

However, with the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions. Consequently, more capital injections and guarantees( THIS IS THE SOLUTION ) may become necessary to ensure stability and the normalization of credit markets. A continuing barrier to private investment in financial institutions is the large quantity of troubled, hard-to-value assets that remain on institutions' balance sheets. The presence of these assets significantly increases uncertainty about the underlying value of these institutions and may inhibit both new private investment and new lending. Should the Treasury decide to supplement injections of capital by removing troubled assets from institutions' balance sheets, as was initially proposed for the U.S. financial rescue plan, several approaches might be considered. Public purchases of troubled assets are one possibility. Another is to provide asset guarantees( I FAVOR THIS. HOWEVER, I MIGHT PREFER WE JUST TOOK THEM OVER. ), under which the government would agree to absorb, presumably in exchange for warrants or some other form of compensation, part of the prospective losses on specified portfolios of troubled assets held by banks. Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank( A POSSIBLE APPROACH, IF THE BANKS ARE GUARANTEED. ). These methods are similar from an economic perspective, though they would have somewhat different operational and accounting implications. In addition, efforts to reduce preventable foreclosures, among other benefits, could strengthen the housing market and reduce mortgage losses, thereby increasing financial stability.( WHAT'S IMPORTANT ARE THE GUARANTEES. THEORETICALLY, WE COULD JUST BUY THESE THINGS, BUT THE POLITICAL PITFALLS ARE HUGE. WHO WOULD DO IT? WILL IT BE SEEN AS OVERPAYING? ANY GOVERNMENT INTERVENTION WILL RAISE THE PRICE OF THE TOXIC ASSETS, SO SOME KIND OF ONEROUS EXCHANGE WOULD BE NECESSARY. UNDER THAT CONDITION, ANY OF THE THREE CHOICES WOULD WORK. BUT IT CAN'T BE AS POORLY NEGOTIATED AS TARP. )

The public in many countries is understandably concerned by the commitment of substantial government resources to aid the financial industry when other industries receive little or no assistance. This disparate treatment, unappealing as it is, appears unavoidable( IT WON'T WORK. SOME MONEY WILL HAVE TO BE SPENT ELSEWHERE. ). Our economic system is critically dependent on the free flow of credit, and the consequences for the broader economy of financial instability are thus powerful and quickly felt. Indeed, the destructive effects of financial instability on jobs and growth are already evident worldwide. Responsible policymakers must therefore do what they can to communicate to their constituencies why financial stabilization is essential for economic recovery and is therefore in the broader public interest( GOOD LUCK. ).

Even as we strive to stabilize financial markets and institutions worldwide, however, we also owe the public near-term, concrete actions to limit the probability and severity of future crises. We need stronger supervisory( MY VIEW ) and regulatory systems under which gaps and unnecessary duplication( RATIONALIZATION ) in coverage are eliminated, lines of supervisory authority and responsibility are clarified, and oversight powers are adequate to curb excessive leverage and risk-taking. In light of the multinational character of the largest financial firms and the globalization of financial markets more generally, regulatory oversight should be coordinated( A GOOD IDEA ) internationally to the greatest extent possible. We must continue our ongoing work to strengthen the financial infrastructure--for example, by encouraging the migration of trading in credit default swaps and other derivatives to central counterparties and exchanges( FINE ). The supervisory authorities should develop the capacity for increased surveillance of the financial system as a whole( MY VIEW ), rather than focusing excessively on the condition of individual firms in isolation; and we should revisit capital regulations, accounting rules, and other aspects of the regulatory regime to ensure that they do not induce excessive procyclicality in the financial system and the economy( TRUE ). As we proceed with regulatory reform, however, we must take care not to take actions that forfeit the economic benefits of financial innovation and market discipline( I AGREE ).

Particularly pressing is the need to address the problem of financial institutions that are deemed "too big to fail." It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period( THAT'S WHAT ALLOWED THEM TO DO IT. THEY WERE COUNTING ON YOU. IT WORKED. THIS IS THE MAIN CAUSE OF OUR CRISIS. THE IMPLICIT GUARANTEES THAT WERE THE UNDERPINNING OF THIS RISKY INVESTMENT. ). The existence of too-big-to-fail firms also violates the presumption of a level playing field among financial institutions. In the future, financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking( TRUE ). Also urgently needed in the United States is a new set of procedures for resolving failing nonbank institutions deemed systemically critical( ESSENTIAL ), analogous to the rules and powers that currently exist for resolving banks under the so-called systemic risk exception.( THEY SHOULD FALL UNDER BAGEHOT'S PRINCIPLES. )

Conclusion
The world today faces both short-term and long-term challenges. In the near term, the highest priority is to promote a global economic recovery. The Federal Reserve retains powerful policy tools and will use them aggressively to help achieve this objective. Fiscal policy can stimulate economic activity, but a sustained recovery will also require a comprehensive plan to stabilize the financial system and restore normal flows of credit.

Despite the understandable focus on the near term, we do not have the luxury of postponing work on longer-term issues. High on the list, in light of recent events, are strengthening regulatory oversight and improving the capacity of both the private sector and regulators to detect and manage risk.

Finally, a clear lesson of the recent period is that the world is too interconnected for nations to go it alone in their economic, financial, and regulatory policies. International cooperation is thus essential( I AGREE ) if we are to address the crisis successfully and provide the basis for a healthy, sustained recovery.

MY MAIN CRITICISM HAS BEEN THE DITHERING ABOUT THE DEPTH AND BREADTH OF THE GUARANTEES. IN A CALLING RUN, THE GOVERNMENT MUST MAKE PLAIN THAT IT WILL DO ANYTHING THAT IT CAN TO STOP IT. BY SEEMING TO BE DECIDING ON A CASE BY CASE BASIS IN AN UNCLEAR MANNER, THE NECESSARY GUARANTEES WERE NOT FORTHCOMING. THIS HAS, PARADOXICALLY, LED TO MORE MONEY HAVING TO BE SPENT. THE WHOLE POINT IS TO EASE THE FEAR AND AVERSION TO RISK, AND STOP THE CALLING RUN BEFORE GOVERNMENT FUNDS ARE ACTUALLY NEEDED. THAT'S THE WHOLE POINT OF THE GUARANTEES. TO FORESTALL THEM BEING USED. THE CURRENT PROBLEM WAS CAUSED BY NOT HAVING BAGEHOT'S PRINCIPLES IN PLACE, WHICH WOULD HAVE MADE COMING TO THE GOVERNMENT FOR HELP A VERY UNPLEASANT DECISION INDEED( WE WOULD HAVE TAKEN THEM OVER IN ESSENCE ). IN OUR CURRENT CRISIS, COMING TO THE GOVERNMENT WAS THE LEAST ONEROUS DECISION. GET THE DIFFERENCE? )

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Footnotes

1. A basis point is one-hundredth of a percentage point. Return to text

2. Board of Governors of the Federal Reserve (2008), "FOMC Statement and Board Approval of Discount Rate Requests of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco," press release, December 16. Return to text

3. Primary dealers are broker-dealers that trade in U.S. government securities with the Federal Reserve Bank of New York. The New York Fed's Open Market Desk engages in trades on behalf of the Federal Reserve System to implement monetary policy. Return to text

4. Detailed information about the Federal Reserve's balance sheet is published weekly as part of the H.4.1 release. For a summary of Fed lending programs, see Forms of Federal Reserve Lending to Financial Institutions (229 KB PDF). Return to text"