Morning Coffee: Time for Action on Finance

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Good morning. I'm Brad DeLong. And this is my morning coffee.

Stage I of a financial crisis involves a financial market that could be in a good equilibrium--with lots of capital committed to sane and sound financial intermediaries, a healthy flow of finance from savers to businesses, relatively high asset prices, and relatively low unemployment--or a bad equilibrium--with financial intermediaries near bankrupt or worse and untrusted, little flow of finance from savers to businesses, relatively low asset pices, and relatively high unemployment. It is the task of a central bank to (a) diminish the chances that we will ever get into a stage I financial crisis by providing incentives that motivate by punishing those who overleverage their businesses and induce moral hazard, and (b) to keep us at the good equilibrium by providing liquidity when a financial crisis strikes even if this goes against the requirement that overleverage and moral hazard be punished, not rewarded, in normal times. As long as we are in Stage I, however, a good central bank will provide liquidity--lend cash--at a penalty rate in order to diminish and punish moral hazard

Stage II of a financial crisis sees a financial market in which the good equilibrium has disappeared--but in which the good equilibrium can be brought back into existence by not just providing but flooding the system with liquidity, pushing safe interest rates way down and so pushing asset prices up. In this case, the idea that a good central bank should only lend cash at a penalty rate goes out the window. The stakes are too high. As Don Kohn said, it is not good to hold the jobs of tens of millions hostage in order to make sure a few feckless financiers get their just deserts.

Stage III of a financial crisis is when a central bank runs out of ammunition--when pushing interest rates too the floor and swapping out all of its assets does not restore the good equilibrium. Then you face a threefold choice: depression, inflation, or public intervention. Depression is to be avoided. Inflation--resolving the financial crisis by printing enough money to boost the price level far enough that all of a sudden everyone's incomes and real asset values are high enough to pay off their nominal debts--is generally best avoided too. As John Maynard Keynes wrote more than eighty years ago: "The Individualistic Capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring-rod of value, and cannot be efficient--perhaps cannot survive--without one."

And this leaves public action. If the good equilibrium has vanished because the supply of risky assets is too large for financial intermediaries to want to hold them given their capital, then the central government has to take action: to boost or to make financial intermediaries boost their capital so that they will demand more risky assets at high prices, and to diminish the supply of risky assets offered on the financial markets by guaranteeing some of them or by buying up some of them itself.

It's time to start thinking. If we don't want to wind up in a deep depression or a big inflation, it is time to think what kind of government action we do want to see, and how quickly we can set in in motion.

My name is Brad DeLong. And this is my morning coffee.

Comments

[Robert Waldmann]

I think your explanation of how inflation would help resolve the problem is too simplistic even for a morning coffee videocast. You say that it would work by increasing the price level. This would imply that it would be even better if the price level suddenly jumped up. How much would it have to increase ? I would guess much more than a few percent. But inflation that is say 2% higher for two years would have an effect which an instant 4% increase in the price level wouldn't have. It would make the lowest feasible real interest rate 2% lower. An 0.75% decline in an interest rate was huge news recently. An additional 2% between where we are and the liquidity trap (a 1 month t-bill rate 0.2% lower than it is) would be a huge difference. You don't mention it at all.

I think that for the Keynes quote to be useful, we would have to know what sort of inflation rate he was thinking of (and what sort of variance of yearly innovations to the inflation rate). If he didn't specify, that statement of his should not be taken seriously. Was he suggesting that 0.1% inflation a year would bring down the capitalist system ? If so, he was crazy, if not the level of inflation he was discussing should be included in the quote, if he disdained mere numbers (which I think likely) he did not give useful advice (in the statement you quote).

Capitalist economies have chugged along with inflation in the mid double figures for decades (Turkey) and, so far, all have survived episodes hyperinflation (IIRC). In any case, the sort of inflation rate which would make a huge difference now is slighly higher up in the single figures.

I think the need for stable prices as a measuring rod is much reduced by the rapid wide availability of decent price indices. Now inflation is a tax and transfer program with the added defect that it violates an implicit promise. Any other form of effective public action would these defects. The case that the efficiency costs of inflation are greater than the alternative can't be made without discussing the alternative.

Personally, I think the main problem with inflation is that people hate it, because they don't understand what it is. That is, I suspect that people imagine that with lower inflation they would have the same nominal wages and keep their jobs. This means that policy makers impose extremely costly anti-inflation policies. Now as an economist who wants to influence policy makers, you have to make it clear that you oppose inflation. However, you don't have to pretend that inflation that is 2 % higher would endanger capitalism.

[anonymous]

were you wearing an Obama shirt?
it is getting down to details. Professor D or others: any perspective on info below?

http://djwinfo.blogspot.com/2008/03/if-richardson-can-endorse-barack-why.html

[J. Michael Neal]

I have no problem with government intervention under certain circumstances. One of those circumstances is that there not be a bailout for shareholders. If their company is sufficiently insolvent that they need the government to purchase their assets at rates higher than the market will pay, then they need to lose their investment. I think that moral hazard arguments are overused, but this is an instance where it is a problem. Excessive risk taking, or incompetent risk analysis, needs to have serious consequences.

[Nick]

Questions from a less educated person:

How does the public buying risky assets at face value (in effect paying more money than they would be worth on the open market) not equate to the public paying off the bad debts ultimately at taxpayer expense? And if it does equate to that, isn't that the same thing as creating inflation (albeit indirectly)?

Furthermore, wouldn't this encourage investment banks to take similar risks in the future, knowing that between risking a recession and creating inflation in the form of a public bailout, the government and pseudo-government organizations will certainly bail them out at public expense if their leveraged risky investments go south? How would this not be directly contributing to, if not encouraging, the next bubble/crash event?

[touche]

We need a government agency that will confiscate foreclosed properties and convert them to cheap rental stock until the market stabilizes in, say, 2012. Once the market stabilizes, the government would gradually sell off the rental housing and any profits would be paid to the former mortgage holders.

[proton]

We need no government agency to intervene in mortgage markets. Government should not subsidize mortgage borrowers and lenders at the expense of other segments of the society. The solution to this crisis is simple: lower house prices so that they are more affordable to people. When they are more affordable, losses on mortgages will decline and financial asset prices will recover.

Lower house prices themselves should not automatically lead to a depression in economy. It is true that the value of a large set of financial assets is tied to house prices and price declines of these financial assets are currently leading to a systemic risk aversion. When the prices of these financial assets are low enough, capital will flow back to arrest this cycle. The real issue is the direction of capital away from unproductive uses such as housing to productive uses.

[bigTom]

So where do you think we are on the scale? I vote 2.9.

[kusaka]

> to boost or to make financial intermediaries boost their capital so that they will demand more risky assets at high prices,

Give financial intermediaries public money? Great idea, where do I sign up?

> and to diminish the supply of risky assets offered on the financial markets by guaranteeing some of them or by buying up some of them itself.

Another great idea. Let me get on the hpone with my broker and I will have some assets for you to guarantee or buy from me by tomorrow morning.

That palace I am building in Bahamas is closer than ever before - and just think that I had to raise through the ranks in the bank and suck up to my superiors for 20 years when the public treasury is available for looting just by screwing up.

[Punk Professor]

What was that screensaver? I never took Prof Delong for a Liverpool fan. Or Inter Milan. I assumed he was a Barca guy.

[achilleas]

Has anyone thought that about the possibility that the current turmoil can be attributed up to a certain extent to the mark-to-market regulations? In many cases the losses in financial institutions are only on paper and in some cases they might never occur. For example, usually in RMBS AAA the stress tests are quite robust, there are differences between the methodologies that the rating agencies apply but they usually assume that there is a recession on the day after the RMBS tranche is sold and that a percentage of borrowers (lets say 30%) defaults anyway. Now, if there is a panic and the the price of insuring these tranches goes really high and the value depreciates, then there are paper losses which might never actually materialize. Of course, if there is a depression they will materialize, but simply the fact that there is a panic and their value depreciates is enough to make the banks to hold liquidity and increase their reserves, therefore reducing credit lines and bringing the economy to a halt. there is an interesting article by S&P in the Ambac website:

http://www.ambac.com/pdfs/SP_Mark%20to%20market%20losses%20and%20insurers.pdf

In his book "The Roaring Nineties" Jo Stiglitz was saying that one of the reasons why the economy went into recession in the beginning of the decade was because of the accounting regulations, basically that they treated long term government bonds as safe assets, which made the banks to go into long term government bonds and they stopped lending. However when the deficit was reduced this allowed the long term interest rates to come down and the value of the bonds to go up, which recapitalised the banking system and allowed the banks to lend again. So there was a credit crunch and that was alleviated when the deficit was reduced. In the same book he also talked about considering accounting as a branch of the economics of information, so when there are bad prices you get a distorted view of what is going on in the economy.

I think that there is the possibility that the mark-to-market regulations in the GAAP might have contributed in amplifying the shock and creating a systemic crisis by causing paper losses to the entire financial system. No wonder most of the banks holding this paper chose to write down their value rather than actually selling those bonds and crystalise these losses. Lets not forget that there are mark to market losses on a lot of european instruments that actually have no problems at all. I didn't have time to think about it a lot, but i do remember a study by the Bank of England couple of years ago talking about the procyclicality of the Basle II treaty.

Finally, i think that perhaps Covered Bonds (Pfandbriefe) might be a better solution for the housing market in the US. They seem to have a better allocation of risk and the fact that no Covered Bond has ever defaulted in the 300 years since their inception is i think at least a fact that worths considering. Plus i think that the ECB accepts covered bonds as collateral, just as the Fed accepts agency paper as collateral for lending.

[Debtpocalypse]

Debtpocalypse's Law on "Kudlow Free Markets":

During a boom in financial assets, the beneficiaries insist that their ungodly riches are justified by workings of the "free market." When the inevitable bust comes, those tied to the financial asset economy insist that public monies be made freely available to backstop "The System."
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It is odd to see you reference "public action" in Stage III; as if the "flooding the system with liquidity" referenced in Stage II was... what, exactly?

"Private action"?

Don Kohn would prefer to hold hostage 100 million responsible savers and non-participants to the asset-bubble by undermining the national currency. He'd prefer to bailout the irresponsible and - gosh, what a coincidence... but only as an unintended consequence - the feckless financiers.

There's all-too-familiar koolaid in your coffee, Professor....

[achilleas]

Ok, i am copy-pasting a part of a paper published in 2005 by the Bank of Japan on the pro-cyclicality of the fair value accounting:

"The greater immediacy of fair values for capital and profitability may
become a source of procyclicality, in which the cycles of boom and bust
are amplified. In buoyant economic conditions perceived credit risk might
decline, leading to a rise in the fair value of banks’ assets, which would in turn boost bank capital and encourage an increase in lending, so strengthening the economic upswing.

These same effects would go into reverse with a vengeance in downturns. As the economy declines, perceived credit risk increases, leading to a fall in the marked-to-market value of banks’ assets, which would in turn erode banks’ capital. This will result in a credit crunch which could reinforce the downturns. A recent position paper from the European Central Bank conducts simulation exercises on EU banks’ assets and capital that suggest strong potential for amplification of the credit cycle (see ECB (2004)). The effects of fair value accounting could, therefore, have far reaching consequences for the overall stability of the economy."

The link for the paper is this one:
http://www.imes.boj.or.jp/english/publication/edps/2005/05-E-11.pdf

I have to say that this sounds a lot like the situation we are in at the moment. Huge losses for the entire financial system, but losses only on paper, since a lot of the instruments that maintain their ratings continue to pay as promised and will continue to pay as long as we dont' have a comlete meltdown. It seems to me that the mark to market acts as a built-in destabiliser of the financial system, especially if we think that we are dealling with incomplete markets and extremely illiquid assets. I have to say that i am not familiar with the entire literature on this issue but i am really puzzled about the mess we are in. I would really like to hear what others have to say about this issue.

[bigTom]

I think achileas makes a lot of sense. Of course I am NOT an economist, but I think I can recognize positive feedback when I set it. We are doing mark to market partly because we worship the market. But for the banks, this can work kind of like margin calls on a thinly traded stock, i.e. once enough investors receive margin calls the stock will rapidly be driven far below fair market value. The same process now seems to be happening on a grand scale today. As in the case of the thinly traded stock driven far below market value, we probably have some well captalized vultures waiting for the right time to purchase assets at firesale prices. Unfortunately for us the biggest of these are likely to be the Sovereign Wealth Funds. I think we need to quickly come up with an alternative to mark to market. Whatever new metric, it should be so designed that over a reasonable time period it trends toward true asset price.

[Richard Kline]

I am not in favor of central banks purchasing mortgage backed securities, at least in so many words. If these derivatives are purchased at a price level that leaves their holding institutions solvent, that's a bailout since the probable value of these instruments is well below that point: this is why the holding institutions are in-solvent. I'm much more in favor of national banking regulators, most especially in the US, nationalizing insolvent institutions as quickly as possible, including investment banks, wiping out shareholders and bondholders, and _then_ stripping out the MBSs into goverment receivership for management, renegotiation, liquidation, or what have you. The re-made institutions receive some small value in Treasuries against the surrendered radioactive securities to give them a capital base, and then they are sold back to the public when able to stand alone.

The banking system can be saved without saving existing stakeholders: they are already lost, or should be; welcome to the destructive re-creation of capitalism. The solution will take public money, but there is no way to avoid that outcome now. By nationalization, though, the public fisc may actually cushion its upfront costs by realizing something out of the underlying mortgages in the mid-term. By buying up MBSs on the open market, we save the banking system at the coast of soaking the public for the losses of the few. This is what the political argument should be but hasn't yet become: should banking shareholders take the hit along with the public, or should the public alone take the hit? I think we know how the public would vote on that one, but banking regulators are eager to avoid the appearance of a choice. Too eager.

It's past time to be thinking about interventions, and fully time to begin implementing interventions---but nationalization, not a bail 'em out buy-up. We always hear that 'it's about saying the innocent millions,' and yes, there is real truth to that: the best way to save us is to throw the feckless plutocrats out of the lifeboat so that we all can eat what lunch is left over. Let's get on with it.

[a]

Stupidity got us into this mess, so damn well stupidity can get us out?

Economists have proposed lowering interest rates since August as the solution to America's economic problems. That hasn't worked. Instead, we have seen financial firms pay out 50 billion dollars in bonuses in December and January, money which could and should have been used for recapitalization. Morgan Stanley paid out twice in bonuses the amount it raised from a sovereign wealth fund. And now, after all those interest rate cuts, which were supposed to forestall recession, we find ourselves still in a recession, but now in a recession with a liquidity trap.

So first, I think there needs to be an explanation by all those economists who screamed that we needed to lower interest rates. Why were lower interest rates called for when the real problem with the real economy is that Americans consume too much? How does one get back to the equilibrium that one needs when one's solution actually encourages the reverse? Why should we trust these economists again, when their solution has only landed us into a liquidity trap?

Secondly, depression, inflation, or government intervention are the choices, but they are not mutually exclusive. One can have inflation and then depression. Or one can have inflation and depression at the same time, if by depression one means mass unemployment of over 20%. And so with government intervention and the other two. The government can intervene - buy up all the mortgages on the market, nationalize the banks - but in doing so will cause inflation or depression if not both.

People were very smart during the Depression. They were as smart as we are now, smarter in some ways. Yet being as smart as they were, and doing the best that they could, they screwed up, in part because they didn't understand that some problems are intractable. Before offering solutions, the first question to ask is, Are we sure that what we are proposing won't make the problem worse? Life doesn't work by magic wand. There are always unintended consequences for every action. Could economists please please think those through, rather than blithely thinking that because they are so smart, their solution must be one which will work, because smart people always propose the best solutions? Maybe there *isn't* a solution, that is, a solution which has the minimal characterizations of providing what we want. The *real* problem is that Americans are consuming too much; that needs to be brought down; to bring it down, Americans will have to have the feeling they are poorer, indeed much poorer.

Anyway, I think we should let the banks and the Agencies go bust. The government intervention that is needed is to take the workforce and keep it employed, using New Deal measures.

[gordon]

We need to remember why any kind of Govt. response is thought necessary. As far as I can see, it is to prevent collateral damage to the "real economy" from the subprime crisis. Such collateral damage is generally thought to occur through a general credit squeeze resulting from banks' illiquidity (nowadays, lots of people would say insolvency, but the difference doesn't matter to the disappointed borrower who can't raise any money either for a sound new project or to keep his/her existing business going).

OK, so that is what we're trying to avoid or at least minimize. Note that proposals to bail out banks aren't aiming to bail out banks just because banks are beautiful or good for us or any other reason having to do with banks as such - only the avoidance of a credit squeeze.

Now consider Alan Blinder's proposal to revive HOLC (Home Owners’ Loan Corporation - a New Deal initiative). Note carefully that this is a proposal to refinance existing loans which are in default. Now consider that businesses which have loans from banks may also have some loans which are in default but which might, in less troubled times, be suitable for refinance. And of course there are businesses which are OK financially but need to roll over existing loans. Both these sorts of businesses will be caught by a credit squeeze, along with people wishing to buy a house for the first time.

We can now ask ourselves, if we support Alan Blinder's HOLC proposal, why the proposed new HOLC should have such a limited role. If homeowners need refinancing, so do some businesses. If some people wish to buy a house for the first time, other people are trying to set up a new business.

There may be good social reasons for concentrating on saving homeowners from a credit squeeze before anyone else, but there are no good financial reasons. So there are no good financial reasons for limiting the function of a HOLC to only refinancing home mortgages.

An expanded HOLC would look very like a new bank. But it would be a bank without the dead weight of unsaleable MBS on its balance sheet and a bank which (since it is to be a Govt. bank) could be chartered to give priority to avoiding the consequences of a credit squeeze. That is, to give priority to refinancing existing business and mortgage borrowers, and financing deserving new proposals.

Best of all, perhaps, such a new bank would avoid all the moral hazard problems associated with bailouts, while still fulfilling the fundamental purpose of avoiding or minimizing a credit squeeze.

[Craig Tindale]

Lol well at least your sounding the alarm :)

I am an economist and some of the drivel thats passed for monetary policy since the mid 90's is exactly that

Why dont you give Bernankes paper from 1999 to some of your students and ask them what the downside risk of such policies ?

here are some of my comments with quotes from his paper on the BoJ situation, Bernanke is not in Japan we need a good shot of Volker :)

I know your very bright Brad and you know exactly what I am questioning

>If you want to increase demand you just print more money and increase inflation

The general argument that the monetary authorities can increase
aggregate demand and prices, even if the nominal interest rate is zero,
is as follows: Money, unlike other forms of government debt, pays zero
interest and has infinite maturity. The monetary authorities can issue
as much money as they like. Hence, if the price level were truly
independent of money issuance, then the monetary authorities could use
the money they create to acquire indefinite quantities of goods and
assets. This is manifestly impossible in equilibrium. Therefore money
issuance must ultimately raise the price level, even if nominal
interest rates are bounded at zero.

>inflation targeting is smoke and mirrors for the markets consumption (propaganda that¡¦s self for filling)

a framework that would have avoided many
of the current troubles, I believe, if it had been in place earlier.
BOJ officials have strongly resisted the suggestion of installing
an explicit inflation target. Their often-stated concern is that
announcing a target that they are not sure they know how to achieve
will endanger the Bank¡¦s credibility; and they have expressed
skepticism that simple announcements can have any effects on
expectations. On the issue of announcement effects, theory and
practice suggest that ¡§cheap talk¡¨ can in fact sometimes affect
expectations, particularly when there is no conflict between what a
¡§player¡¨ announces and that player¡¦s incentives. The effect of the
announcement of a sustained zero-interest-rate policy on the term
structure in Japan is itself a perfect example of the potential power
of announcement effects.

>Depreciation of the yen (or in the current case the US dollar) is the theme throughout this paper

as the Japanese economy has fallen
back into recession. Since interest rates on yen assets are very low,
this appreciation suggests that speculators are anticipating even
greater rates of deflation and yen appreciation in the future.
I agree with the recommendations of Meltzer (1999) and McCallum
(1999) that the BOJ should attempt to achieve substantial depreciation
of the yen, ideally through large open-market sales of yen.

>creating import price inflation

Through its effects on import-price inflation (which has been sharply negative
in recent years), on the demand for Japanese goods, and on
expectations, a significant yen depreciation would go a long way toward
jump-starting the reflationary process in Japan.

>a determined central banker can cause the currency to deprecate

The important question, of course, is whether a determined Bank
of Japan would be able to depreciate the yen. I am not aware of any
previous historical episode, including the periods of very low interest
rates of the 1930s, in which a central bank has been unable to devalue
its currency.

>how do you drive down your own currency ?

In short, there is a strong presumption that vigorous
intervention by the BOJ, together with appropriate announcements to
influence market expectations, could drive down the value of the yen
significantly. Further, there seems little reason not to try this
strategy. The ¡§worst¡¨ that could happen would be that the BOJ would
greatly increase its holdings of reserve assets.

>or if you want to keep the currency strong you can divert money to domestic households (or the home equity atm)

Suppose that the yen depreciation strategy is tried but fails to
raise aggregate demand and prices sufficiently, perhaps because at some
point Japan¡¦s trading partners do object to further falls in the yen.
An alternative strategy, which does not rely at all on trade diversion,
is money-financed transfers to domestic households¡X-the real-life
equivalent of that hoary thought experiment, the ¡§helicopter drop¡¨ of
newly printed money.

>growth in money equals inflation like we have all been saying

I think most economists would agree that a large
enough helicopter drop must raise the price level. Suppose it did not,
so that the price level remained unchanged. Then the real wealth of
the population would grow without bound, as they are flooded with gifts
of money from the government¡X-another variant of the arbitrage argument
made earlier. Surely at some point the public would attempt to convert
its increased real wealth into goods and services, spending that would
increase aggregate demand and prices. Conversion of the public¡¦s money
wealth into other assets would also be beneficial, if it raised the
prices of other assets.

>taxes go up and spending goes up its neutral

The newly circulated cash bears no interest and thus has no budgetary
implications for the government if prices remain unchanged. If instead
prices rise, as we anticipate, the government will face higher nominal
spending requirements but will also enjoy higher nominal tax receipts
and a reduction in the real value of outstanding nominal government
debt.

>you don¡¦t need to increase taxes you just raise inflation so that the lower taxes provide increased govt revenue because there is more money

To a first approximation then the helicopter drops will not
erode the financial position of the government and thus will not induce
a need for extraordinary future taxes.

>So you cut taxes and increase monetary supply

Of course, the BOJ has no unilateral authority to rain money on
the population. The policy being proposed¡X-a money-financed tax cut¡X-
is a combination of fiscal and monetary policies.

> So the world would need to inflate together

All this means is that some intragovernmental cooperation would be required. Indeed, the
case for a tax cut now has already been made, independent of monetary
considerations (Posen, 1998); the willingness of the BOJ to purchase
government securities equal to the cost of the tax cut would serve to
reduce the net interest cost of the tax cut to the government, possibly
increasing the tax cut¡¦s chance of passage.

> It¡¦s the role of the central bank to stabilize prices

In financing a tax cut, the BOJ would be taking a
voluntary action in pursuit of its legally mandated goal, the pursuit
of price stability. Cooperation with the fiscal authorities in pursuit
of a common goal is not the same as subservience.

>but in the process don¡¦t bail out poor ly managed banks

In thinking about nonstandard open-market operations, it is useful to
separate those that have some fiscal component from those that do not. By a
fiscal component I mean some implicit subsidy, such as would arise if the BOJ
purchased nonperforming bank loans at face value, for example (this is of
course equivalent to a fiscal bailout of the banks, financed by the central
bank). This sort of money-financed ¡§gift¡¨ to the private sector would expand
aggregate demand for the same reasons that any money-financed transfer does.

> and the Central Bank cant do that kind of thing anyway

Although such operations are perfectly sensible from the standpoint of
economic theory, I doubt very much that we will see anything like this in
Japan, if only because it is more straightforward for the Diet to vote
subsidies or tax cuts directly. Nonstandard open-market operations with a
fiscal component, even if legal, would be correctly viewed as an end run
around the authority of the legislature, and so are better left in the realm
of theoretical curiosities.

>so instead you purchase assets eg bonds at market value this way you raise asset prices and in turn stimulate spending (does this sound familiar)

A nonstandard open-market operation without a fiscal component, in
contrast, is the purchase of some asset by the central bank (long-term
government bonds, for example) at fair market value. The object of such
purchases would be to raise asset prices, which in turn would stimulate
spending (for example, by raising collateral values).

>So maybe the fed could start purchasing foreign currencies then they could deprecate it owns currency

I think there is little doubt that such operations, if aggressively pursued, would indeed have
the desired effect, for essentially the same reasons that purchases of
foreign-currency assets would cause the yen to depreciate. To claim that
nonstandard open-market purchases would have no effect is to claim that the
central bank could acquire all of the real and financial assets in the
economy with no effect on prices or yields.

>So the central bank begins acquiring targeted asset which rise in value

Of course, long before that
would happen, imperfect substitutability between assets would assert itself,
and the prices of assets being acquired would rise.
As I have indicated, I doubt that extensive nonstandard operations will
be needed if the BOJ aggressively pursues reflation by other means. I would
hope, though, that the Japanese monetary authorities would not hesitate to
use this approach, if for some reason it became the most convenient.

>and this in turn would be neutral to the central banks balance sheets

It is
quite disturbing that BOJ resistance to this idea has focused on largely
extraneous issues, such as the possible effects of nonstandard operations on
the Bank¡¦s balance sheet. For example, BOJ officials have pointed out that
if the BOJ purchased large quant

[bob]

"Markets are even worse for panic reasons bred out of uncertainty than they ought to be on reasoned grounds" Keynes , September 1931

Some excellent discussion points have been made. The choice between financial stability and moral hazard in a credit crisis is a challenging one.But any central bank or government worth its salt would not immediately bailout the risk takers at prevailing par value but at a deep discount (essentially to get more "bang for the buck" for its policy action).If a bailout occurs at par or sunk cost, then its crony capitalism of "privatise the profit and socialise the loss". Given Bear Stearns rapid and painful demise for their employees and shareholders, the argument of moral hazard is not an immediate concern.
Now is not the time for petty recriminations under the watch of the "moral hazard majority", but to understand the US crisis and mitigate the impact on the global economy. As an outside observer (OZ economist), I have profound reservations that any one particular policy measure (lower interest rates, recapitalisation of the wounded financial institions , the bailout or nationalisation of the terminally ill or even the FED buying MBS) will immediately restore financial stability. This caution that there is one miraculous policy prescription reflects the confusing mix of government and private firms across the globe that is involved in this mortgage meltdown, extending from America's GSEs and investment banks to German state banks and Australian hedge funds...

However all of us should observe a Federal Reserve that is actively and aggressively responding to this crisis by cutting interest rates and now starting to use its balance sheet.This is of longer term benefit for all of us. Is more needed ?? That's the US$11 trillion question for the US mortgage market. But at the very least we have a FED not acting as though this is 1931 and fighting the last war in inflation. To reduce uncertainty, the FED also need to insure that all finacial institutions involved in US financial markets account for and disclose their impaired assets, otherwise we will have a contining slow train wreck of doubts and rumours that leaves even the solvent under suspicion.

To say that the Fed or US Governemnt has run out of ammunition so soon in this crisis is defeatist and detrimental. Let me close with some wiser words from FDR that governments and policymakers need to aggressively involved in these crisis rather than watch the tide of prosperity recede ...
" Better the mistake of a govenment living in the spirit of charity, than the constant ommissions of a government frozen in the ice of its own indifference"

.

[Matt]

My situation is a microcosm.

I sold a house and financed it for the borrower. The borrower works for the local county government. The borrowers wife works for in the state disability legal area, both jobs subject to ultimate tax collection.

She lost her job, and the county is starting to cut back on its local department costs, because the government cannot get property taxes.

I let my borrower slide a month or two, I did this by simply delaying my property tax payment for a while.

Working for the government was the second largest job opportunity in this central California county, has been for three years past. Most of these extra jobs come from the federal legislature money, 911 money, which among other things bought a lot of Camaros for the local police, and they sit parked at the local substation.

The problem is the massive growth in government under conservatives, and the solution is a whole lot less of their increase in government. We have more government under Bush (either Bushy, and throw in Reagan) then we can afford.

The solution to the mess is a reduction in government to the relative levels under Clinton, or better. The effect would be to release resources to the private sector which could then recapitalize without the huge burden of government costs hanging over their head.

[craig tindale]

Meddlesome monetary policy without fiscal responsibility is part of the part of the problem

DeLong , Bernanke and co are part of a cult of meddlesome monterarists, cutting interest rate, money funded tax cuts, monetary transmission to the consumer through the asset channels, etc etc are all about steering the consumer toward consumption.

The "moral hazard" is in terms of the mal investment, when policy leans to easily toward the monetary measures and allows the government be soften on fiscal restraint it creates the policy physics for credit bubbles

There have been some monumental screw ups in monetary policy over the last 10 years with repercussions that were well identified by Keynes, Minsky, Schumpeter etc etc

Bernankes paper I mentioned and quoted above is impossibly naive in what it doesnt mention, most of his work assumes an ideal world without risk and with neutral trading partners

These are the brilliant ideas are the ideas of the Fed Chairman

You folk are destroying your own country with ill conceived monetary policy snake oil

Krugman and Delong suggest its now a political solution

I would suggest it cant be fixed that way either

The only way to fix it is the old fashioned way, sure soften the blow but the axe still must be swung.

[John]

If intervention is necessary, it seems to me that there are much cheaper ways of insulating the real economy from these problems than finding a way to pour enough money into the bad paper the existing set of players produced to somehow get them to return to status quo ante behavior. The financing demands of the non-financial sector are beginning to seem small in relation to the amount of capital required to prop up the money center banks and large investment bankers.

I see in the Flow of Funds borrowing tables that the non-financial business sector borrowed an average of $500bn annually over the last ten years. State and local governments averaged about a hundred billion per year. Consumer borrowing was way above trend, thanks at least in part to the wizards who brought us this crisis, and there is a strong case to be made that a return to trend behavior in borrowing and consumption might not be such a bad thing there.

Those numbers are about the same order of magnitude as what the Federal Reserve has been committing to propping up the speculative financial sector. They have arranged extraordinary credit lines amounting to a couple of hundred billion in credit facilities for the commercial banks, around the same for the investment banks, and $30bn to guarantee Bear Stearns' bad paper alone. So far there is little evidence that the credit markets relied on by the non-financial business, consumer and municipal sectors are functioning well enough to leave alone.

Or if they are returning to normal, then why the panic, why the calls to commit taxpayer dollars to a rescue plan? The hostage proposition on which a looting strategy depends is based on the argument that the real economy will fail along with the credit market players who have invented this crisis.

Given the actual financing needs of the real economy, I don't see why, with a little creative thought, the problems of counterparty risk in the CDS market, valuation questions for CDOs, any of the mumbo-jumbo heartburn issues need to matter a bit more than what the gamblers at InTrade think about who will win the Democratic nomination.

There is a military maxim that one should never reinforce failure. So far, I've been unable to see proposals that do anything but that. If we are concerned about commercial paper or municipal finance markets seizing up, why not target interventions to commercial paper and municipal finance markets?

If we are going to accept the proposition that government agencies will be in the business of supporting markets, then let them support the necessary and relatively healthy markets directly. A strategy that calls on taxpayers to absorb enough credit risk to cause the benefits to trickle up to financial elites who will then return to lending them the money they need to run their businesses will probably work as well as the trickle-down theories of the speculative boom that preceded this crash.

I think that we could find alternatives based on supporting the stronger areas of the banking system and the parts of the credit market that are really needed by the non-financial sector, and that these would be less expensive, more effective, more fair to taxpayers and much easier to justify politically than the path we are on. As for the wizards who have apparently bankrupted themselves with their perpetual motion machines - "you have sat here too long for any good you have done. Depart, I say..."

[nanya]

> As for the wizards who have apparently bankrupted themselves with their perpetual motion machines - "you have sat here too long for any good you have done. Depart, I say..."

I pulled from the shelf an old book written in 1991 entitled "Generations - The History of America's Future, 1584 to 2069". In Chapter 5, the authors present the theory that secular crises occur (roughly) every 4 generations:

The Armada Crisis (1580 - 1588)
The Glorious Revolution Crisis (1675 - 1692)
The American Revolution Crisis (1773 - 1789)
The Civil War Crisis (1857 - 1865)
The Great Depression - World War II Crisis (1932 - 1945)

These events are spaced (in average) 88 years apart. So the next one is due in 2020. We're getting there...

[halbhh]

Profoundly missing from the analysis is whether the "high asset prices" are in fact an equilibrium.

That's likely an illusion if applied to house prices in 2005 or 2006.

To be an equilibrium, the median house price in a locality would need to correspond to historical knowledge of the limits of affordability. Completely independent of interest rates is just whether a family can sustain, over years of time, mortage payments over 30% of available monthly income.

History says not generally -- that is, defaults rise sharply above 30% of income.

This is quite a missing piece. It's missing from most of the analysis by most parties in positions of power and influence.

This would make sense if they are well above middle class incomes and/or have held their homes for quite a while, and didn't buy well in excess of 30% of income. In other words, they have little idea of whether median houses are affordable (sustainable) for median family incomes.

In other words, many people in public influence positions lack perhaps the single most important piece of knowledge for this situation.

[Andrew]

If you believe Brad's thesis that we are at stage three and on the verge of public action, do any of the posters on this thread have any advice on how one should position their investment portfolio? Do you buy financials because they will be bailed out? Do you buy gold, emerging markets, foreign currencies because public action will futher erode the value of the dollar? Thanks in advance for any thoughts.

[nanya]

I see no reason why salaries should not rise in the future, especially with Democrats in power. There are several analyses that suggest that we are entering an era in which government will take a more active role in infrastructure investment, economic and financial system stability, etc. Hell, if government has bailed out Bear with public money, then it will be regulated just like banks are. (Anyway, this is just an example of how such analyses are coming true.)

So yes, as a result of government action with an agenda leaning towards a social system, salaries should also rise to keep up with the higher RE prices that result from MBS purchases. But this will not happen overnight.

Perhaps a good way to position your portfolio is to buy RE. I would like to know the details of such an MBS purchase plan before deciding if, when, and for how much.

[Nick]

To Andrew:

As far as I can tell (not an economist, just an observer), there are not too many safe places for money when you expect high inflation. Say we assume we're going to get a public bailout (seems fairly safe bet), the government will increase spending to keep the GDP up and keep people employed as businesses collapse (seems equally likely), and Benny flies around in his helicopter, redistributing wealth. Ignoring hedonic regression and other manipulations to make the CPI lower than actual inflation, say inflation runs at only 10% annually (I'd guess closer to 20%, but that's just me).

I wouldn't buy financials, because even when they get bailed out, their stock will probably be worthless (only the executives will come out wealthy from salary/bonuses). Foreign stocks/currencies will do well, but only if they are not pegged/related to the dollar, and only if their large companies do not have US-industry based investments. Commodities may do well, but they are realistically limited at production cost, since additional production is usually not limited by anything other than market. Inflation-protected treasury securities will probably offer great returns, but remember they will be less than actual inflation, due to hedonic regression and the other BS tricks to make the CPI lower than real inflation.

Also, remember taxable income is not after devaluation, so you will need to make roughly double inflation on your investments to break even (depending on your tax situation). The best bet, if you can do it, and as high-end investors have already figured out, is move out of the country during periods of massive inflation, preferably to somewhere with less inflation. I'd guess the next best bet is law firms and other legal service based industries, since their income will rise with real inflation and they stand to make huge profit when everyone sues everyone else as the government literally re-writes contracts and arbitrarily manipulates public company valuations as they bail out banks.

Other than that, your best investment might be in lobbying to get people in public office who do not endorse or propose public bailouts, government intervention in market (which is usually the same thing), or any other sort of loosely-disguised wealth re-distribution or socialization. I hear there's an election coming up somewhere...

[gordon]

John, I think you and I are on the same wavelength - see my earlier comment. How would you go about "supporting the stronger areas of the banking system and the parts of the credit market that are really needed by the non-financial sector"?

[phil]

Dear Professor;

The screensaver is very distracting. It's like when somebody in a clown suit dances around in the background of a news reporter on the scene of an event. There's a reason the pros don't let that happen, because it devalues and/or colors the remarks of the on-camera commentator. There were more than a few images that made me think WTF is going on with this guy while listening to your comments.

The "sipping the coffee" affectation is fine, in sort of an Andy Rooney, 60-minutes sort of way, and goes with the theme of a quick comment over a morning coffee, but the screensaver's got to go.

If your point is that the commentary is what's interesting and relevant, fine, just post some audio, but if you're going to do video, just remember that a large part of the content in video is the image whether you want it to be or not.

[Blissex]

«Economists have proposed lowering interest rates since August as the solution to America's economic problems. That hasn't worked. Instead, we have seen financial firms pay out 50 billion dollars in bonuses in December and January, money which could and should have been used for recapitalization.» That's a Communist argument! All that money has indeed been used to recapitalize bankers who can now afford the much better lifestyle that they fully deserve. That's how the American Way works: the winners win, and the losers pay the bills. All those bonuses are owed to the winners because of all the CDOs and other products they have put together and sold over the past year -- they have to be rewarded for all that high productivity, and low interest rates have been just the way for the government to make sure that financial institutions could make margins to pay all those bonuses. The winners were owed in their contracts lots of money for their productivity in making derivatives and working around regulations, and it would be Communism to suggest that the government should not help banks pay out what they owe to their executives and traders.

[Andrew]

Does anyone find it likely that the Treasurey will use the GSE's to buy up garbage mortgages, backstopping them the same way they did JPM, but with more money (ie., the treasury will absorb the first XXX billion of losses)? Would this not be a huge windfall for the GSE shareholders?