Friday, April 16, 2010

Krugman Once Again

Today's Krugman column points out a key problem with our friend Paul. There is nothing wrong with writing columns to make the Democratic party look good. I'm all for political discourse, but he does such a bad job of it. Here's the problem paragraph:
Even more important, however, the financial industry wants to avoid serious regulation; it wants to be left free to engage in the same behavior that created this crisis. It’s worth remembering that between the 1930s and the 1980s, there weren’t any really big financial bailouts, because strong regulation kept most banks out of trouble. It was only with Reagan-era deregulation that big bank disasters re-emerged. In fact, relative to the size of the economy, the taxpayer costs of the savings and loan disaster, which unfolded in the Reagan years, were much higher than anything likely to happen under President Obama.
The key piece of banking deregulation Krugman is referring to was the Depository Institutions Deregulation And Monetary Control Act of 1980 (or MCA) which was signed into law by Jimmy Carter. This was a first-rate piece of legislation which dramatically improved efficiency in the banking system - rationalizing pricing of services, eliminating interest rate ceilings, and reducing reserve requirements, among other things. The MCA is a great accomplishment of the Carter Administration, along with airline deregulation for example. Why Reagan is viewed as the Great Deregulator and Carter is given no credit I have no idea.

Now, the savings and loan crisis was not directly a product of the MCA. The MCA permitted savings and loans to get into lending activity that was formerly prohibited, but the key problem was that the savings and loan regulators did not do their jobs. The savings and loan crisis was a classic case in moral hazard - savings and loans took too much risk given deposit insurance. Savings and loan regulators had the power to limit risk, but they did not do it. Get it straight, Paul!


  1. hello,
    I'm certainly no fan of Paul Krugman, but want to comment on one of your preceding post:
    "Indeed, it is useful to think of these reserves as being equivalent to T-bills, which is of course why we have not seen severe inflationary consequences from the massive increase in the stock of base money. What happens when monetary policy starts to tighten (in terms of the fed funds rate target), and nominal interest rates rise? Then, if the interest rate on reserves were to remain constant, reserves would become increasingly unattractive to banks. In the process of trying to rid themselves of reserves, prices of goods and services would have to rise, and some reserves would be converted into currency. This of course is the Fed's nightmare - reserves unleashed must create inflation. This, the "hold" strategy implies that the interest rate on reserves must rise to induce the banks to hold reserves."

    I am afraid you don't understand basic elements of Central Bank accounting and operations, it would be impossible for the Fed to increase the Fed fund rate if interest rate on excess reserves stays at current level as private banks would automatically bid down the fed fund rate to the rate paid on excess reserves. The two has to move together for the Fed to have any success in reaching its target. Regarding your "reserves unleashed=inflation", I hope you are aware that excess reserves, while staying at approx the same level in the aggregate, move from banks to banks as we speak. Holders of these excess reserves could change on a daily basis. So these reserves are already unleashed so to speak, and where is the inflation your are talking about?

  2. I think I understand the basic elements of Central Banking. You did not understand what I wrote, or I was too obtuse. Yes, when banks are holding excess reserves overnight, the interest rate on reserves is the relevant policy rate, and moving the interest rate on reserves moves the fed funds rate in tandem. However, your logic about reserves would tell us that whenever we see any stocks changing hands that stock prices should be moving one way or the other. Assets are changing hands all the time - what matters for asset prices is the collective willingness of the market to hold the stocks of assets in existence. If the banks become collectively less willing to hold the reserves (holding everything else constant) then the price level has to rise.

  3. Unless people start to massively stack paper-money under their mattress, private banks have no choice but to hold excess reserves. It is not a question whether banks are "wiling" or "less willing" to hold excess reserves. The day the Fed/Treasury decided to purchase MBS from the private sector in a unsterilised manner (ie. without issuing T-Bills), this automatically meant that excess reserves would grow approx by this same amount at the FEd.

    Lets assume that banks holding excess reserves would decide to lend them all away in a given day, then at the end of this same day the aggregate level of reserves would have not changed, because loans would have created deposits in financial institutions. These institutions would then "park" this money at the Fed at the end of the day. Why would "price level" as you say would have to rise in this scenario? Bank lending is capital constraint not reserves constraint. During the real estate bubble, did the fact that private banks did not hold any excess reserves stop them from making NINJA loans...? Excess reserves is not a decision making criteria for a private bank to make a loan or invest in the stock market. Remember,if all the Fed interventions would have been sterilised, privates banks would hold T-Bills instead of excess reserves. From a private bank perspective, there is no difference between holding excess reserves or T-Bills.

    In a nutshell, the high level of excess reserves in itself say nothing about banks lending activity, economic activity and the prospect for future inflation.
    This is very well explained in a NY FED paper
    "First, the Federal Reserve’s new liquidity facilities have created, as a byproduct, a large quantity of reserves and these reserves can only be held by banks. Second, while the lending decisions and other activities of banks may result in small changes in the level of required reserves, the vast majority of the newly-created reserves will end up being held as excess reserves almost no matter what banks do. The central message of the article is that the data in Figure 1 only reflect the size of the Federal Reserve’s policy initiatives; they say almost nothing about the effects these initiatives have had on bank lending or on the level of economic activity."

  4. Maybe we're more or less in agreement. I think the point of difference has to do with where the reserves go when the Fed buys assets (MBS or Treasuries). Apparently you want to think of the demand for currency as inelastic. This may are may not be true, but I can give you that. I think you're right that capital requirements matter right now for bank lending, but as we pull out of the recession, they'll start to relax. The payoff to lending will start to look a lot better, and then the banks will want to shift out of reserves and into loans. In your view, they can't shift out of reserves - they are stuck with them. But they're stuck with them in nominal terms. If the real demand for reserves drops, the price level rises. Q.E.D.

  5. Another point: The Keister/McAndrews paper you cite makes exactly my point (see "Inflation Control"). The Fed has the ability to control inflation by setting the interest rate on reserves.

  6. In defence of Krugman, the MCA enabled the S&L industry to engage in risky lending, but the Reagan-appointed regulators failed to do their jobs. You say the regulators are to blame, and, to a point, Krugman would surely agree.

    More generally, I don't believe that Krugman has distorted the history of deregulation in a partisan way. He has apportioned good heapings of blame on the Clinton players (Rubin etc.) as well as Greenspan who enjoyed the support of both parties.

    Perhaps more importantly, he believes that optimal regulation that depends on brilliant regulators is less preferable than less optimal regulation that can work with more mediocre regulators (see his post on Greek vs. Roman military tactics).

  7. Steve,
    When you said:
    "In your view, they can't shift out of reserves - they are stuck with them. But they're stuck with them in nominal terms. If the real demand for reserves drops, the price level rises."

    Indeed, it is exactly my view. In the aggregate they are stuck with them until MBS are paid off or Treasury finally decide to sterilise. How exactly do you see private banks increasing price level as a result of a real decline in demand for reserves? By starting to lower their lending standards and renewing with NINJA-type of loans? Alternatively, by starting to lower their investment standards and aggressively betting on penny stocks or commodities? They don't need excess reserves to do any of these things.

    Lots of economists/traders in the last 10 years thought that excess reserves in Japan would ultimately lead to higher interest rates/inflation and shorted Japanese bonds. These guys have lost their shirt in the process (of course economists did not loose anything, this bunch never put there money where their mouth is, so they have no incentive to make correct forecast, but this is an issue for another day)

    I repeat... excess reserves have no impact on bank lending or investing standards or price level. Period.

  8. This is just standard monetary theory. When we write down a general equilibrium model with some role for outside money, and the central bank increases the stock of outside money, once and for all time, the agents in the model are stuck with that quantity of money if the central bank does not want to take it back. Then, the price level is essentially the terms under which these agents are willing to hold the given nominal stock of outside money. If we do the comparative static experiment and change something exogenous that decreases the willingness of the agents to hold the outside money, the price level must be higher, everything else given. If banks in Japan were impressively willing to hold a huge stock of reserves, it's certainly interesting to figure that out, just as it's important to understand why our banks are currently willing to hold so much reserves. The risk, as I said, has to do with future events which cause the banks to be less willing to hold the reserves. If the Fed doesn't increase the interest rate on reserves when those future events unfold (or sell enough assets), the price level has to rise. Period. Period.

  9. I will leave you with your misconception of modern central bank operations (particularly as it regards banks being "willing" or "unwilling" to hold reserves... do you really think that Banks in Japan have been "willing" to hold excess reserves at 0% for more than 10 years now???), but before, I would encourage you to read the following November 2009 paper from the Bank for International Settlements (
    "In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 – by far the most common – in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively.The main exogenous constraint on the expansion of credit is minimum capital requirements.By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks. "

  10. Well, you're a tough nut to crack aren't you? In the economics I learned, we look at what economic agents do and think of that as the outcome of some choices - if Japanese banks are holding a lot of reserves, some prices had to adjust in order to make them willing to do that. The paper you're quoting from is not some empirical evidence or a theory - it's someone's interpretation of what is going on, which is no better or worse than my interpretation. In any case, it's mainly consistent with what I have been telling you. It's been a pleasure. This has actually been quite helpful for me.

  11. Stephen,
    You definitely have a point: I am way more interested into actual day-to-day operations of modern central bank than any kind of university-made theory of how it is supposed or should work. I am not saying this disrespectfully, but I would tell you that "operation" guys are having a good laugh when they hear mainstream economists (eg. Krugman, Stiglitz, Rogoff) talk about central bank operations. I am definitely in agreement with you regarding the fact that "the money multiplier is probably the most misleading piece of monetary economics known to humankind" (I am not totally sure if it is for the same reasons however... my position results from my knowledge of central bank/banking operations).

    The NYFED and the Bank for International Settlements papers I shared with you are good starting point to understand modern central bank operation in my view. I will leave you with these words: theory are sometimes useful to understand the reality, but are also sometimes totally harmful particularly when they do not keep pace with changing reality. Today, most monetary economics theory are gold standard era theory totally inapplicable to modern Central Bank operations. If you want another example of gold-era theory, look no further than the "crowding out" theory. Reserve requirements (that Canada was clever enough to eliminate) is also a relic of this gold-standard mentality.


  12. As you say, it's very important to understand the basics of how central banks actually work. But theory is critical to organizing our thinking about what the effects of central bank actions are, determining what good policy is, and designing central banking institutions. The interplay been theory and practice is critical - that's why I spend time working with abstract models, and also working with central bankers. I got my first serious job as an economist in a central bank in 1979, and have had close contact with central bankers ever since. You shouldn't think that academics are stuck in lala land - sometimes we like to get our hands dirty.