Saturday, February 13, 2010

What is the Fed Trying to Do?

Arnold Kling commented on Ricardo Reis' new paper on Fed policy in the crisis, saying that the Fed is no longer a central bank, but rather a piggy bank.
Rather than try to come up with an economic theory to explain Fed policy, I would suggest a more cynical approach. The goal has been to transfer wealth to banks and to the holders of mortgage securities. The thinking is that those constituents are more important to the economy than taxpayers.
Bryan Caplan asks if this is the reason for Sumner's Parodox.

Pre-crisis, Scott and Ben were in almost perfect agreement. But when the crisis hit, Bernanke seemed to suddenly come down with amnesia. What's up with that?
Caplan sees Kling's approach as being a conspiracy theory.
Bernanke's running the economy into the ground on purpose in order to help his new cronies? Arnold's story fits the facts, but it just seems too conspiratorial. Does anyone want to convince me, one way or the other?
What is Reis' paper about? Reis tries to explain the Fed's policies over the last three years. He divides the policies into three parts. There is the traditional interest rate policy. The Fed set interest rates to prevent output gaps and stabilize the inflation rate. Then there is the Fed's "quantitative" policy. This would be what I would call, "quantitative easing." Reis, being a conventional macreconomist, sees the quantity of bank reserves as irrelevant. Currency? What currency? And then finally, there is "credit policy." This is about the particular assets that the Federal Reserve holds. My comment will focus on Reis' analysis of Fed credit policy.

Reis develops a model that includes entrepreneurs, lenders, traders, and investors. Households purchase consumer goods from the firms, provide labor to the firms, and serve as investors. The entrepreneurs fund production, primarily hiring workers, partly with loans from the lenders. The lenders fund loans partly by selling securities to the traders. The traders fund their security holdings partly by accepting deposits from investors.

So, households purchase short term commercial paper from Lehman Brothers. Lehman Brothers buys securitized loans from Wachovia. Wachovia makes loans to GM. GM hires workers and produces cars. Households, of course, work and buy cars from GM.

If this chain of finance works more or less perfectly, then the households will work and purchase and utilize cars at the optimal level. Because households are unable to monitor firms or lenders, if the system breaks down, investors will directly purchase securities instead of making deposits with traders. The banks and entrepreneurs will fail to allocate resources properly. More generally, the financial system is constrained, and not enough funds are flowing from the households (investors) to the traders, to the lenders, and to the entrepreneurs. Too little work is done and too few cars are consumed.

Households don't buy enough short term commercial paper from Lehman Brothers, which doesn't buy enough securitized loans from Wachovia, which doesn't lend enough to GM. So GM hires too few workers and produces too few cars. And households work too little and consume too few cars.

It turns out that lending to the traders, (Lehman Brothers) is the most effective way for the Fed to help overcome these constraints!

Of course, I would think that "traders" would buy securitized loans from the lenders and sell them to the investors. The purpose of loan securitization is to have households directly bear the risk of holding shares of the loans made to the entrepreneurs. Having the "traders" serve as financial intermediaries, accepting deposits from the investors and funding securities, sounds a bit like the traditional role of "lenders." (Of course, Lehman Brothers and the other investment banks did sell short term commercial paper and use it to fund portfolios of asset backed securities.)

Where I think the model fails is that investors (households) are not permitted to deposit funds at the lenders. Lenders are not able to directly tap the funds of households (using, say, FDIC insured deposits) and then lend them to the entrepreneurs.

In my view, during the financial crisis "investors" (households) shifted funds from "deposits" with "traders" (like Lehman brothers,) and moved them to FDIC insured deposits with "lenders" like Wachovia. What's the problem? The lenders can still fund the entrepreneurs.

The actual problem was that "the lenders" (Wachovia), were holding large portfolios of securitized loans, and after taking losses on them, had capital constraints. Loosening (rather than tightening) capital regulations on lenders, and using FDIC to reorganize insolvent lenders, would have been more obvious solutions.

Further, when the investors no longer deposit funds with the "traders," what do they do with the funds? In Reis' model, they save them. Oddly enough, there is never a problem with demand. Households earn wages and use the funds to purchase all of the consumer good produced. The model has three periods, and the purchase of goods occurs when they are completed during the third period. The problem is that the entrepreneurs need funds during the first two periods.

However, in the real world, firms are selling output continuously. Suppose, households purchase consumer goods now with the funds they would have deposited with the "traders." Then, the entrepreneurs receive these additional funds when they sell their products now, proving funds to pay workers that are producing goods to be sold in the future. In the model, entrepreneurs do have their own capital for self-finance, but the model has no mechanism for firms to increase their ability to self finance by earning increased profits because of increased sales.

Suppose the Fed was stablizing nominal expenditure. The credit constraint described in the Reis model results in less production. With nominal expenditure unchanged, less production implies higher prices and unchanged revenue. With Reis' model, less production implies less wage cost. Profits expand--providing entrepreneurs with funds to self finance.

In my view, the financial crisis disrupted credit markets. I think that this likely resulted in a less than optimal allocation of credit and investment. I think this somewhat depressed the productive capacity of the economy. However, I don't think lending money to insolvent traders was desirable, much less necessary. It is the limits of Reis' model, making "traders" the sole conduit of funds from households to entrepreneurs, that creates that illusion.

To what degree is mainstream macro about developing formal models to show the value of whatever it is that the Fed is doing?


  1. Insolvent traders should be reorganized by converting their debt to equity and preserving their going concern value.

    In my blog I argue that the primary role of QE and credit easing is to increase AD and should reduce the time the short term interest rates have to stay at very low levels. Reis completely misses that.

  2. The Money Demand:

    Thank you for your comment.

    I agree that shifting debt-holders to equity holders is the sensible approach to reorganizing financial firms. If the new owners want to wind up the firm, then let them.

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