Tag Archives: financial crisis

Don’t Blame Ben!

The Economist has a comment on central banks financing governments in the wake of the financial crisis. Basically, the point is that central banks that did QE bought tons of government bonds. At the same time, at least some of them – the Bank of England, for example, but the Fed as well – wrote their respective governments a yearly check, transferring any profits they made (after paying salaries). They always do that, but now, some of the money they made was from interest earned on their huge government bond positions. So the government paid them interest, they collected it, and at the end of the year sent it back to the government. Which, you know, isn’t too far from monetizing government debt – i.e. financing the government.

But what’s the problem? In the continued absence of hyperinflation, you might conclude that there really isn’t much of an issue here. However, says the Economist:

But another reason why monetisation has always been frowned upon is that it is an easy option. Why should governments finance spending with unpopular taxes or borrow from suspicious bond investors when they can get the money from a friendly central bank? The process makes democratic leaders less accountable; by boosting asset prices, which are mostly owned by the rich, it may well have led to a rise in inequality, without the sanction of any vote. Perhaps in ten or 20 years’ time, recent events will be seen as the moment the world crossed a line.

I have a couple of miscellaneous points on this, and one bigger point on the idea that this promotes inequality.

Why government bonds?

One of the questions we have to ask ourselves in this context is obviously, why only allow the central bank to buy government bonds (and a very limited set of other ‘save’ assets)? We obviously had this discussion in class: the Fed (or BoE, or other central bank of your choice) being able to buy stocks would give them a lot more firepower. They could reduce interest rates that are much further from zero than a three-month T-bill. Beyond that, buying stuff that isn’t issued by the government also means you’re not monetizing government debt. So here’s another argument for giving the Fed freer reign with regards to asset purchases!

Who’s afraid of government financing?

The Fed, BoE, and central banks around the world generally pay their governments yearly checks, even in times when none of their profits come from interest on government bonds. Something has to happen with their profits! Sure, if the US, England or other places had a sovereign wealth fund, that would be one place to put them, and it might be at least semi-autonomous from the government. So that’d be nice. But nobody has those, so not an option right now. But yet another reason to have them!

By the way, in better times, central banks raising interest rates hurts the government, in so far as that it has to pay higher interest on newly issued bonds. So it’s not clear that the government generally benefits from central bank actions, at least not directly (although it does reap the benefits of a smoothly running economy if the central bank does a good job and doesn’t have to worry about the ZLB).

Inequality and all that

The point about QE raising asset prices and helping the rich is actually quite interesting. For one thing, QE also reduces interest rates (that’s just the flip side of higher asset prices), so it’s not quite clear that all rich people benefit from it. Specifically, the classic rentier would actually suffer. On the other hand, people sitting on tons of assets may of course benefit. but the question is: when did they acquire those assets?

If they held them throughout the financial crisis, chances are they’re about back to break-even now, because they probably copped huge capital losses throughout the crisis. If they bought them right in the depth of it, well… smart investment on their part, but some of their profits were certainly subsidized by the central bank. The question is: did the Fed (BoE, any other central bank) have an alternative strategy, given the ZLB? Not in the absence of electronic money. And not doing anything would have prolonged the crisis. It’s not obvious to me that the middle class or the poor would have preferred a longer crisis to what we had. So as long as we’re unwilling to have electronic money – this is as good as it gets!

I think that next time (which I’m sure will be different) we should have a new set of tools at the ready. That may contain a sovereign wealth fund, a more powerful central bank, or electronic money. And maybe that way, expansive monetary policy – which was absolutely necessary, macroeconomically speaking – won’t have as many side-effects as it may have had this time around, and be more effective. But ultimately, it’s difficult to fix the economy without the rich taking their share of the recovery. And more importantly, that’s not the central banks domain; distribution is government’s domain. And if it’s unwilling or unable to act, don’t blame Ben (Bernanke, or really any other central banker)!

Thankful for Doves

The Federal Reserve transcripts from the financial crisis were recently made public. According to the Wall Street Journal, “They provide the most complete view yet into developments inside the nation’s central bank as the financial crisis worsened and threatened to plunge the U.S. into another Great Depression”. I am fascinated by this opportunity to gain a glimpse into the thought process of the Fed during such a turbulent time period. In addition to eight formal policy meetings, there were also six emergency policy meetings in 2008. Ac lose reading of these transcripts provides valuable insight into monetary policy decisions and the discussion among central bankers.

In January, Fed cut rates twice in effort to stave off crisis. According to the Wall Street Journal, “Officials acted boldly in January 2008, but spent much of the spring and summer hamstrung by uncertainty, disagreement and an unexpected inflation jump”. On January 22nd, the Fed announced a Fed funds target cut by 75 basis points to 3.5% and only eight days later reduced the target rate by 50 basis points to 3%. Although the Fed hoped these reductions would be sufficient in getting out ahead of declining markets, history shows that the Fed could have cut interest rates even further.

In March, Fed acknowledged increasing probability of a recession and the New York Fed announced it would provide $29 billion in financing for JPMorgan Chase to acquire Bear Stearns. According to the Wall Street Journal, “Exchanges between officials got occasionally testy, especially after Mr. Bernanke’s decision to help J.P. Morgan Chase & Co. finance the rescue buyout of Bear Stearns in mid-March”. Fed officials opposed to easy-money policies, also known as hawks, did not agree with all of these policy decisions. Although I respect the noble cause of hawks to prevent inflation, inflation is more likely to occur during a boom than during a recession. From the perspective of a hawk, low interest rates combined with additional Fed liquidity spells inflation. However, this really only means a larger money supply and this will not cause inflation unless households and businesses are spending.

Mr. Bernanke, who might be considered more dovish, did not hide his disagreement with the hawks. According to the Wall Street Journal, “In June, Mr. Bernanke gently chastised Mr. Fisher for voting against a decision to keep interest rates steady in the face of rising inflation. The Fed acknowledged in its statement it was alert to financial risks, as Mr. Fisher wanted, but he also wanted a rate hike”.  The spike in inflation seemed to validate the concerns of the hawks. As a result, some hawks such as Mr. Fisher became concerned and hoped to see an increase in interest rates. The increase in the price level could have been for a number of reasons such as increasing commodity prices. I am happy that Mr. Bernanke stood his ground because an interest rate hike would have likely caused a disaster.

In July, the Fed made other decisions and left rates unchanged. According to the Wall Street Journal, “The Fed held an unscheduled meeting on July 24 to discuss and modify some of its emergency lending facilities in a bid to help provide additional liquidity to markets”. Although it is easy to criticize certain decisions in retrospect, the Fed should have cut rates lower and sooner in 2008. I believe this was because the Fed did fully comprehend the amount of leverage in the economy and the complexity of certain financial instruments (i.e. mortgage-backed-securities and credit default swaps). Finally, the Fed established a target range for the Fed funds rate of 0-0.25% on December 16th. In hindsight (which is always 20/20) the Fed should have arrived at the zero lower bound sooner. Due to the inability to implement negative interest rates caused by zero lower bound, the best way for the Fed to handle a devastating recession is to cut interest rates to zero very quickly.

The decision to alter interest rates is challenging to the many different impacts it has, however, it seems to me that there was significant hesitation at the Fed while lowering rates. Although there are moments when rates need to be high to cool down booming economy, there are also moments when rates need to be low (theoretically negative, but in reality zero) to aid a weakening economy. In conclusion, there is a time and a place for everything.

Replacing the Unemployment Rate

The unemployment (UE) rate, which is a measure of the prevalence of unemployment as a percentage, is one half of the Federal Reserve’s dual mandate (the other half is inflation). Since the 2008-2009 financial crisis, the UE rate has been on the forefront of both financial and mainstream news. According to the Wall Street Journal, “[The UE rate] was used to justify the nearly $800 billion stimulus bill in 2009”. In addition, the stubbornly high UE rate was also used to defend the numerous rounds of quantitative easing. Thus, the UE rate is a key factor in decisions about fiscal policy as well as monetary policy.

In January, the unemployment rate fell to 6.6%. This is a significant improvement from its peak of 10% in late 2009. The downward trend in the unemployment rate has been cited as an indication of a strengthening economy, but there are reasons to believe it might not tell the entire story. According to the Wall Street Journal,

The unemployment rate is falling so quickly in part because of many people dropping out of the labor force. The portion of Americans who are working or looking for work has been on a downward trajectory for many years, a process that gained momentum during the recession and which puts downward pressure on ratios of both employment and unemployment”.

Who are those dropping out of the labor force? On the one hand, some are part of the aging population. On the other hand, some are discouraged workers. As the economy returns to full speed, discouraged workers will hopefully be able to find jobs and return to the labor force (while those as part of the aging population will not return to the labor force). Although the economy is returning to full employment, the level of full employment will likely be lower.

For these reasons, I have started to lose faith in the UE rate as an effective economic indicator. According to the Wall Street Journal, “The unemployment rate, in short, is one of the most consequential numbers shaping our body politic. Unfortunately, it is the most misleading”. Not only does it misrepresent the health of the labor force, but it is also put on a pedestal and given outsized importance over other statistics. For example, the UE rate declined in both the January and December employment reports despite the number of jobs added falling significantly short of projections. I think the fact that the Fed is mandated to make decisions based on the UE rate is becoming a more obvious problem. As a result, I think the Fed should consider replacing the UE rate with another benchmark that better indicates when it needs to change monetary policy.

I am not alone in this belief. At the recent FOMC meeting, Fed officials explained they will not immediately change the course of monetary policy when the UE rate falls below the 6.5% threshold. The inappropriateness of the UE threshold is because it is a function of the labor-force participation rate, which means the UE rate can become distorted by events such as the expiration of unemployment benefits. An effective replacement might be a nominal GDP target, which represents real growth and real inflation. If the Fed can successfully target and achieve 4-5% nominal growth, then we would almost be back to our growth rate before the 2008-2009 financial crisis.

Banks’ High Willingness-to-pay In Crisis

The main reason for banks being willing to pay a lot more in crisis was to avoid Fed’s discount window which is the Fed’s facility that provides banks with short-term loans, typically overnight.

Let me bring in the background: one of the main goals of central banks is to act as a lender of last resort to the banking system. In the United States, the Federal Reserve has relied on the discount window for nearly a century to fulfill this task. There are several different rates charged to institutions borrowing at the Discount Window. In 2006, the rates were: the primary credit rate (the most common), the secondary credit rate (for banks that are less financially sound), and the seasonal credit rate. Primary (set 100 basis points) and secondary (50 basis points) credit is normally offered on a secured overnight basis, while the seasonal (set from an averaging of the effective fed funds rate and 90-day certificate of deposit rates) credit is extended up to nine months.

In the article posted on Wall Street Journal, William Dudley, now-president of the New York Fed, believed that the problem with the discount window is that people view it as a risk and therefore don’t like to use it. I agree with this point of view because the discount window allows other banks to borrow from central bank – you buy in a large volume and you get a good price, but this is not the only way of raising money (capital markets can achieve this too). I also think it unfair for those Fed member banks to borrow money at a discount rate and lend it out at a much higher rate they want.

To deal with this, the Fed created an alternative way of lending – Term Auction Facility (TAF). “The average premiums that banks paid to use the Fed’s TAF or to borrow from the asset-backed commercial paper and the tri-party repo market were very similar at 44, 42 and 47 basis points, respectively.” written by Olivier Armantier, an assistant vice president in the reserve bank’s research and statistics group.

After the collapse of Lehman Brothers, the premium to borrow from the private markets instead of the discount window jumped to about 120 basis points. I think this is because the private markets also have the supply and demand effect that the markets will decide how much it’s going to pay for this debt. In the article posted by Federal Bank of New York, during the 2007-2008 financial crisis, we find that banks were willing to pay a premium in excess of 44 basis points to avoid borrowing from discount window. Discount Window stigma is economically relevant since it increased banks’ borrowing costs by up to 32.5 percent of their net income during the crisis.

In the recent research, Armantier showed that banks could have decreased their interest expenses during the financial crisis of 2007-2008 by borrowing from the Discount Window instead of from the TAF or from the financial markets. I agree with him because the interest expenses on such a large amount of money would be a great cost under the financial crisis of 2007-2008. Besides, the magnitude and opportunity cost of Discount Window stigma was very similar on whether banks borrowed from the Fed, at the TAF, or from private institutions in the ABCP and repo markets. Therefore, I think banks should make a clearer valuation before making a decision on the Fed, the TAF or those private institutions.