Friday, April 30, 2010

FOMC Statement, Part II

My previous post, point 1, reflects some ignorance on my part (the ignorance has now been corrected). The
Federal Reserve Act
specifies that decisions about the interest rate on reserves are made by the Board of Governors, not by the FOMC. Obviously Congress did not think through the issue properly when it amended the Act. Since the interest rate on reserves is now the key policy rate, decisions about how to set it would appropriately reside with the FOMC. An interesting section of the Act is this one:
Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.
This passage may be vague, but 1-month T-bills are now trading at 0.139% and the interest rate on reserves is 0.25%. The problem is that the Fed cannot do its job and (apparently) conform to the law. The T-bill rate has to be lower now, as the marginal liquidity value of a T-bill is higher than for reserves.

FOMC Statement, April 28

The April 28 FOMC statement was pretty much identical to the previous one. It includes, for example, the usual (wrongheaded) Phillips curve logic:
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.
As well, Hoenig puts in his two cents' worth, as before:
Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer run macroeconomic and financial stability, while limiting the Committee’s flexibility to begin raising rates modestly.
In light of what I wrote earlier here, two things are noteworthy.

1. The FOMC is still announcing its interest rate target in terms of the fed funds rate. As I noted earlier, the relevant policy rate when there are positive excess reserves in the financial system is the interest rate on reserves. Either the FOMC does not understand this yet, or they think it might lead to confusion if they announced the target in terms of the interest rate on reserves (which of course would not be a target - the interest rate on reserves is administered). It should be easy to make this clear to the public, so my guess is that at least some members of the FOMC don't get it.

2. There is nothing explicit in the statment about offloading mortgage-backed securities and agency securities from the Fed's balance sheet. In line with what Kocherlakota has been saying in public (see here), the Fed should be committing to sell these assets at a constant rate. What should that rate be? I think they could sell the assets at the rate they bought them - no problem.

Thursday, April 29, 2010

The Use of Currency

There is an interesting piece a here on new cell-phone technologies, that allow individuals to make small decentralized transactions without currency. I like to tell students stories about why we still need some currency in circulation. These stories often involve small hot-dog vendors who won't take credit cards, but clearly that could become a thing of the past, along with the problem of splitting up the dinner bill among 12 people. Certainly the experience of us relatively wealthy people is that currency is much less useful than in the past - few retailers will turn down a credit or debit card, and even the short trip to the ATM may not be worth the bother. However, if we look at the data, the use of currency in the world is remarkably persistent. I didn't take the effort to give you references to these studies (I'll let you find them yourself), but the numbers I remember are the following (check for accuracy if you want). One hard number is the following (it's in my textbook). The quantity of US currency in circulation in the world was $2776 per US resident in April 2009. That's a lot of currency - the stock held at any point in time is about 6% of US annual GDP. In case you think that's all held overseas, a study by the Bank of Canada (in the Bank of Canada Review - look it up) shows that Canadian currency outstanding is about 3% of annual Canadian GDP, and most of that has to be in Canada. That's still a huge amount of currency, and that quantity does not appear to have been falling recently. In some other countries people hold even more currency, for example the Japanese hold a quantity of currency which is about 15% of annual GDP. Fernando Alvarez (again, look it up) at the University of Chicago documents a persistently large stock of currency held in the world.

How do we reconcile these aggregate observations with what we observe at an individual level? First, it appears that the denomination structure of the currency in circulation has changed, with less low-denomination notes and more high-denomination notes. We all know what that is about. Currency is the principle means of payment for drug dealers and for people who want to evade taxation. Second, survey evidence for the US (e.g. the Federal Reserve's Survey of Consumer Finances) tells us that a significant fraction of the population (mainly in poor urban areas) have no relationship with a bank. These people are executing all their transactions using currency.

What implications does this have for monetary policy? First, currency is still important. After all, in normal times, most of the Fed's liabilities consist of currency - the stuff is financing the central bank's portfolio. We want to understand what motivates people to hold currency, why they want to hold so much of it, and what the prospects are for currency-holding in the future. All these things matter for how monetary policy works. Second, in terms of optimal policy, there may come a day when it seems appropriate that the central bank withdraw all currency from circulation. Though currency is the medium of exchange for the poor, central banks may ultimately decide that currency is not worth the bother. We have to pay the costs of thwarting counterfeiters by designing the currency appropriately, we have to print new currency to replace worn-out notes, and for what? To provide a medium of exchange for criminals?

Now, what happens if we get rid of currency? Does this mean that monetary policy has nothing left to do? Absolutely not. The central bank still has a role as the lender of last resort and in most countries it runs an interbank payments system - Fedwire in the US. The liabilities of the Fed - reserves - are the medium of exchange in the payment system. Outside money (reserves) can finance a central bank portfolio of assets (just as reserves are now financing more than half of the Fed's portfolio), and open market operations in the usual sense can matter, even without currency in circulation.

New Faces on the FOMC

It appears that the President is about to nominate (if he has not done so already - I haven't looked at the most recent news) Janet Yellen as Vice Chair of the Board of Governors and Peter Diamond and Sarah Bloom Raskin as Governors of the Fed. As you probably know, the Governors are powerful people on the Federal Open Market Committee (FOMC). They always vote at FOMC meetings, in contrast to the 12 regional Fed Presidents, only 5 of whom vote at any given time (though the New York Fed President always votes).

Janet Yellen is currently the President of the San Francisco Fed, and I have talked about her views here. I had characterized her as a New Keynesian (in the sense of Mike Woodford), but someone corrected me on this - she is actually an Old Keynesian (think Walter Heller). Yellen is an economist with a PhD and some success as an academic, which I think is good. What is bad about Yellen are two things. First, she views inflation experience through the lens of the Phillips curve, and I think that is dangerous thinking. We know how this got us into trouble in the 1970s, and we risk repeating that experience if we think that way about monetary policy. Second, she seems inclined to think of one of the jobs of the Fed as being the reallocation of resources across sectors of the economy. Most recently, this view was reflected in the effort by the Fed to subsidize the housing market through heavy investment in mortgage-backed securities.

Peter Diamond seems an odd choice as a Fed Governor. He is a distinguished academic, and is often mentioned as a Nobel prize hopeful. However, his policy work is mainly on fiscal issues (e.g. Social Security), and has touched little on monetary policy or financial issues. The likely route by which he got appointed is that he knows Peter Orszag, the Director of the Office of Management and Budget in the Obama Administration. Orszag and Diamond coauthored this book.

Sarah Bloom Raskin seems more-or-less unobjectionable, and she's relatively young, as compared to the other 2, who would be ready for retirement in most lines of work. She has a BA in Economics, a law degree, and experience in financial regulation and at the New York Fed. It would be better if she had some serious credentials as an economic researcher, and a PhD in Economics, but sometimes smart people can pick up quickly what they need to know. She is married to a Maryland Democratic state senator, but it's not clear what her connection is to the Obama administration. Maybe she knows Geithner from the New York Fed?

I don't see much in these appointments to get excited about. Maybe these people can hold their own in an FOMC meeting with Bernanke, Kocherlakota, Lacker, Plosser, Rosengren, and Bullard. But maybe not.

Wednesday, April 28, 2010

The IMF and Financial Sector Taxation

The IMF recently came out with some proposals for taxation of the financial sector, summarized here. There are 3 proposed schemes, which are somewhat related. These are:

1. Financial Stability Contribution (FSC)
2. Financial Activities Tax (FAT)
3. Financial Transactions Tax (FTT)

What might the role of such taxes be? First, we might argue that financial bailouts result in a redistribution toward the financial sector, and that we could compensate for this through taxation. This applies to bailouts that have already happened, and bailouts that might potentially happen. Any of these proposed taxes will result in redistribution away from the financial sector, but the IMF appears to think of the FSC in particular in terms of its role in redistribution. One could make the case, of course, that there has not been much redistribution during this recession - the Treasury will recover most or all of its TARP transfers, and the Fed appears (judging from its last financial statement) to be doing unusually well recently (though perhaps only due to its monopoly power). There is always the implicit redistribution, though, that comes from too-big-to-fail.

Second, taxes could be important in promoting efficiency. (i) We could argue that there is an externality at work here. What is it? Because of explicit deposit insurance and the implicit insurance from too-big-to-fail, financial institutions take on too much risk, and we have a hard time pricing this risk correctly in the market. There is a classic market-failure-externality problem, and we can correct it with a Pigouvian tax. We could approach this by making some calculations about how financial institutions of different sizes and functions will behave, and set the tax rates appropriately based on size so as to correct the externality. Also, we might imagine a system where we measure individual institution risk and set the tax rate as a function of risk. The IMF seems to want to think of the FAT as involving risk-adjusted tax rates. This has the same drawbacks as subordinated debt, which I discuss here. The basic problem is that we can't price the risk well, in part because financial institutions will behave in ways that make their portfolios look less risky. (ii) A second inefficiency comes from concentration in the financial industry. I have argued here that this results more from scale economies than too-big-to-fail, but in either case we could justify a tax to rake off the monopoly profits. The IMF seems to think of the FAT in this way. The FAT is essentially a value-added tax for the financial industry. The key problem here is measuring the value-added of financial activities, which is a very thorny problem. National income accountants have known for a long time that measuring the contribution of the financial sector to GDP is really hard, if not impossible. Think about it. What's an input? What's an output? Somehow assets are transformed, and we make everyone better off by redistributing risk efficiently? How do you measure the benefits of that redistribution? What happens when you have incentive problems? Yikes! The principle behind the FAT seems to have some merit, but I don't know how you implement it in a sensible way.

It's useful to think of approaches to correcting environmental externalities as an example here. With some types of pollution, market-based solutions like cap-and-trade may work, if it is relatively easy to measure the extent of the activity causing the externality. For other things, the bad activities are hard to measure, and the problem can only be corrected with direct regulation and monitoring. I tend to think that, in the case of financial regulation, that market based solutions involving corrective taxes or subordinated debt, for example, will not work to solve the basic incentive problems. What we need is better direct regulation and monitoring of risk with a systemic view in mind. Of course, there is nothing wrong with taxes on the financial sector aimed simply at correcting the negative effects of concentration and generating badly-needed revenue for the Treasury.

Tuesday, April 27, 2010

Eliot Spitzer and Adam Smith

I have commented on Eliot Spitzer before here. Today, he has a piece on the Goldman Sachs case in Slate. The beginning of the piece is quite useful, as it makes clear that past behavior like Goldman's would more likely have a resulted in a more private reprimand by the SEC. It seems clear, particularly given the timing, that the SEC case against Goldman is aimed at lending political support to financial reform. Nothing wrong with that, of course. The rest of the piece is interesting, as it points out some of the dangers of the culture of too-big-to-fail, and misguided attempts to correct it. Spitzer thinks that Goldman should make a case for its social usefulness, and he poses seven questions, which are
1. What percentage of Goldman's capital is dedicated to proprietary trading, as opposed to capital formation for client companies?

2. What percentage of Goldman's profits derives from proprietary trading, asset management, and prime brokerage activities; and what percentage comes from capital formation for client companies?

3. What percentage of Goldman's profits derives from marketing and trading derivatives, specifically the synthetic CDOs that are at the heart of the SEC investigation?

4. What percentage of Goldman's capital has been invested in U.S. government securities over the last year, essentially taking advantage of an interest arbitrage between Goldman's cost of capital and the rate being paid on Treasury bills?

5. How much income did Goldman derive from bets against products it marketed?

6. How much capital—debt and equity—have Goldman and the other major investment houses raised for their clients over each of the past five years?

7. How much capital have they invested overseas in foreign-based companies—especially through private equity funds?
Here's the problem. Once we start thinking of large financial institutions as too-big-to-fail institutions with oversight by a systemic regulator, it is tempting to start thinking of these institutions as public rather than private. Spitzer needs to be reminded about this quote from Adam Smith's Wealth of Nations, where he states that a private business
by directing that industry in such a manner as its produce
may be of the greatest value, … intends only his
own gain, and he is in this, as in many other cases,
led by an invisible hand to promote an end which was
no part of his intention. Nor is it always the worse for
the society that it was no part of it. By pursuing his
own interest he frequently promotes that of the society
more effectually than when he really intends to
promote it. I have never known much good done by
those who affected to trade for the public good. It is
an affectation, indeed, not very common among merchants,
and very few words need be employed in dissuading
them from it.
People sometimes forget the whole idea behind the "invisible hand." What Smith is saying is that the greedy person pursuing his or her own interests (i.e. Goldman Sachs) can do more for the social good, than someone who is certain of his or her altruism. Further, the greedy person may have a hard time making the case that his or her actions are actually socially useful, even though they are. What's the lesson? Financial regulation needs to be hands-on and hands-off. We need to regulate financial risk-taking, and do it in a systemic way, but we need to be mindful of letting the financial sector do its job.

Sunday, April 25, 2010

Bad Fixes

I have something to say about two recent pieces in the New York Times. The first is here in Sunday's Week in Review section (you can tell I still read the physical object), and the second was Krugman's April 23 column. Krugman gets some things right. First, the moral hazard problem associated with too-big-to-fail led large financial institutions to create aggregate risk that would have otherwise been diversified away. Second, the creation of sophisticated financial instruments cuts both ways - it makes financial markets more efficient by concentrating aggregate risk in institutions that are best able to bear it, but it (along with, or in tandem with sophisticated accounting practices) also permits financial institutions to hide what they are doing. (I'm using "sophisticated" here in the same sense in which I would say that a thief is sophisticated.) Other than this, both pieces are essentially a summary of some bad ideas that are in circulation. I'll go through the bad ideas in sequence and try to debunk them.

1. The Chinese and the Fed kept our interest rates too low, and thus helped cause the financial crisis. First, the Chinese are giving us a great deal; they sell us their goods cheap, and lend us the funds to finance these purchases at low interest rates. Who could ask for more? Stop bashing China, it's unseemly. Second, we are still groping our way toward understanding what an optimal inflation rate might be, and to figuring out how and why a central bank can make real rates of return move around. Frankly, no one has the faintest idea whether real interest rates in the United States were too high, too low, or just right in the late-Greenspan era before the financial crisis. The financial crisis was caused by incentive problems in mortgage markets and at higher levels in the financial system. Of course, these incentive problems were exacerbated by low real interest rates. The point is that we are not going to solve the incentive problems of the financial industry by, for example, ending the use of the U.S. dollar as the primary international reserve currency, as Stiglitz seems to be suggesting. What a stupid idea!

2. Narrow banking will help. Kotlikoff's suggestion that we have deposit-taking banks hold only safe assets is familiar to anyone who has read Friedman's Program for Monetary Stability. This is much like Friedman's 100% reserve requirement proposal, though the motivation is different. It's wrongheaded for the same reasons, as it throws the baby out with the bathwater. Converting risky and illiquid assets into relatively safe liquid assets that can be traded in transactions is what banks are about. The benefits from this intermediation activity are large, and likely these benefits are larger than conventionally measured. Further, the financial industry is becoming a place where it is hard to tell what is a bank and what is not - we need a systemic approach to regulating the whole industry, not some attempt to fix deposit-taking institutions.

3. The problem is that financial institutions are too big. I have addressed this before here and here. Krugman in his Friday column falls into this trap.

4. Subordinated debt might work. This proposal has been around for a long time. See for example, this piece by Charlie Calomiris. The idea is to constrain banks to structuring themselves to include a subordinated class of debt on their balance sheets. The holders of this debt would bear the risk of a bank failure along with the shareholders. The key to the proposal is that the risk would then be priced in credit markets, and the subordinated-debt holders would take an interest in and constrain a bank's risk-taking. It is unclear to me why we were unable to price mortgage-backed securities but would somehow figure out how to price subordinated debt. What we actually need are correctly motivated regulators who we can appoint to optimally constrain large financial institutions.

5. It helps to blame someone. We shouldn't let our moral indignation get in the way of good policy. The behavior of the Bank of America, AIG, Lehman Brothers, Bernie Madoff, or whoever, may work us into a lather, just as I could get worked up if some poor person walked off with my flat-screen TV. However, my anger at the flat-screen thief does not help me think about how to efficiently deal with crime. As Krugman recognizes, moral indignation can be used in a good way to get a political job done. He,unfortunately, lets it get the better of him, and proceeds to blame everyone in sight (in his Friday piece and elsewhere) - large banks, small banks, Republicans, Democrats, laissez-faire economists, macroeconomists in general, whatever. It might be better if we all take the collective blame for this mess - after all we elected the politicians. These politicians (members of both parties) made the regulations and appointed the regulators who failed to exercise sufficient oversight.

6. Financial innovation is bad. Here is what Krugman says:
What’s the matter with finance? Start with the fact that the modern financial industry generates huge profits and paychecks, yet delivers few tangible benefits.
The history of thought here, according to Krugman appears to be: Once all economists told us that all financial innovation was good. It completes markets, allows us to share risk, promotes growth, etc. What a wonderful thing. The financial crisis happens. Now it is clear all financial innovation is bad. What actually happened was the following. Basic Arrow-Debreu theory from the 1950s tells us about the gains from trade in financial markets, and the benefits of diversification and risk-sharing. From 1970s information theory, and the 1980s theory of financial intermediation and banking, we understand a lot about moral hazard, adverse selection, incentive problems in financial markets and the banking sector, and the need for regulation. Most financial economists understand the tradeoff between risk-sharing and incentives. The financial crisis gave us a large quantity of new information about risks and incentives in the financial system which we can use to do a better job of the regulation. Again, don't throw out the baby with the bathwater. For example, appropriate regulation of derivatives markets requires more transparency and possibly some constraints on what can be traded, but probably should not prohibit whole classes of securities.

Saturday, April 24, 2010

Gary Stern and Minnesota Macro

I'm in Minneapolis for a conference in honor of Gary Stern, who retired last year after serving since 1983 as President of the Minneapolis Federal Reserve Bank. For me, this conference was like going to my high school reunion, and it put into focus the remarkable achievements in economic research and policy that have come out of the Minneapolis Fed, and helped me think about the practicalities of the interaction between theory and policy.

The foundation for the Minneapolis Fed model of economic research was built up in the 1970s through the hard work of people like John Kareken, Tom Sargent, Neil Wallace, and Chris Sims, academics at the University of Minnesota, who built a bridge with the Research Department at the Minneapolis Fed. In the 1980s, Gary Stern, and his Research Director and Senior Vice President Art Rolnick, built an unmatched central banking research unit on that foundation. This research department has a close relationship with the University of Minnesota, including: 1) the participation of Minnesota students at the Fed as research assistants and seminar participants; 2) a stream of visiting researchers, regular and irregular; 3) interaction between cutting edge scholars and policymakers.

Most people know this, but for those who don't, the Minneapolis Fed operation was an important input to essentially all the valuable (and here I've got some views on what is valuable) research accomplishments of the last 40 years. These include the adoption of the standard tools of economic theory by macroeconomists, the Lucas critique (Sargent has a story about this one), real business cycle analysis, sustainable plans, unpleasant monetarist arithmetic, and the modern theory of money and banking. Through the "graduates" of the Minneapolis Fed and passers-through, Minneapolis ideas have traveled far and wide. Minneapolis alumni reside in essentially all countries where serious economic research is done, and have strong representation at the University of Chicago, Stanford, UCLA, Yale, Princeton, New York University, the University of Pennsylvania, Arizona State, various Federal Reserve Banks, and Washington University in St. Louis (of course), among other places.

One strength of the Minneapolis Fed model has been that researchers are given an immense amount of freedom. The Research Department has to do some of the day-to-day work of a central bank of course: someone must be responsible for doing policy briefings, and the background work required to keep the President well-informed. In Minneapolis, these appear to have become specialized tasks - some researchers need have little to do with getting their hands dirty with policy. Given the times, this was a practical, and productive, arrangement. Gary Stern is a smart guy who was eager to learn from his Research Department, but there was some distance there, since Gary got his education at a time when the revolution in macroeconomics had not become common currency everywhere. He did not have the background or the time to work out how he could use the ideas of, for example, Neil Wallace or Rao Aiyagari, to implement monetary policy.

But the times they are a-changin. There are now cutting edge macroeconomists who have made significant research contributions to the economics profession (both within and without the Federal Reserve System - and sometimes it is hard to tell the difference) who are influential on the FOMC. Those people include Chairman Bernanke himself, along with Jim Bullard (St. Louis Fed President), Charlie Plosser (Philadelphia Fed President), Jeff Lacker (Richmond Fed President), and Eric Rosengren (Boston Fed President).

Now, along comes Narayana Kocherlakota. Narayana is formidable, in all respects. I have been in the same room with Narayana many times - in seminars, department meetings, and conferences. I have also been forced to play cards with him, along with table hockey (a Canadian passtime). This is a guy with a remarkable intellect - sharp, witty, and a match for almost anyone in the economics profession, academic or not. Why does he want to run a Federal Reserve Bank? Well, I think that Narayana understands something that the rest of us are just beginning to catch on to, and that Ed Green understood a long time ago. Some ideas in economics which people once viewed as too esoteric for public consumption - for example mechanism design theory or the theoretical apparatus necessary to analyzing monetary economies - are in fact useful, indeed critical for solving policy problems. Further, in the right hands, these ideas can be explained to, and understood by, people with little or no background in economics. It is important that somebody put these ideas into use, but it takes someone ambitious, articulate, and forceful like Narayana to do it.

How does this matter for the Minneapolis model for economic research and policymaking? I think this means that researchers on the cutting edge of macroeconomic theory and applied work can play a much more active role in policymaking, as they now share a common language with management. Further, this won't cost the researchers anything - indeed it can enhance their research in important ways. It was once thought that spending too much time thinking and talking about policy could only dull the academic mind - not any more.

I am very optimistic about the future of the Minneapolis model. The fine work done by Gary Stern, Art Rolnick, and others set the stage for what I expect to be a fine run under Narayana Kocherlakota and his new research director, Kei-Mu Yi. As well, other central banks have put into practice some of the lessons from the Minneapolis experience. Indeed, we're doing it in St. Louis under the leadership of Jim Bullard and Chris Waller at the St. Louis Fed.

Thursday, April 22, 2010

The Fed's Balance Sheet

The Fed released its financial statements for 2009 yesterday, with a New York Times business section story here. The transfer from the Fed to the Treasury increased 50% over 2008. One might think that the dramatic interventions by the Fed would surely have caused losses for the central bank, but obviously that is not so. We might then be led to the conclusion that the Fed's interventions were justified - if the Fed can make a profit, it must be doing something right. Of course we don't want to be too sanguine about it, as the Fed is in part just exploiting its monopoly power to issue outside money.

In the New York Times piece, there is a quote from Vincent Reinhart, formerly at the Fed, who says
“The Fed can only play this game as long as the public is willing to hold its liabilities,” said Mr. Reinhart, now a scholar at the American Enterprise Institute, a conservative research organization. “If it tried to increase its balance sheet tenfold, say, the public would be unwilling to hold those reserves. You’d get dollar depreciation and inflation.”
Wrong. As I discussed here, the Fed can successfully induce the banking system to hold large quantities of reserves by setting the interest rate on reserves appropriately, with no inflationary consequences. Indeed, if the Fed wanted to, it could fully exploit its monopoly power and take over most of the financial intermediation activity in the United States, set the interest rate on reserves appropriately to get the banks to hold the reserves and not generate any inflation, due to the fact that the price level can essentially be viewed as being determined by the supply and demand for currency. We would not like the result much, of course, as the Fed is not likely to be a very good banker, and it would be determining all the details of how credit is allocated in the US economy. Indeed, I don't like what we have already, which is a situation where the Fed is subsidizing the housing market for, I think, no good reason.

Wednesday, April 21, 2010

Big Banks, Regulation, and Greece

This front-page piece in the New York Times this morning is a good summary of what the major players in the financial legislation debate are saying. There are a number of voices (including some of the ones I have already mentioned) arguing (misguidedly as I've argued) for the breakup of large banks, bringing back Glass-Steagall, etc. I thought that this quote from Gary Stern was important:
Gary H. Stern, the co-author of “Too Big to Fail: The Hazards of Bank Bailouts,” said policy makers largely ignored the warnings contained in the title when the Brookings Institution published the book in 2004.

Mr. Stern, who retired last year as president of the Minneapolis Fed, is lukewarm about the bill. “It tries to address the problem but it’s half a loaf at best,” he said. “It doesn’t address the incentives that gave rise to the problems in the first place.”

In Mr. Stern’s view, ending “Too Big to Fail” should subject uninsured creditors — bondholders — to losses if the bank fails. Without that fear, he said, unsecured creditors will not exert discipline on the banks by monitoring their risk-taking and pricing their loans appropriately. Mr. Stern said the bill in the Senate is vague about how such creditors would be treated if the government were to seize and dismantle a failing bank.
That seems important to me. There is no good reason for implicit or explicit insurance of any bank liability holders other than small depositors. Taking away the implicit insurance can only help the moral hazard problem.

One commenter yesterday made an important point about Greece. I think the underlying principle is that monetary policy, fiscal policy, and financial regulation are inextricably linked. I'm wondering if the EU is not doomed to fail given how it was set up. How can one have a monetary union without somehow linking the fiscal authorities of the members with the central bank? The simplest solution in the current context would seem to be that, if the other EU members want to keep Greece in the club, the ECB should just take on more of its debt. It can sterilize by selling some other assets. My guess is that the rules the ECB operates under do not allow it to do this. Maybe someone can fill me in on what the rules are. What exactly is on the ECB balance sheet?

One last point. I'm beginning to think that the following might be an optimal arrangement. Why not have a setup where the central bank is the sole regulatory authority, with all large financial institutions having reserve accounts and access to the central bank's lending facility? The central bank would have authority to regulate financial institution risk, and the power to take over any institution and resolve it, if it deems it insolvent. Also: no deposit insurance.

Tuesday, April 20, 2010

Financial Regulation

One of our commenters (Kosta) led me to this blog piece by Krugman. I'm feeling bad that I keep giving him a hard time, so this is my opportunity to show you that I don't harbor some irrational hatred for the guy. Krugman does a nice job of laying out the issues and summarizing the key influential viewpoints, so this is a useful platform on which to build a discussion.

I especially like Krugman's analogy to health reform, though I disagree that health reform is somehow easy while financial regulation is hard. What we have just been through was a long, painful, and costly process of passing health care legislation. I think we have an improvement, but we'll see what happens when the government tries to enforce participation. The analogy to health reform draws in my running Canadian example, which I discussed here among other places. Just as there are lessons for the US in Canadian health insurance, there are lessons in Canadian banking. As one of my former colleagues at the University of Western Ontario, Ig Horstmann, was fond of saying, "Canadians love insurance." They have government-provided health insurance, relatively generous unemployment insurance, and their banks (because they are forced to do it, or in part for other reasons) are essentially self-insured. As economists know of course, there can be problems with being too well-insured, and it seems clear that the US does not want to be Canada. But that doesn't mean you can't learn something from what Canadians do.

Now, the first point of discussion has to do with a typical characterization of US banking and monetary history. The story goes like this. In pre-Civil War times there were only state-chartered banks, and these banks could issue private currency. There was a plethora of banks, and a plethora of circulating bank notes, and it seems generally agreed (with some exceptions) that this system did not work well. Bank notes circulated with discounts, counterfeiting problems were severe, and the quality of bank notes could be hard to evaluate. After the Civil War, the state bank notes were taxed out of existence, and the National Banking System was created. Given the regulatory structure, the currency issued by National banks was essentially safe, so one problem was solved. However, during the National banking era (post Civil War to 1914) there were banking panics, the last of which was in 1907. By the early twentieth century, the view was that the financial system was unstable, and that having a central bank could cure the problem. Thus, we have the Federal Reserve Act of 1913, and the Fed goes into business in 1914. Things seem to work reasonably well until the Great Depression. Then, the conventional view seems to be that the Fed was somewhat inept, and did not appropriately perform its roles as lender of last resort and supplier of liquidity to the financial system. Further, there was too much risk-taking by banks (they were somehow too closely connected to the rest of the financial industry) which, combined with the helping hand of the Fed, led to the failure of 1/3 of the banking system in 1933. Then, according to the conventional view, this was all fixed in the Banking Act of 1933 (otherwise known as the Glass-Steagall Act) which introduced deposit insurance, Fed regulation of savings deposit rates (regulation Q) and the separation of banking from other financial intermediation activity, among other things. Then we have the Quiet Period of US banking (Krugman says "quiet period" comes from Gary Gorton - I was looking for the reference but couldn't find it - anyone know?) until the savings and loan crisis (late 1980s, early 1990s). In 1980, there was a key piece of legislation, the Depository Institutions Deregulation and Monetary Control Act, an important part of which deregulated savings and loan institutions and made them look more like banks. This was followed by the Gramm–Leach–Bliley Act of 1999, which further relaxed the Glass Steagall Restrictions that prevented bank holding companies from getting into non-bank financial business. Now, one could see how deregulation could accentuate moral hazard problems in banking and lead to a need for regulators to limit bank risk-taking in new ways. However, some people (including Gary Gorton apparently, but I've heard other people say this) argue that Glass Steagall limited competition among banks (and between banks and other financial institutions) in ways that made them take less risk, and that lifting these restrictions produced the obvious result.

Part of the conventional view of this historical experience is that there is something inherently wrong with banking - in converting illiquid assets into liquid liabilities banks leave themselves open to runs and panics. A Canadian perspective on this might be entirely different. A Canadian might look at US banking history and wonder why these Americans can never get it right. They get off on the wrong foot, and it just goes from bad to worse. Canadian banking history is essentially one long Quiet Period. Before the Bank of Canada came into being in 1935, chartered banks could issue currency. This private money system worked quite well (see this paper) - notes issued by different banks traded at par, banks redeemed each others' notes, and there was an apparently efficient system for clearing the notes. Further, without a central bank, the Bank of Montreal played a quasi-central banking role, and the banks appeared to be self-policing and capable of preventing incipient panics. Private note issue was ultimately phased out in 1944. There was no deposit insurance in Canada until 1967, and yet failures of banks in the 20th and 21st centuries has been insignificant - one failure in the 1920s, the failures of two small banks in the 1980s, and no failures during the Great Depression or the recent financial crisis.

One interpretation of what is going on in Canadian banking is consistent with Gary Gorton's ideas, and one commenter (Kosta) suggested something similar. We could say that Canadian banks have a lot to lose from bad behavior. They enjoy significant monopoly rents, and they risk losing them. If they take on too much risk and there is a large chartered bank failure, the Canadian government will step in and break them up like ATT. In equilibrium the government never has to impose the punishment, but the banks understand that the government is committed to this off-equilibrium behavior. The more I think about this story, the less I like it. One lesson from the US financial crisis is that some of the players who contribute to the riskiness of large financial institutions really have nothing to lose. The professionals who designed financial instruments and marketed them for Bear Sterns and Lehman Brothers, for example, have valuable skills, and some of them are now employed at the Fed, Fannie Mae, Freddie Mac, and in other financial firms. They were handsomely compensated and are doing just fine now, thank you. It seems to me that we can explain the behavior of Canadian banks adequately by looking at how they are regulated - it doesn't have much to do with the implicit threat of punishment.

Now, particularly since Krugman brings up the Diamond-Dybvig (DD) model, I should talk about that. This paper by Gary Gorton is also essentially a DD story. I have found DD useful in modeling (e.g. here and here). The model captures in a nice way the insurance role played by banks - essentially a story about how liquidity is shared through the banking system in an efficient way. But that is about as far as it goes - people just give DD too much credit (sorry Doug and Phil). In the original paper, it can be easy to write a bank contract that prevents a run, and when it's not DD don't solve the problem properly. Ultimately, the model has nothing to say about deposit insurance, moral hazard, or central banking - all the things we really care about. For the bottom line on the DD model, see work by Huberto Ennis (Richmond Fed) and Todd Keister (NY Fed).

I have no doubt that the possibility of runs and panics is a real problem in some banking systems, but DD is not instructive. One thing that seems clear is that deposit insurance is one fix put into the US banking system that appears to be working. Runs (other than the phenomenon Gorton discusses in the paper I linked to in the previous paragraph) were essentially absent in the US banking system during the financial crisis, and the the FDIC seemed capable of resolving small bank failures (and even larger ones like Washington Mutual) quickly.

If we get away from a Diamond-Dybvig view of banking, and think in general equilibrium terms, in monetary economies with central banking (like this one, we can come away with a very different view, both of history, and of the reasons for the financial crisis. Panics, of the type discussed by Gorton here could just be viewed as liquidity shortages, as could the National Banking era panics (see this paper). It was a problem for some financial institutions during the financial crisis which were funding long-maturity assets with short-term repurchase agreements that they could not borrow from the Fed (though of course the Fed was lending to pretty much anybody who had decent collateral and maybe even some who did not), just as it was a problem in the National banking era that the currency was not "elastic." Canadian banks in 1907 facing a line of depositors wanting to withdraw their deposits could print notes and simply swap the deposit liabilities for notes in circulation - they created the liquidity privately. In banking systems without private note issue we rely on the central bank to supply liquidity appropriately.

Here's a question. Once there is a central bank lending facility in place, why isn't deposit insurance redundant? Surely the central bank can stand ready to lend on good collateral, and if the collateral is no good and the bank is deemed to be insolvent, the central bank can resolve it in the same way the FDIC does. Why not?

That's all for today. Comments are welcome. I'm all ears.

Sunday, April 18, 2010

Small Banks and the Fed

Thomas Hoenig (President, Kansas City Fed) has an op-ed in the New York Times this morning, which is quite interesting, on a number of dimensions. It's important that we understand our FOMC members better (though this one is retiring soon), and he raises some key issues concerning the financial regulation legislation that is starting to wend its way through Congress.

Hoenig clearly has adopted the pervasive view, that I discussed before in Big Banks, that too-big-to-fail is primarily responsible for the increase in concentration in US banking. He writes:
This explains why it undermines the very foundation of our economic system when the government decides that a financial institution is too big or too powerful to fail. The big banks and investment companies hold a significant advantage in the competition for funds (for example, from depositors and bond holders), because creditors know that they will be bailed out when a crisis occurs. This advantage has systematically undermined the competitive position of every smaller bank, and has enabled the largest banking organizations to more than double their share of industry assets since the 1990s.
Though too-big-to-fail is a problem that needs to be solved, there is a strong case that the increase in concentration in US banking occurred mainly due to inherent economies of scale in banking coupled with the elimination of regulatory restrictions that kept banks small.

Hoenig then goes on to discuss two aspects of the Senate regulatory reform bill. The first has to do with the systemic-risk-regulation component of the the legislation. The proposed legislation includes a means for quickly resolving a failed financial institution, akin to the resolution authority currently given to the FDIC over banks. What is important here is that this authority will apply to large (i.e. "systemically important") non-bank financial institutions - i.e. Goldman Sachs, AIG, etc. Hoenig complains that the proposed resolution authority will not work quickly enough, and proposes this instead:
Instead, the new law should require that any institution deemed insolvent, based on an established, objective set of criteria, be placed into receivership and resolved in an orderly fashion — just as banks on Main Street are.
I think Hoenig is missing the point.

We need a comprehensive approach to regulating large financial institutions - large banks and large non-banks. I am willing to be convinced that systemic risk is a problem, but I have never seen convincing evidence that we cannot deal in a sensible way with the failure of a large financial institution - Citigroup for example. Indeed, one could make a case that people screaming "systemic risk" is just a feature of too-big-to-fail. If you want your bailout, you have to make a big noise about how systemically important you are. The problem is not systemic risk, it's moral hazard and the need to regulate risk-taking. Of course if I believe in systemic risk, then solving the moral hazard problem solves the systemic risk problem too.

Hoenig seems naive in arguing that we can somehow treat large financial institutions in the same way we treat small banks. For example, under current arrangements all of the large US banks are owned by bank holding companies, which makes resolution particularly difficult. The regulation of banks under bank holding companies may involve multiple regulators, including the FDIC, the Comptroller, the Fed, and the SEC. What a mess! For large non-bank financial institutions, it seems ludicrous to argue that I can handle AIG in the same way I handle Mom and Pop Bank of Peoria.

On this issue, it is useful to look at Canada, which I've been using as a nice reference point. Canada has one key financial regulator, the Office of the Superintendent of Financial Institutions. This is the regulatory authority for banks, insurance companies, and pension funds. Further, in Canada, the big 5 chartered banks appear to essentially be much like Bank of America, AIG, and Goldman Sachs rolled into one. This is the direction the US is headed in. Banks will become increasingly indistinguishable from other financial intermediaries, and the too-big-to-fail problem has to be solved in the same way for all these institutions. Multiple and competing regulatory authorities are not going to solve the problem - they are the problem.

The second feature of the proposed financial regulatory legislation Hoenig focuses on is a proposal to narrow the Fed's supervisory role to large banks and eliminate supervision by the regional Feds of small banks in their district. Head offices of most bank holding companies reside in New York, so all regulatory authority would go to the New York Fed.

One can easily see why the regional Feds would be bothered by this. Employment at the regional Feds has already dropped because of the vanishing demand for check-clearing services. If it loses authority over bank regulation, the activities of a regional Fed will mainly consist of the distribution of new currency, the shredding of old currency, and economic research. The regional Feds would then be concerned that this is a slippery slope, with power in the Fed system ultimately concentrated in New York and Washington. This is certainly a legitimate concern. One of the strengths of the Fed system is its decentralization, which allows for competing viewpoints on policy issues.

For social welfare, however, the elimination of Fed regulation of small banks looks like a good thing. One argument in favor of Fed bank regulation might be that this is important for its role as lender of last resort. However, if the Fed cannot get sufficient information from the FDIC concerning how it should evaluate collateral posted against discount window loans, then something is wrong. Indeed, the Fed was quite willing to lend in the commercial paper market during the financial crisis, to firms which it was not regulating. Fewer regulators (and better regulation by these few) seems like the way to go, and this is a small step in that direction.

One final remark. Hoenig, like Charlie Plosser, wants a preemptive tightening in monetary policy. Unlike Plosser, he is currently a voting member of the FOMC, and has voted against the policy action at the previous 2 meetings (see here). I tried to debunk the case for preemptive tightening in Inflation Control.

Saturday, April 17, 2010

The Money Multiplier

When I was at the University of Iowa, I was the Chester Phillips Professor. When my Dean, Gary Fethke (who I now appreciate as a perceptive and skilled administrator - but that's another story) told me he was going to make me a chaired professor (more like a stooled professor actually), he told me a story about Chester Phillips. Apparently Chester was thought to be the inventor of the money multiplier. I have no idea who else might lay claim to this dubious honor, but my response to Gary was something like: "That's too bad, the money multiplier is probably the most misleading piece of monetary economics known to humankind." Gary's response was something like: "Well, Steve, that's very interesting, but if you share that thought with any of the College donors you can be the Sam Schwartz Professor of toilet cleaning."

Yesterday, at the beginning of a lunchtime seminar at the St. Louis Fed, I was eating my tuna sandwich waiting for the seminar to start, and the money multiplier came up (don't remember how). I said something akin to what I said years ago to Gary Fethke. Then, David Levine frowned at me (the look that usually says: "I think you said something stupid, but I'm going to grill you to find out") and said: "What's wrong with a fractional reserve requirement?" At the time I was too tired to argue with David (which led to a later conflagration - another story), and just dropped it.

After some thought, here's a story that might help David. Suppose a world where every owner of a refrigerator has an account with the central bank. Call this account a reserve account, and require every refrigerator owner to hold reserves - say 10% of the market value of the refrigerator. Now, in our undergraduate Economics of Refrigerators class, we could tell a story like the following. Suppose that the central bank makes a transfer of more reserves to each refrigerator owner (lump sum, in proportion to existing reserves, whatever). Refrigerator owners find themselves with excess reserves, and they spend them on goods and services (the central bank provides a full array of transactions services associated with its reserve accounts). Ultimately the reserves are spent on more refrigerators, which increases required reserves, and there is a multiplier process. In equilibrium the nominal quantity of refrigerators rises - in this case by 10 times the increase in the quantity of reserves. The refrigerator multiplier is ten.

Now maybe you see the analogy at this point, but maybe not, so I'll explain it. The money multiplier story is no more than a description of the obvious truth that, under a fractional reserve requirement, if the reserve requirement binds, the nominal quantity of the objects that one must hold reserves against must expand by a fixed multiple of a reserve injection by the central bank. But that is as far as it goes. Sometimes undergraduate money and banking professors spend an enormous amount of time explaining the multiplier process, and there is essentially no economic content to it. It sounds like something magical and mysterious is going on, but the story is actually obvious, and misleading, for the following reasons:

1. It makes us think that what is important about central banking is the control of the quantity of "money" - some aggregation of assets that appear to serve a medium of exchange role. Liquidity is actually a matter of degree, and we can't arbitrarily draw the line between assets that have some "moneyness" property, and others that do not. Currency is exchanged in many types of transactions. Transactions deposits at banks are traded in other types of transactions. Transactions using different payments instruments have different arrangements for settlement. Treasury bills have liquidity value in part because they serve as collateral in some types of lending in financial markets. Reserves serve a transactions role in interbank clearing and settlement.
2. Transactions deposits at banks are not the same as outside money (just as refrigerators are not reserves) - one is a private liability backed by a bank's portfolio of assets, the other is a public liability backed by the central bank's portfolio of assets, and outside money is not a promise to any explicit payoffs.
3. A central banker whose intuition comes from money multiplier stories has no idea how to think about a banking system with no reserve requirements. Some central bankers are pretty smart though - in New Zealand and Canada, for example, they have figured this out.
4. Under the current regime where large amounts of excess reserves are being held by banks, a central banker with undergraduate money and banking intuition will again get lost.
5. There is only one question to which the money multiplier gives us a useful answer: How much will assets subject to the reserve requirement increase in nominal terms in the long run if there is an unbacked, one-time increase in reserves? But if I understand the neutrality money, I know the answer to the question anyway. Otherwise, the money multiplier is in general not policy invariant - i.e. the Lucas critique comes into play.

For more details, read the "Intermediation" section of this paper.

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!

Wednesday, April 14, 2010

Inflation Control

The CPI report for March came out yesterday, so this seems like a good time to discuss inflation control in the US. Where are we today, and what are the prospects for the future? By any measure, recent inflation rates have been low. Year-over-year increases in the CPI are running at a little more than 2% (with monthly increases at an annual rate much lower), and year-over-year increases in the GDP price deflator were lower than 1% in the third and fourth quarters of 2009. Though the inflation rate has been low, rates of growth in conventional measures of the money stock have been very high. Since the fall of 2008, the monetary base has increased by a factor of about 2 1/2, while year-over-year increases in M1 over that period have ranged from 7.5% to 17.5%.

How would an Old Monetarist explain these observations, for example what would Milton Friedman have to say if we could resurrect him? An Old Monetarist might appeal to a liquidity trap argument (though of course the liquidity trap idea is typically associated with Keynesians) and argue that, at a zero nominal interest rate (and 0.25% is close enough to zero) banks are willing to hold any outside money injections as reserves, so the money multiplier is not working to bring about a large increase in media of exchange, which would otherwise have increased the price level. Perhaps our Old Monetarist would argue that the increases in M1 have been somewhat large, but there were also large increases in the demand for M1 as asset holders fled to the quality of insured deposits and currency during the financial crisis, and this mitigated any potential inflationary effects.

An Old Monetarist would have dire predictions for the future, however. He or she might say that, once better lending opportunities arise for banks, and they loan out the reserves on their balance sheets, the money multiplier goes to work, and dramatically large increases in M1 fuel a large increase in the price level. Indeed, there appear to be Old Monetarist voices on the FOMC. For example see this speech by the Philadelphia Fed President, Charlie Plosser. Plosser echoes Milton Friedman in this line:
Ultimately, inflation is a monetary phenomenon and there is no question that current monetary policy is extraordinarily accommodative.
Plosser argues that the Fed should be preemptive, pulling reserves out of the system before inflation rears its ugly head, so as to put a brake on an increase in inflationary expectations.

It is views like Plosser's that are likely behind proposals for new monetary instruments to supposedly withdraw reserves, without the Fed having to sell assets from its balance sheet. As the theory goes, the Fed can have its cake and eat it too. One proposed instrument is a Fed term deposit facility, which I discussed in an earlier post. Another is the reverse repurchase agreement. Reference to this instrument can be found as early as this 2002 press release from the Fed, but the New York Fed was experimenting with this relatively recently, as if it were new and they had to figure out how it worked in practice. From the Old Monetarist point of view, the reserves can still be in the system, but if they are somehow "locked up" in term deposits and reverse repos, they can't get out into the economy through the money multiplier process and cause the price level to rise.

An alternative school of thought, New Keynesianism, also has voices on the FOMC, including that of Janet Yellen. This speech does a good job of capturing her views on how monetary policy works. The following two paragraphs are quite useful, for my purposes.
In light of these continuing headwinds in the financial system, the housing market, and the job market, I expect that the economy will be operating well below its potential for several years. Economists use the term “output gap” to refer to an economy that is operating below its potential. We define potential as the level where GDP would be if the economy were operating at full employment, meaning the highest level of employment we could sustain without triggering a rise in inflation. Obviously, with the unemployment rate so high, we are very far from that full employment level. In fact, the output gap was around negative 6 percent in the fourth quarter of 2009, based on estimates from the nonpartisan Congressional Budget Office, or CBO. That’s an enormous number and it means the U.S. economy was producing 6 percent fewer goods and services than it could have had we been at full employment. In view of my forecast of moderate growth and high unemployment, I don’t expect the output gap to completely disappear until sometime in 2013.

This idea of an output gap has important implications for inflation. We have a tremendous amount of slack in our economy. When unemployment is so high, wages and incomes tend to rise slowly, and producers and retailers have a hard time raising prices. That’s the situation we’re in today, and, as a result, underlying inflation pressures are already very low and trending downward. One simple gauge of these trends comes from looking at the U.S. Commerce Department’s price index for core personal consumption expenditures, which excludes the prices of volatile food and energy products. These prices have risen a modest 1.4 percent over the past 12 months, below the 2 percent rate that I and most of my fellow Fed policymakers consider an appropriate long-term price stability objective. I just predicted that the output gap might not disappear until 2013. If the economy continues to operate below its potential, then core inflation could move lower this year and next.
In Yellen's view, it is the New Keynesian Phillips curve that determines the inflation rate. In the 1960s and 1970s, Friedman and Lucas, among others, dismissed the Phillips curve relationship (a negative relationship between the unemployment rate and the inflation rate) then observed in the data as nonstructural, and therefore not exploitable by policymakers. However, the Phillips curve has been revived by Woodford and others (see Woodford's book, Money, Interest, and Prices) as a positive relationship between the inflation rate and the output gap. As far as I can tell, New Keynesians view this Phillips curve as structural and exploitable by the Fed in the short run.

Now, from Yellen's point of view (in contrast to Plosser's), inflation is not a problem. Her view of the recovery from the current recession is quite pessimistic, and she expects the currently large output gap (as measured by the CBO apparently) to persist for several years, thus subduing inflation for a long time. I don't have a direct quote on this, but my impression is that the prediction for current inflation coming out of New Keynesian Phillips curves estimated on previous data is negative and large in absolute value. An extreme New Keynesian might even argue, in the manner of Krugman for example (see here), that the immediate risk is not inflation, but deflation, due to the large output gap.

Mike Woodford might say that New Keynesianism somehow encompasses both Plosser and Yellen, i.e. as in the 1960s when some macroeconomists argued that there was a neclassical synthesis, now there is a New Keynesian synthesis that has absorbed all the key advances in macroeconomics (Old Monetarism, the Lucas critique, real business cycle theory, or whatever) in the New Keynesian framework. Then we can just view Plosser and Yellen as Taylor-rule policymakers, but with different weights on inflation and the output gap in their quadratic loss function. However, it appears that Plosser does not really want to be absorbed - he seems not to buy the Phillips curve logic, and sounds like an unrepentant Old Monetarist.

Now how would a New Monetarist think about the current observations on inflation, money growth, and the prospects for inflation control in the future? In case we haven't been speaking loudly enough for you to hear, Randy Wright (University of Wisconsin-Madison) and I are self-proclaimed New Monetarists, and we lay out our case for New Monetarism here and here. Also see this working paper of mine. First, let's throw out the money multiplier - a misleading load of tripe that remains an integral part of most undergraduate money and banking and intermediate macroeconomics textbooks (excepting this one of course).

In my opinion no one takes currency seriously enough. I use currency very little, and my friends and colleagues appear to do the same, but the quantity of U.S. currency held by the average US citizen was about $2900 in 2009, or about 6% of annual GDP in the aggregate. Now, some of this currency is clearly held abroad (and by various nefarious characters), but the last I checked, Canadians held about 3% of annual GDP in currency at any one time, and the Japanese held about 15%. As Fernando Alvarez pointed out to me, the stock of currency per capita in the world has not been falling, in real terms. Further, in normal times most of the liabilities of the Fed are currency - i.e. outside money is typically mostly currency. We are now in an unusual situation where currency outstanding is $935 billion, or 46% of total outside money, with reserves accounting for the other 54%.

What determines the price level? It's the supply and demand for currency. As I told someone the other day, currency is where the rubber hits the road. The price level has to be determined by the rate at which outside money trades for goods and services, which is the rate at which currencytrades for goods and services. Now this is not so helpful if one wants to be a quantity theorist (particular an American quantity theorist), as (i) we have only a vague idea where U.S. currency resides, so (ii) it seems pretty hard to uncover all the important determinants of the demand for the stuff. However, important determinants of the demand for US currency would have to include the costs of using alternative transactions technologies (checks and debit cards, for example), nominal interest rates, the ease of exchanging other assets for currency (in part determined by access to and costs of using ATM machines), the potential for loss and theft, and the role of counterfeiting.

Now, note that year-over-year percentage increases in the stock of US currency outstanding rose to a peak of about 11% in early 2009, and have since fallen to a little more than 3%. This coupled with an increase in the world demand for US currency (which is probably much more popular in places like Iceland) seems easily consistent with the low inflation rates we have been seeing. One can be a Monetarist - but it helps to be a New Monetarist who is looking at the right monetary quantity.

Should we take the Phillips curve seriously as a guide for monetary policy? Absolutely not. First, Harold Cole and Lee Ohanian long ago provided convincing evidence here that Phillips curve relationships are of no value in forecasting inflation. Second, particular in the current context, we have no idea what the output gap is. Given that we cannot fully understand and quantify the causes of the current recession, we cannot measure the output gap. Maybe the drop in output was all due to inefficiencies, and the output gap is huge. Maybe there were no inefficiencies and the output gap is zero. Further, even if the output gap is huge, it's not a sticky-price-inefficiency output gap, it's a financial-frictions-inefficiency output gap, which has to mean something different.

How do we control inflation over the medium to long term? Is inflation control possible without somehow "draining" reserves from the system? As I discussed in an earlier post, as long as there are positive excess reserves in the banking system overnight, the relevant policy rate is the interest rate on reserves (IROR). Due to the fact that some important players in the system do not receive interest on reserves (principally Fannie and Freddie), and some lack of ability to arbitrage, fed funds currently trade at 10 or 12 basis points below IROR. There appears to be no reason to believe that this gap will not persist as IROR rises, and it should get smaller, as reserves will tend to shift to the banks that earn interest on reserves as IROR gets larger.

Now, inflation is not hard to control, even with a huge quantity of reserves in the system. As returns on other assets increase as we pull out of the recession, banks' willingness to hold reserves will lessen. Given the quantity of assets on the Fed's balance sheet, if IROR remains fixed at 0.25%, the quantity of reserves will fall, the quantity of currency will rise, and so will the price level. To prevent inflation from happening, the Fed will have to increase IROR, which will increase interest rates on all short maturity liquid assets.

Given that a positive quantity of excess reserves are held overnight, and fixing IROR, what would be the effect of an open market sale of assets (treasuries or mortgage backed securities - MBS) by the Fed? Given the current level of reserves, very little. Since the marginal liquidity value of reserves is essentially nil (the system is awash with the stuff) in daylight transactions, reserves are no better than T-bills, and arguably worse, since T-bills are useful both inside and outside the banking system as collateral. However, as the level of reserves falls, open market operations start to bite. With a fixed IROR, an open market sale of assets replaces an asset with a high marginal liquidity value (reserves) with an asset with a lower marginal liquidity value, and this should increase the T-bill rate, but would have no effect on IROR (obviously it's fixed by the Fed) or the fed funds rate. Thus, with a low enough level of reserves, tightening can be achieved with two instruments - asset sales and increases in IROR. The more asset sales there are, the lower IROR needs to be to prevent serious inflation, and that will be important.

It seems imperative that asset sales (MBS or treasuries) begin as soon as possible. The case for selling MBS is strong - holding private assets is just unseemly for a central bank. The goal of the MBS purchase program was to favor the housing sector, and I think that is both inefficient, and a dangerous political game for the Fed. The Fed should aim to get rid of MBS holdings within 2 or 3 years.

What about the term deposit facility and the reverse repos? Both are silly ideas. The Fed can do everything it wants with either outright sales of assets or by moving up IROR. For example, increasing IROR is more efficient than trying to tie up reserves as term deposits or executing a costly reverse repo.

Finally, what are the potential risks as we move out of the recession? First, there is the possibility that the Fed will not have the stomach to increase IROR as necessary to squelch an escape of reserves. Second, it is possible that the Fed has boxed itself in by mismatching maturities on its balance sheet. The Fed is holding a large quantity of long-maturity MBS and long-maturity treasuries. As the Fed moves up IROR, the Fed's profits fall, though of course it still will pay zero interest on currency. At some point IROR becomes large enough that the Fed has to start printing outside money to pay for the losses on its intermediation activity. I'm sure someone at the Fed knows what this level is, but I don't. Alternatively if the Fed sells its long maturity securities, it will be moving asset prices against itself. Given that the Fed sells the assets at a lower price than it bought them, the outside money that financed the original purchases is in circulation forever. I don't know what the potential quantitative effects would be, but this is something the Fed needs to ascertain.

In conclusion, I see no reason for a preemptive strike on an inflation that has not yet made itself apparent. Once we see more inflation, there is plenty of time to respond to it. However, inflation control should be done in a context where we dispense with output gaps and money multipliers.

Tuesday, April 13, 2010

Spitzer and Bank Regulation

Among politicians (or ex-politicians in this case), Eliot Spitzer is quite perceptive about financial regulation. He has been writing pieces for Slate, the most recent of which is this one. It's too bad that his own risky behavior ruined his political career, but maybe he can redeem himself - stranger things have happened. Generally, Spitzer makes a good case that the Financial Crisis Inquiry Commission is not doing its job. The key passage in his piece is this:
During the pallid congressional debate over reform, Washington has utterly abandoned the structural reform that we actually need. There is an international consensus that banks are too big and the concentration within the banking sector is increasing, not decreasing. Fundamental reform will not come from having a few regulators "oversee" the sector. Reform will come from breaking apart the overly concentrated banks and separating them. The banks need to be broken up as AT&T and Standard Oil were busted, in order to stimulate competition and creativity.

Perhaps it's not too late for Congress to consider adding these three simple rules to its reform bill:

-Banks receiving taxpayer guarantees cannot engage in any nonbanking activity. Institutions must choose: Either you can have public guarantees or you assume risk through investment banking and proprietary trading, but you can't have both.

-Increase capital requirements to no less than 15 percent, and require on-balance-sheet disclosure of all material information pertaining to liabilities of the entity.

-require that banks pay penalties, dilute equity, eliminate management options, and repay executive bonuses before receiving any taxpayer bailout.

As I commented in an earlier post, it is certainly true that concentration in the banking industry is increasing, but I attribute that more to scale economies than the implicit subsidy from too-big-to-fail (though I think the latter is significant). I also disagree with Spitzer's notion that a key element of reform is breaking up the big banks. As I've said in other posts, I think we should embrace large banks and reform the regulators. I think Spitzer's three simple rules are good ones, though. In the case of the third, though, with appropriate regulation there should be no "bailouts" as we know them.

The regulatory reform which we should have (and have zero probability of getting) would be an elimination of overlapping and competing regulatory authorities, with one regulatory institution given the authority for supervising banks.

Monday, April 12, 2010

Big Banks II

This piece concerns an about-to-be-released report on the failure of Washington Mutual in September 2008. The failure looks like a classic moral hazard episode, and highlights the failure of regulators to properly control WaMu's risk-taking. Moreover, the two regulators with an interest in limiting risk at WaMu, the FDIC and the Office of Thrift Supervision (OTS) became embroiled in a disagreement over the soundness of WaMu prior to its failure, with OTS apparently in denial until it was too late. I think we could make a case that the key problem in the US banking sector is not that the banks are too big - they are just badly-regulated. See also Krugman's column here, which makes some sense for a change (though I don't think he has the story entirely right). Krugman points out problems with risk-taking at small banks in Georgia - i.e. it's not size, it's the regulators.

Sunday, April 11, 2010

Fed Interest Rate Targets, Part III

After reading Andolfatto's comment on the previous post, and thinking about it for bit, I think it's confusing (or just wrong) to call some element of the Fed's policy under a regime with positive excess reserves "fiscal policy." The only "fiscal" aspect of current Fed policy is that the Fed has taken over a piece of the activity that was being conducted by Fannie Mae and Freddie Mac.

Now, consider how monetary policy works when the banks are holding positive excess reserves. As discussed in previous post, the relevant policy rate is the interest rate on reserves, which the Fed can set at will. Moving the rate up will tend to increase reserves and reduce currency. Now, what happens if the Fed conducts an open market sale of treasuries. Nothing much important, except that the quantity of reserves drops - essentially one-for-one - with the open market sale. All that has happened is that the financial sector is now holding more treasuries and less reserves - no big deal. Thus, the Fed really has only one instrument available, aside from issues related to the maturity structure of the assets on its balance sheet.

Alternatively, when the banks are holding zero excess reserves overnight, the relevant policy rate is the fed funds rate, and an open market sale of treasuries will move the policy rate up. Not much difference between how monetary policy works in this case and in the other one.

It's possible we should think of monetary policy as being much tighter currently than is widely believed. Think of the reserves as T-bills. We have a very low policy rate (0.25% - the rate on reserves), but the supply of currency has not expanded like the supply of reserves, and we could argue that the world demand for US currency has gone up substantially.

Saturday, April 10, 2010

Fed Interest Rate Targets, Part II

I had a brainstorm in the Whole Foods store, and thought I would write it down. Currently, we should think of the Fed as operating in a regime much like the Bank of Canada's. This is a channel system, but one where the banking system holds a positive quantity of reserves overnight. This necessitates that the riskless rate on overnight interbank lending is equal to the interest rate on reserves held overnight. In its policy statement, the Fed mentions only its fed funds rate target, but the relevant policy rate is actually the interest rate on reserves, currently at 0.25%. As I discuss in my earlier entry, lending on the fed funds market has risk associated with it (which of course varies across borrowers), so it's hard to know what to make of the reported fed funds rate.

I mentioned in my earlier post the possibility of paying interest on reserves in the future at the T-bill rate. Scrap that idea. Let's think about how monetary policy works in a world where the riskless interbank overnight rate is identical to the interest rate on reserves. First, the Fed can choose what goes on the asset side of its balance sheet at will. T-bills, long-maturity Treasuries, mortgage-backed securities, agency securities - whatever. However, just like the Bank of Montreal circa 1925, it cannot determine the composition of its liabilities. Collectively, the nonfinancial and financial sectors determine how the quantity of outside money is split between currency and reserves held at Federal Reserve banks, much as note issuing banks were subject to the whims of their liability-holders.

Now, in this regime, what determines how much reserves are held relative to currency? The interest rate on reserves of course. In some sense, what is going on in this regime is that the Fed is doing both fiscal and monetary policy. Fiscal policy is determining the size of the balance sheet, and monetary policy is about setting the interest rate on reserves. Some talk I hear suggests that there are three instruments - i.e. add the fed funds rate to the mix. This is wrong, as the fed funds rate cannot be set independently of the other two instruments.

Next, how is monetary policy (the setting the interest rate on reserves) going to matter? It matters in exactly the same way that a conventional open market operation matters. A higher interest rate implies that the banks hold more reserves (essentially T-bills) and there is less currency in circulation. Perhaps the most amazing feature of the current environment is the large quantity of reserves that the banks are willing to hold at an interest rate of 0.25%. Obviously the Fed won't be able to sustain this and keep prices from rising without increasing the interest rate on reserves and/or reducing the size of its balance sheet.

Now, what about the Fed's proposed term deposit facility. The more I think about this idea, the more lame it seems. As I discussed in my earlier post, a bank's term deposit with the Fed will not satisfy reserve requirements and, more important, cannot be used for clearing and settlement. To induce banks to hold these term deposits, the Fed will have to offer an interest rate higher than the interest rate on reserves. Further, this will only make reserves scarce in the payments system, and increase the fed funds rate, for a given interest rate on reserves. Thus, the return on the Fed's portfolio falls, and efficiency is reduced. The Fed can make monetary policy as tight as it wants using the interest rate on reserves - the term deposit facility would only increase inefficiency.

Now, once we are back to "normal" and the size of the Fed's balance sheet has been reduced, we can go back to a channel system where the interest rate target is the fed funds rate, and there are no excess reserves in the system overnight. Of course, as any good New Monetarist knows, in this type of regime the fed funds rate is determined by the quantity (and maybe the composition) of assets on the Fed's balance sheet.

Friday, April 9, 2010

Krugman Again

I shouldn't read Krugman's NYT column. I have work to do and shouldn't distract myself with this nonsense. Oh well, here goes. This morning, here, Krugman writes about Greece's government debt problems. What he has to say about Greece is half coherent and contradictory, but I have not thought enough about Greek debt to say anything useful about it. What I'll focus on is the last three paragraphs, i.e. what the US is supposed to learn from Greece. Krugman says:

But what are the lessons for America? Of course, we should be fiscally responsible. What that means, however, is taking on the big long-term issues, above all health costs — not grandstanding and penny-pinching over short-term spending to help a distressed economy.

Equally important, however, we need to steer clear of deflation, or even excessively low inflation. Unlike Greece, we’re not stuck with someone else’s currency. But as Japan has demonstrated, even countries with their own currencies can get stuck in a deflationary trap.

What worries me most about the U.S. situation right now is the rising clamor from inflation hawks, who want the Fed to raise rates (and the federal government to pull back from stimulus) even though employment has barely started to recover. If they get their way, they’ll perpetuate mass unemployment. But that’s not all. America’s public debt will be manageable if we eventually return to vigorous growth and moderate inflation. But if the tight-money people prevail, that won’t happen — and all bets will be off.

1. Why is Krugman still wrought up about the possibility of deflation? The Fed has intervened so massively that it is hard to think of how they get their balance sheet back to normal without a large inflation over an extended period of time (I hope you understand the joke in the last few words).

2. I love this guy's use of words. The "inflation hawks" are "clamoring." Sounds like the angry mob in a Frankenstein movie. "Mass unemployment." Sounds like the Great Depression. How frightening. Please spare us the hyperbole.

3. I suppose I'm a "tight-money" person. It's quite obvious that monetary policy needs to be tighter in some sense - the key question is how and when, as I've written about elsewhere on this page. Maybe Krugman can help us out a bit here, but I doubt it. I have not seen any evidence that he knows squat about how monetary policy works or why.

Thursday, April 8, 2010

Big Banks

The too-big-to-fail problem is clearly at the heart of the recent financial crisis. Obviously, our policymakers believe that some financial institutions are so large and "systemically important" that they cannot be allowed to be fail, the large financial institutions in question understand this, and the result is a moral hazard problem. Through some failure of financial regulators to use their endowed powers, insufficient regulations, or due to the ability of financial institutions to evade regulatory scrutiny, large financial intermediaries took on more risk than was socially appropriate. This caused, or at least exacerbated, the financial crisis.

Leaving aside the issue of what should be done about large non-bank financial institutions (a key problem in itself), what should be done about the too-big-to-fail problem associated with large US banks? If we think too-big-to-fail is a problem, then it is clear that the problem is getting worse. As Ned Prescott (Richmond Fed) pointed out in a discussion at a recent conference at the Philadelphia Fed, the number of US banks has fallen dramatically recently, and concentration has increased - a larger fraction of market share is accounted for by the largest banks. There are potentially two reasons for this. First, with the deregulation of the US banking industry - the dismantling of various barriers to setting up additional branches and otherwise expanding individual banks - banks can reap the returns from economies of scale. Second, to the extent that there is too-big-to-fail, large banks are implicitly subsidized.

In my opinion, some economists tend to overemphasize the second effect, and want to lead us to believe that economies of scale are no big deal in banking activity. Certainly my old friend John Boyd (U. of Minnesota Finance Department) thinks this way. Others with this attitude are Simon Johnson and James Kwak, who have written here about it. Their proposed solution to too-big-to-fail is breaking up the large banks, much like we broke up ATT in 1984. For some econometric evidence on economies of scale in banking see this paper by David Wheelock and Paul Wilson.

There are still many small banks in the US, mainly due to historical accident and regulation. US banking started as a system where banks were chartered and regulated by state governments and typically restricted to operating within the state - sometimes restricted to one establishment (a unit bank). It was not until after the Civil War that we had a system that included National banks, regulated by the OCC (Office of the Comptroller of the Currency). A key problem with a unit banking system is that a local bank with loans collateralized primarily by local real estate is risky - it is poorly diversified and will fail with high probability. Diversification is where the economies of scale in banking come from. A large bank that can branch nationally is better diversified, and therefore more efficient.

How do we pool risk and get the diversification we need from a unit banking system that cannot provide it on its own? Securitization. For example, in the mortgage market, Fannie Mae and Freddie Mac did a tolerable job of creating a set of standards for conforming loans that mortgage lenders met, with the mortgages sold to Fannie Mae and Freddie Mac, bundled as tradeable securities, and then held and traded by various financial institutions. There is some loss in efficiency relative to a system with large banks, though, as local mortgage lenders have little discretion about who to lend to. They may have good information that a borrower is creditworthy, but if the borrower does not fit the Fannie Mae cookie cutter profile, he or she does not get a loan. Further, as became clear with the subprime crisis, securitization can be associated with some severe incentive problems, which we are painfully aware of now. In addition, Fannie Mae and Freddie Mac, due to political pressure, ineptitude, corruption, or some combination of the three, relaxed its standards, and had to be taken over by the federal government.

Large banks that branch nationally can clearly avoid the incentive problems associated with securitization. Loans are originated and held by a given bank, and loan officers who do a poor job of screening loans suffer termination, unlike the fly-by-night mortgage broker villains of the financial crisis. Does such a banking system exist? Of course, everyone knows that. Our neighbors (and my friends and relatives) in the Great White North have what appears to be one such first-rate banking system. The Canadian banking system is dominated by the five largest banks - the Royal Bank of Canada, the Toronto Dominion Bank, the Bank of Nova Scotia, the Bank of Montreal, and the Canadian Imperial Bank of Commerce. Indeed, where I grew up, a town of 10,000 people at the time (Cobourg, Ontario), there was one of each. These five banks have been around (or the banks that merged to yield these giants have been around) since the 19th century, and they are remarkably stable. There have been a total of three chartered bank failures in Canada since 1900 - one in the 1920s and two small regional bank failures in the 1980s. Canada has had deposit insurance since 1967, but apparently the CDIC (Canadian Deposit Insurance Corporation) does not have much to do. There were no bank failures in Canada during the Great Depression, and Canadian banks received no direct government support (outside of the essentially zero interest rate policy of the Bank of Canada) during the financial crisis. Further, the Canadian banking system is apparently not some slothful oligopoly. They compete successfully in international financial markets, and have always been well ahead of the average US bank in terms of electronic banking - for example the use of checks (or cheques in appropriate Canadian English) faded long ago.

Looks pretty good, right? Well, not according to Peter Boone and Simon Johnson, who write here. The gist of this piece is that (i) Canadian banks may look safe, but they are actually highly levered and risky; (ii) Canadian banks are subsidized by government-provided mortgage insurance; (iii) Even if we wanted a Canadian banking system in the US, we couldn't have it anyway.

Boone and Johnson state that "Canadian banks were actually significantly more leveraged — and therefore more risky — than well-run American commercial banks." First, given the distortions in the rest of the piece, I'm suspicious about Boone and Johnson's leverage numbers. However, suppose I think that the leverage comparisons they report are accurate. Any good Sloan School Professor should know that leverage and risk are not the same thing. For example, a bank that holds only treasury bills could be very highly levered and essentially riskless - riskiness of the bank is determined by capitalization and the riskiness of the asset portfolio. The financial crisis ran the stress test on Canadian banks - they just can't be characterized as risky. Notice as well in the Boone and Johnson piece that they pick and choose their banks. Obviously they're not making comparisons to Bank of America, Citigroup, or Wachovia (oh right, that one doesn't exist anymore).

Next, Boone and Johnson say: "If Canadian banks were more leveraged and less capitalized, did something else make their assets safer? The answer is yes: guarantees provided by the government of Canada." Any mortgage made by a Canadian bank with less than a 20% down payment must be insured, and the insurance is provided by a government agency, CMHC (the Canada Mortgage and Housing Corporation, which has a role something like the FHA). CMHC provides the mortgage insurance, and the bank that makes the mortgage loan pays the insurance premium. If the mortgage-holder defaults, CMHC pays off the bank.

To understand what is going on here, we have to go deeper into Canadian banking regulation. My hypothesis is that the Canadians have somehow solved the too-big-to-fail problem. The banks are too-big-to-fail, but they never fail, so problem solved. How do they do it? Canadian banks are regulated by the Office of the Superintendent of Financial Institutions (OSFI). Apparently, there is ONE banking regulator, rather than the highly inefficient alphabet soup of overlapping and competing regulators we have in the US. In Canada, the Bank of Canada collects banking data, and the Bank of Canada and the CDIC cooperate with OSFI, but it is OFSI that has the regulatory authority. Further, OSFI also regulates insurance, and guess what? OSFI regulates the mortgage insurance activity of CMHC. There may be some subsidy implicit in the CMHC insurance, since CMHC is in part a vehicle for direct government lending and some of that subsidy may spill over. However I can't see that it's the big deal that Boone and Johnson want to make it out to be. The mortgage insurance certainly looks redundant - the banks seem quite capable of diversifying the risk on their own - but it looks relatively innocuous.

Boone and Johnson want to conclude that embracing large banks in the US, and simply doing a better job of regulating them, is a recipe for disaster. Baloney. Why not figure out what OSFI does, try to replicate it, do away with Fannie and Freddie, and do what we can to discourage mortgage securitization? Economizing on the replication in regulation in the US would be nice, but you can't have it all.