A bit off the Paulson plan topic, but not entirely …
Not a day has gone by since this crisis began that I haven’t been thankful that Ben Bernanke is the chairman of the Fed; had events gone a bit differently (thank you Harriet Meiers!) the post might well have gone to some unqualified Bush loyalist.
That said, the Fed’s experience in this crisis has been humbling; getting traction has proved harder than BB himself suggested in his pre-crisis writings. Here are my thoughts on why.
So: we usually don’t think of it this way, but the Fed can be seen simply as one of many players in the financial market. It’s a very big player, but not that big compared with the market as a whole — the Fed has roughly $800 billion each of assets and liabilities, in a $50 trillion credit market. And conventional monetary policy consists, basically, of enlarging or contracting the Fed’s balance sheet. Why does the size of a financial player constituting less than 2 percent of the credit market matter?
The answer is that the Fed’s liabilities are special: nobody else has the right to create monetary base, which can in turn be used either as currency or as bank reserves. When the Fed expands the money supply, the key thing isn’t that it’s buying Treasury bills, it’s the fact that it’s doing so by expanding the monetary base, which increases liquidity to the economy as a whole.
But in March, and again this week, interest rates on T-bills fell close to zero — liquidity trap territory. What does that do to the Fed’s role?
You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills — the two sides of the Fed’s balance sheet — become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent.
But why not purchase stuff other than T-bills? This can be thought of as changing the composition of the Fed’s balance sheet, rather than enlarging it; and Ben Bernanke, in happier days, thought that might be an effective policy in a liquidity trap.
There are, however, three reasons to be doubtful about this stuff:
1. The Fed is now trying to move a much bigger rock: it is, in effect, trying to raise the price of financial assets other than T-bills by selling T-bills and buying other stuff. There’s only (yes, “only”) $800 billion of monetary base. There are, by contrast, many trillions of stuff other than
T-bills, so the Fed has to make huge changes in its balance sheet to achieve any noticeable effect.
2. T-bills and other assets, such as long-term bonds, are probably much better substitutes for each other than T-bills are for monetary base — money is unique as a medium of exchange, whereas once you get past that you’re only talking about competing stores of value. So it should take much larger changes in relative supplies to get major changes in asset prices.
3. The reason T-bills are an imperfect substitute for, say, corporate bonds — to the extent they are — is risk. Therefore, the reason changing the composition of the Fed’s balance sheet can move prices, to the extent it can, is because the Fed is taking on risk. This isn’t a role the central bank is meant to play; you’re sliding over into fiscal policy.
Nonetheless, I guess the Fed had to try the “Bernanke twist.” And it did — the old Fed balance sheet, in which T-bills were the vast bulk of assets, is no more. But the effects have been disappointing, especially weighed against the risk, which I know is making Fed officials very nervous.
And now, with the Paulson plan — about which I have my doubts — responsibility is clearly shifting from the Fed to the fiscal authorities.
So Ben Bernanke came into his current position believing that central banks have the power, all on their own, to fight Japan-type problems. It seems that he was wrong.
15 Comments
Seems to me that a government of the people would intervene at a different point in the process, by supporting homeowners and helping them with their mortgage payments, thereby infusing the needed capital via individual familes and providing the stability of the market that will break that vicious cycle of devaluation. Any windfall would be sent to those who need and deserve it most instead of to fund golden parachutes.
Can you envision a plan that would employ this approach, and do you think it has any merit?
— GreenVTsterProf Krugman, are you suddenly going Austrian?
The ultimate issue is bank and financial institution solvency and bad balance sheet, so just like what happened after the telecom crash it will end up in a forced debt-for-equity swap or an outright nationalisation.
Now that Goldman Sachs and Morgan Stanley have become normal Bank Holdings, a forced swap might be easier to implement. And that is neither the Japanese solution, nor the one Bernanke had hoped might work.
— Hendrik RoodWhat if the central banks starts to swap corporate bonds directly to newly printed cash. (Not at face value, naturally.) What happens to a central bank if the risks are realized? Except that it can no longer get the liquidity back, and a massive moral hazard.
— Reino RuusuWe have to let the bank collapse happen. Pouring money in isn’t going to stop it any more than it did under Hoover.
Direct aid to homeowners, industrial businesses, and so forth is the only way to avoid letting the financial crisis hurt real companies and real individuals. Essentially, the financials are so toxic we have to replace them, at least for now, as an element of the financial system.
In the future, we have to regulate anyone who borrows short and lends long as a “bank” (with much stricter capital requirements than now), and anyone who offers a payment on an unlikely but “bad” event as an “insurance company” (with national regulations to avoid regulation-shopping). That would fix the long-term problems, and as soon as all the overleveraged financials go bankrupt, everything will start to recover. Until then, direct loans to non-financial businesses will cover all problems.
— Nathanael NerodeBernanke is certainly not a political hack like AG Gonzalez or the countless Bush appointments to less-visible positions. But Bernanke would not have been appointed unless the Bush administration was confident that he would not make decisions contrary to their interests and philosophy (such as it is). Think about what that implies, if you disagree with Bush administration economic policies.
So Bernanke thought that central banks could fight Japan-type problems and presumably have some success in it. He said explicitly that the Fed could have prevented the Great Depression and pledged that it would not be repeated. But the Fed did not prevent the depression and the BOJ did not prevent the very severe Japanese slump. Evidently Bernanke was convinced that he was the true Maestro, and could succeed where others have repeatedly failed in the past.
In reality he began denying the housing and credit bubbles as soon as he took office. Even if he really understands what went on in the Depression, this is irrelevant if he can’t see what is going on under his nose.
If if the Fed really has the power to do all the things which it is reputed to able to do, it seems that the Maestro who can actually wield this power consistently in a constructive way has not been born yet.
“It seems that he was wrong.” Was he the only one?
— skeptonomistWhy does Harriet Meiers get credit for the appointment of Ben Bernanke?
— Tom TaylorI wouldn’t say Bernanke was “wrong” that he could fight Japan-type problems. I’d say his initiatives, especially the TAF, have had large and beneficial effects. It’s just that, as you say, he doesn’t have enough money to fix a problem of this magnitude. The housing price collapse will probably cost around 6 trillion, if prices revert to pre-bubble norms. Not all of this, probably not even most of this, will fall on the financial system, of course, but it’s no surprise you can’t block the damage with a 800 billion loan which is constrained to be conservative and accept only low risk.
— FairEconomistExcellent analysis, as usual, but I want to question a premise: That there is no willingness no lend.
I live in California. If a family that makes 80K per year walks into a bank ans asks for a mortgage of 630K to buy a house of 700K, they will be shown the door. How horrible is that?
But if their income were $230 per year and wanted to get the same mortgage, the banks would roll out the red carpet competing who would give them a loan! From where I stand, there is plenty of money to lend to anyone with a reasonable chance to repay.
By the way, what happened to Bernanke’s “savings glut”?
— TortoiseIt is time to consult ecologists and natural philosophers–eg, Garrett Hardin–to bridge the large, unsustainable gap between the “physics” of economic reality and the seemingly random aspects of Game Theory that current policy engages. The take-home paraphrase of Dr. Hardin is: virtually all fortunes are made by privatizing profit and socializing costs. I’ve seen many systems that soften the edges of that observation but none that refute its basis.
— Steve EngberSo the Fed is taking on risk? What, exactly, happens if the risk blows up and the Fed ends up with more liabilities than assets- if it goes under? Do the markets panic? Does the Fed become unable to operate? Does it have to go and ask Congress for a bailout? Some more insight on this would be nice.
— IrisProfessor Krugman, how do you reconcile your pessimism here with your advocacy in the late 90s for escaping a liquidity trap via having the central bank increase inflationary expectations? You seem to be saying now that what you were advocating for Japan in 1999 won’t work for the US today, but I am missing the explanation.
— RaskolnikovIf I understand correctly, one lesson of the 1930s was to try to not contract the money supply and so support asset prices, confidence and economic activity.
But the other larger lesson was that when the income distribution becomes more unjust, investment grows (creating bubbles)but demand shrinks (the people with a bigger share of GDP have lower propensities to consume). The problem fundamentally is that the mass market for houses cannot afford current house prices (much less top of bubble previous prices). Since house prices are therefore above the fundmental value dictated by supply and demand, the so called toxic mortgage paper is not underpriced at all, it is still probably overpriced. The cash flows called for by the mortgage contracts will never be realized. Average losses on foreclosed properties have been about 40% of the loan balances. That loss percentage will rise as the housing market falls in the debt deflation crisis scenario (more REO for sale). Somebody has to take a hit.
It will be healthy if the people who did the deals go broke and are flushed out of the system. If they are not, they will keep doing it, keep generating more bad paper. There has to be market discipline in a market economy. No way around that. Sorry. Lot’s of pain. Only question is how to allocate the pain. The Japan lesson is do it quick and get people back to work. The Sweden lesson is take control. But the U.S. problem is worse than either of those. What we have to do is decide who will be poorer at the end of the day.
— Max KummerowA FIX FOR THE LIQUIDITY TRAP?
What if the Federal Banks directly lended to homeowners, investors of real estate, and small businesses at 2% – 3% APR?
Now, homeowners adn real estate investors save hundreds of dollars on theri monthly payments. Those close to foreclosure may be able to keep their homes. Homowners and investors not on the edge just increased their disposable income. They can make improvements on their properties, rentals, or spend additional funds to stimulate the economy.
Small businesses would lower their borrowing costs allowing them to keep their doors open. Would this entice entreupreneurs to create other small business ventures and create more jobs?
The Fed would just have to print more money adn put these new instruments on their balance sheet.
As more people could afford to buy homes financed at the lower APR, teh housing market would turn around, foreclosures wouls be bought up and banks would have them off their balance sheets.
We would be back in inflation.
Does anyone have thoughts on this? Wouldn’t this solve our liquidity trap?
— K. DurhamThe mathematical conditions of a Keynes’ Liquidity Trap, we found, is when long-term interest rates get so low as not to compensate the lender for his interest risk.
We found that as long as there is such a thing as credit the economy will stay in a Liquidity Trap.
Remember Japan Lost Decade is already 15 years old.
There is One Solution That Works:
A Credit Free, Free Market Economy
— Adam Smithhttp://www.17-76.net/
but the quantitative easing could do some other good things. Why not start retiring the national debt by printing money? eventually you will jumpstart inflation if you retire enough of the debt.
— Caldem