Here is an interesting quote:
Ben Shalom Bernanke was raised a druggist’s son in Dillon, South Carolina, a city (today) of 6,800. He studied the Depression as a graduate student at MIT, and as a young academic earned his reputation by expanding on Milton Friedman’s classic monetary history. According to Friedman, the Fed’s failure in the 1930s was a matter of not printing enough money. Bernanke deduced that the real failure was letting the banking system implode. “What Bernanke discovered was that it wasn’t the quantity of money, it was that the banks stopped lending,” says Stanley Fischer, formerly Bernanke’s thesis adviser at MIT and currently the governor of the Bank of Israel. “More than the decline in money, it was the collapse of credit.” The implication was that regulating banks in good times—and, if need be, rescuing them in bad—was of prime importance, something Bernanke would remember in the 2007–09 crisis.
When will economists recognize that Friedman was right and Bernanke was wrong? Or rather, the problem is the growth path of Nominal GDP, and bailing out the banks while letting nominal GDP fall to a lower growth path doesn't fix the problem.
If the problem was that banks stopped lending, then one wonders why the Federal Reserve started paying interest on excess reserves. Moreover, the interest rate offered on excess reserves was competitive, given the circumstances, with alternative uses.
ReplyDeletePlease understand, I have no objection to the Fed paying interest on reserve balances (not just excess reserves), but 2008 was not the time to start doing it and, in any case, the interest rate should probably have been negative. If the goal is to prevent bank lending from seizing up, then why pay banks competitive rates to not lend?
I understand the Fed was concerned about losing control of the federal funds rate, but was it really worth it? If the whole recession was caused when banks stopped lending, and rectifying that means temporarily losing control of the federal funds rate, isn't it worth it? How does one come out of that cost-benefit analysis with the conclusion that it's better to have a recession?
Maybe the Fed introduced interest on excess reserves because it was concerned about the inflationary potential its unprecedented expansion of the monetary base. Fair enough. But there is an easy solution to that problem: expand the monetary base less. As it happens, the Fed's actions appear to have more than compensated for any inflationary concerns, since we had a brief period of deflation and unusually low inflation ever since.
The only way it makes sense is that the Fed wasn't actually concerned with bank lending at all. It was concerned with shoring up the balance sheets of fragile banks by taking assets, specifically "toxic assets", off their hands and replacing them a risk free interest-bearing alternative.
Great analysis as always, Lee.
ReplyDeleteI think the Fed's goal was to rebuild the house of cards that was the shadow banking system. The gamble was that the Fed could inject credit at just the right places, and the model of banks making loans, selling them to investment banks, the investment banks pooling the loans, and then selling asset backed commercial papers or repurchase agreements to be held by mutual funds would all go back to where it was in 2007. If this all worked out, nominal spending on output would recover and loans could continue to be made with minimal capital. (When banks hold loans to maturity, the stockholders must put up 10% of the funds and depositors only fund 90%. With the shadow banking system, those holding mutual shares can provide approximately 100% of the funds for the loans.)
The Fed needed to increase reserves to fund the targeted credit. If the gamble worked, once the shadow banking system recovered, any increase in reserves would be inflationary. Of course, the Fed really looked at this through the lens of interest rates. The interest rates in the fall of 2008 would be just fine if the gamble worked and the shadow banks recovered. The Fed had to pay interest to keep interest rates from falling "too low" when they created reserves to fund the targeted credit. These "too low" interest rates would have created inflation when the shadow banking system recovered.
Unfortunately, the gamble failed. The Shadow banking system didn't recover.
Bill,
ReplyDeleteIt still doesn't make any sense to me. I mean, your hypothesis is plausible, but I can't understand how the Fed would ever think it would work.
The Federal Reserve wants banks to create more of the assets the shadow banking system, ultimately, depends on for collateral, because existing assets, like mortgage-backed securities, have fallen in value. The Federal Reserve attempts targeted injections of reserves to provide banks with the necessary base money to make the new loans. Meanwhile, the Fed worries about interest rates falling too low and creating undesirable levels of inflation, so it basically creates a price ceiling on assets by paying interest on excess reserves. The Fed's hope is that the shadow banking system would be saved by an influx of new safe assets.
Is that right? It seems like sheer incompetence by the central bank. I mean, where were the banks going to find all these low-risk loans to create the new assets? They couldn't, evidently, and chose to simply hold excess reserves instead.
Your hypothesis suggests the Fed inadvertently offered a competitive rate of interest on excess reserves, because it hadn't anticipated the sudden dearth of safe investment opportunities. But, of course, the main reason for that shortage was the falling aggregate nominal income that the Fed was supposed to prevent.
It really does seem that the Fed was just too concerned with the financial sector and not paying enough attention to broader monetary developments.
Your story makes the most sense of any I know, but it still doesn't make much sense.
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