Decomposing the Yield Curve Spread

Just last week I had a post titled "The Interest Rate Conundrum that Wasn't" where I discussed how many observers misread the flattening and then the inverting of the yield curve over the 2005-2007 period. As I noted then, the popular story was that the term premium was falling and thus there was nothing to fear from the changes in the yield curve. As we all now know, this interpretation was incorrect: the yield curve was telling us that a recession was in the making after all. Well today, Zubin Jelveh directs us to a similar posting he made back in January titled "That Trusty Yield Curve". The entire post is worth reading, but one part in particular I want to mention here. Zubin notes a study by Joshua Rosenberg and Samuel Maurer that decomposes the yield curve spread into its (1) interest rate expectations and (2) term premium components. What they find can be seen in the following figure where the gray columns denote recessions: (click on figure to enlarge.)

This figure shows--and the authors demonstrate more formally with some statistical tests--that it is changes in the interest rate expectations component that predicts recessions, not changes in the term premium. The variation in the term premium is typically too small to matter, including during the "conundrum" period. This is interesting work.

Repeating the Fed's Policy Mistake of 1936-1937

Is the Federal Reserve (Fed) making a similar mistake to the one it made in 1936-1937? If you recall, the Fed during this time doubled the required reserve ratio under the mistaken belief that it would reign in what appeared to be an inordinate buildup of excess reserves. The Fed was concerned these funds could lead to excessive credit growth in the future and decided to act preemptively. What the Fed failed to consider was that the unusually large buildup of excess reserves was the result of banks insuring themselves against a replay of the 1930-1933 banking panics. So when the Fed increased the reserve requirements, the banks responded by cutting down on loans to maintain their precautionary level of excess reserves. As a result, the money multiplier dropped and the money supply growth stalled as seen in the figure below. (click on the figure to enlarge.)
This development, in conjunction with a contractionary fiscal policy, led to the recession of 1937-1938 and ultimately prolonged the Great Depression.

Now in 2008 the Fed did not suddenly increased reserve requirements, but it did just start paying interest on excess reserves. The Fed, then, just as it did in 1936-1937 has increased the incentive for banks to hold more excess reserves. As a result, there has been a similar decline in the money multiplier and the broader money supply (as measured by MZM) which I documented yesterday. If the Fed's goal is to stabilize the economy, then this policy move appears as counterproductive as was the reserve requirement increase in 1936-1937.

So why is the Fed paying interest rates on excess reserves? The answer from the Federal Reserve Board and other commentators is that this policy move makes the federal funds rate more manageable. Jim Hamilton gives a more compelling reason:

It's clear that the Fed is now also using yet another tool to balloon its balance sheet, namely, deliberately encouraging banks to sit on their excess reserve deposits. When these started to shoot up at the end of September, I initially attributed this to frictions in the interbank lending market. But with the announcement on October 6 that the Fed would begin to pay interest on those deposits, and the further announcement on October 22 that the Fed is now raising that interest rate to within 35 basis points of the target for the fed funds rate itself, it is clear that the Fed has now settled on a deliberate policy of encouraging banks to just sit on the reserves it creates, giving it another device with which to expand its balance sheet without increasing the quantity of cash held by the public.

Now the reason the Fed is ballooning its balance sheet is to be able to "buy" targeted assets from the troubled financial sector without actually increasing the overall money supply. The idea, as I understand it, is to restore confidence to financial markets--what Paul Krugman calls the "Face Slap Theory"--without actually creating any additional spending or inflationary pressures. Pardon me for being skeptical, but from what I can see this approach has only encouraged banks to hoard more excess reserves. I may be missing something here--and please let me know if I am--but it seems like we are making the same policy mistakes that were made in 1936-1937.

George Selgin Discusses Good Money

George Selgin has been highly influential in shaping my own thinking about monetary policy. My critique of U.S. monetary policy in the early-to-mid 2000s that has been a prominent part of this blog is based on Selgin's work on deflation. Selgin, though, has other research interests. This past summer he published a book called Good Money which I posted on here. Now you can listen to Selgin discuss his new book in this podcast interview. For more commentary on this book, see Alex Tabarrok's review of the book here.

Thinking About the Dollar

The U.S. may be heading into its worst recession in 40 years. Normally, such a development would result in a declining U.S. dollar. Instead, the dollar is strengthening as seen in the figure below which shows a weighted average of the dollar against its trading partners (click on figure to enlarge):

So what explains the rapid appreciation of the dollar? Bloomberg says the following:

Oct. 25 (Bloomberg) -- The dollar gained the most in 16 years against the currencies of six major U.S. trading partners as a global economic slowdown spurred demand for the greenback as a haven from losses in emerging markets.

``The foreign-exchange market is basically saying we are in a global recession and perhaps a very, very deep one,'' Richard Franulovich, a senior currency strategist at Westpac Banking Corp. in New York, said in an interview on Bloomberg Radio.

[...]

``We are in a financial crisis,'' said Richard Clarida, a global strategist at Newport Beach, California-based Pacific Investment Management Co., which oversees $830 billion in assets, including the world's biggest bond fund. ``The flight to quality is boosting the dollar and the yen.''

Emerging-market currencies tumbled as Argentina seized private pension funds, and Belarus, Ukraine, Hungary and Iceland joined Pakistan in requesting at least $20 billion of emergency loans from the International Monetary Fund. Brazil's real dropped 8.2 percent to 2.3075 against the dollar, the South African rand decreased 10.4 percent to 11.18 and the Russian ruble fell 3.2 percent to 27.1991.

So a negative economic shock that originated in the United States--the downturn in the U.S. housing market--has set off a global recession that is causing a flight to the dollar and is thus increasing its value. If this understanding is correct, then I have failed to appreciate the full extent of the exorbitant privilege the United States gets from having the main reserve currency of the world.

Update: Mark Thoma directs us to Paul Krugman, Dani Rodrik, Edward Harrison, and Simon Johnson for discussion on the stresses in emerging markets from the declines in their currencies.

This Picture (Almost) Says it All

Dani Rodrik recently showed us the financial crisis in one picture. Well here is the financial crisis in one cartoon, complements of Slate. I only wish the cartoon had depicted the low interest environment in the early-to-mid 2000s under one of seven deadly sins. (Click on the figure to enlarge):

The Interest Rate Conundrum That Wasn't

Thanks to the prompting of ECB, I was reminded of the interest rate "conundrum" of 2005-2006. The "conundrum" at this time was that long-term interest rates refused to follow short-term interest rates up as the Fed tightened monetary policy. Based on the expectations theory of interest rates--which says long-term interest rates are the average of expected future short term interest rates plus a risk premium--there were two obvious interpretations for this development: (1) the risk premium had fallen or (2) the economy was headed for a recession. Despite the inordinate run up in leverage and house prices at the time--signs that U.S. economic expansion was not sustainable--many observers chose to believe some variant of (1). For example, one very prominent Fed official said the following in 2006:

Although macroeconomic forecasting is fraught with hazards, I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come, for several reasons. First, in previous episodes when an inverted yield curve was followed by recession, the level of interest rates was quite high, consistent with considerable financial restraint. This time, both short- and long-term interest rates--in nominal and real terms--are relatively low by historical standards.Second, as I have already discussed, to the extent that the flattening or inversion of the yield curve is the result of a smaller term premium, the implications for future economic activity are positive rather than negative.

Other reasons given around this time for not viewing the inverting of the yield curve as pointing to a recessions were that (1) other financial indicators such as the rise in stock prices indicated solid economic growth ahead and (2) the conundrum was a global phenomenon, not just a U.S. one. We now know the inverting of the yield curve was not a "conundrum", but simply a sign of the recession to come. The term premium and other financial indicators pointing up interpretations were off the mark in this case, while the global scope of inverting yield curves meant a global recession was in store.

The figure below--which shows the 10 year-3 year treasury yield curve spread, the NBER-dated recessions, and the recession that presumably started in 2007:Q4--indicates that during the time of the "conundrum" the yield curve spread was simply doing what it does best: predicting a recession. (Click on figure to Enlarge.)


Although many observers somehow missed this straightforward interpretation of the inverting yield curve, others got it right. For example, Calculated Risk wrote in 2005 the following:

I think the PRIMARY reason for Greenspan's conundrum is that the economy is weaker than it appears. Using GDP growth and unemployment, the US economy is healthy. But the level of debt (both consumer and government), the real estate "boom" that seems based on leverage and loose credit (see Volcker's recent comments), and the poor employment situation (especially the low level of participation) indicate an unhealthy economy. I believe this recovery is being built on a marshland of debt and the bond market is reflecting this weakness.

For some observers, then, there was no "conundrum". The inverting yield curve was simply a sign of future economic weakness. How prescient they now look.

The Monetary Policy - Long Term Interest Rate Link

Tyler Cowen argues that the Fed's low interest rate policy in the early-to-mid 2000s may have been a contributing factor, but certainly was not the most important one leading to the financial crisis. In making his case, Tyler says the following:

[O]ther reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates.

I am not sure what Tyler exactly means by "bigger", but I do know there has been a spate of empirical studies showing monetary policy affects long-term rates in a non-trivial manner. Richard Froyen and Hakan Berument (F&B) provide a good survey of this literature in their forthcoming paper, "Monetary policy and U.S. long-term interest rates: How close are the linkages?" From their introduction is the following:

[T]he effect of monetary policy on long-term interest rates is a subject of considerable interest. Given current U.S. monetary policy procedures, this question reduces to that of how a change in the federal funds rate affects the yields on longer-term securities. A decade ago a reading of theliterature would have indicated considerable doubt about even the direction of this effect. There was also a view that the size and persistence of the effect of the federal funds rate on longerterm yields would vary with economic conditions. The prevailing theory of the term-structure of interest rates, the expectations hypothesis, by itself provides little guidance about the effect monetary policy actions will have on longer-term interest rates: the nature of the effect depends on the way in which the policy action affects expected future short-term interest rates and risk premiums imbedded in long rates.

Research since 2000 has changed the situation. Studies by Kuttner (2001), Cochrane and Piazzesi (2002), Gurkaynak, Sack, and Swanson (2005a), Ellingsen and Soderstrom (2003), Ellingsen, Soderstrom, and Masseng (2004) and Beechey (2007) provide evidence that unanticipated changes in the federal funds rate have significant effects on U.S. interest rates at maturities as long as 10 or 30 years. Kuttner’s estimates, for example, indicate that an unanticipated rise ofone-percentage point in the federal funds target rate will increase the interest rate on a 10-year government security by 32 basis points and the rate on a 30-year security by almost 20 basis points.

(F&B also note that though some research based on vector autoregressions (VAR) show results more consistent with Tyler's view, these studies ultimately are flawed.) Now if we make the reasonable assumption that the drop of the fed funds rate (ffr) all the way to 1% for a sustained period was unexpected by several percentage points--the ffr has not been dropped that low since the 1950s--and adopt Kuttner's magnitudes then it is easy to imagine the Fed having a significant influence on long term interest rates during the early-to-mid 2000s.

One could also argue that some of the "global saving glut" and its influence on long-term interest rates was simply an amplification of the Fed's easy monetary policy via the dollar block countries' central banks. But I digress. The key point here is that there is evidence monetary policy still matters in a meaningful way for long-term interest rates.

Barry Ritholtz on the Origins of the Financial Crisis

The summary:

The perfect storm of ultra-low rates, securitization, lax lending standards and triple AAA ratings -- these are the key to how we ended up in the current crisis.

Read the entire piece here. See Ritholtz's earlier discussion of these developments here.

Inability to Smooth Consumption = A "Doozy" of a Recession

Standard economic theory tells us that individuals will try to smooth consumption over the business cycle. This can be seen in the figure below. It shows the year-on-year (y/y) growth rates of consumption and investment--the two biggest expenditure components of GDP--over time and across business cycles. Consumption is represented by the blue line, investment by the red line, and the officially dated recessions by the grey columns. (Click on figure to enlarge)

This figure indicates that relative to investment, the y/y growth rate of consumption has been remarkably stable--evidence of consumption smoothing. So should this give us comfort going forward into to current recession? Will individuals continue to smooth their consumption, providing an offset to the weakening economy? Henry Blodget (ht Felix Salmon) emphatically says no:

The last recession was mild. The stock market and corporate profits tanked, but consumer spending--long the major engine of the US economy--danced merrily on through. In recent decades, it has ever been thus: bearish analysts and strategists have been underestimating the voracious spending habits and resilience of the US consumer for 50 years.

Unfortunately, at risk of invoking the four most expensive words in the English language, "this time it's different." This recession, to quote the great Julian Robertson, will be a "doozy."

Why?

Because the US consumer is finally broke. For thirty years, we piled on debt and then spent almost every new penny we got. This borrowing spree was made possible by a smorgasbord of no-money-down lending products and ever-appreciating asset prices. Unfortunately, the situation has now changed. The lenders who created those products have now been demolished, and asset prices are falling fast. And this is leaving American consumers with no choice but to cut back.

A few exhibits:US debt has risen from 163% of GDP in 1980 to 346% in 2007. Household debt, a subset of this, has risen from 50% of GDP to 100%.

[....]

Analyst John Mauldin explained this week how growing consumer debt in the form of Mortgage Equity Withdrawals allowed consumer spending to power right on through the last recession (What's home-equity withdrawal? When your house price rises, you borrow more, keeping your debt to house-value percentage the same. Then you spend these "earnings."). Thanks to the housing crash, consumers have less and less mortgage equity to withdraw, so this source of cash is rapidly disappearing. As consumer net worth shrinks, other sources of financing--credit cards, home equity loans, car loans, student loans, etc.--will follow a similar path, and consumers will increasingly be limited to spending what they make.

[T]ake a look at GDP during the last recession as reported (blue bars) and after factoring out the impact of mortgage equity withdrawal (red bars). The bottom line: without that source of consumer cash, we would have had a nasty recession, and our growth would have been anemic since.

Bottom line: consumption will not be the economic hero it has been in past recessions.

Is Morgan Stanley's Stephen Roach the Long Lost Son of Anna J. Schwartz?

I have long been a fan of Stephen Roach who early on called attention to the distortionary policies of the Federal Reserve in the early-to-mid 2000s. His main beefs with the Fed were (1) its failure to acknowledge its own policies were contributing to one of the biggest asset bubbles of all time and (2) its unwillingness to address the asset bubble problem. His frustration with the Fed reached a high with the publication of the now classic "Original Sin" article in 2005 where he wrote the following:

In all my years in this business, never before have I seen a central bank attempt to spin the debate as America’s Federal Reserve has over the past six or seven years. From the New Paradigm mantra of the late 1990s to today’s new theories of the current-account adjustment, the central bank has led the charge in attempting to rewrite conventional macroeconomics and in making an effort to convince market participants of the wisdom of its revisionist theories. The problem is that this recasting of macro is very self-serving. It is a concentrated effort on the part of the Fed to exonerate itself from the Original Sin of failing to address asset bubbles.The result is an ever-deepening moral hazard dilemma that poses grave threats to financial markets.

He recently repeated this view in an interesting interview with Bloomberg's Tom Keene and Ken Prewitt. What is interesting is that this weekend Anna J. Scwhartz, the matriarch of monetary economics, made a rather similar critique of the Greenspan Fed in the Wall Street Journal. Here are the key excerpts:

How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

"The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses."

The house-price boom began with the very low interest rates in the early years of this decade under former Fed Chairman Alan Greenspan.

"Now, Alan Greenspan has issued an epilogue to his memoir, 'Time of Turbulence,' and it's about what's going on in the credit market," Ms. Schwartz says. "And he says, 'Well, it's true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased, if the Fed had tightened and crushed the boom. They would have felt that it wasn't just the boom in the assets that was being terminated.'" In other words, Mr. Greenspan "absolves himself. There was no way you could really terminate the boom because you'd be doing collateral damage to areas of the economy that you don't really want to damage."

Ms Schwartz adds, gently, "I don't think that that's an adequate kind of response to those who argue that absent accommodative monetary policy, you would not have had this asset-price boom." Policies based on such thinking only lead to a more damaging bust when the mania ends, as they all do. "In general, it's easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well."

I think both Roach and Scwhartz would agree there were other important factors at work in creating this boom-bust cycle. However, given the Fed's monetary superpower status--its ability to shape monetary policies across the globe and create a global liquidity glut--both believe the Fed could have and should have done more to (1) an avoid overly accommodative monetary policy in the early-to-mid 2000s and (2) reign in the housing bubble once it started. (Even if there had been "collateral" damage in popping this asset bubble several years ago, certainly it would not have been any worse than our current situation.) The Fed's failure to do so means it shares some of the blame for what appears to be a looming global recession.

Enough of the Financial Crisis; What About the Real Economy?

Nouriel Roubini's answer: the worst recession in 40 years.

Nouriel Roubini, the professor who predicted the financial crisis in 2006, said the U.S. will suffer its worst recession in 40 years, driving the stock market lower after it rallied the most in seven decades yesterday.

``There are significant downside risks still to the market and the economy,'' Roubini, 50, a New York University professor of economics, said in an interview with Bloomberg Television. ``We're going to be surprised by the severity of the recession and the severity of the financial losses.''

The economist said the recession will last 18 to 24 months, pushing unemployment to 9 percent, and already depressed home prices will fall another 15 percent. The U.S. government will need to double its purchase of bank stakes and force lenders to eliminate dividends to save them from bankruptcy, Roubini added. Treasury Secretary Henry Paulson said today he plans to use $250 billion of taxpayer funds to purchase equity in thousands of financial firms to halt a credit freeze that threatened to drive companies into bankruptcy and eliminate jobs.

Read the rest of this economic prophet's outlook here.

The Canadians and Their Resilient Banking System

One of the interesting facts from the Great Depression of the 1930s is that Canadian banking system had zero bank closings. This accomplishment is all the more amazing when one considers that there was no central bank in Canada until 1935. The United States, on the other hand, had a central bank from the outset of the Great Depression but still somehow managed to let thousands of banks to fail. This development caused a massive disruption of financial intermediation in the United States and is believed by some observers to be the main reason for the severity of the the U.S. Great Depression. As I have noted before, many observers believe the resiliency of the Canadian banking system during this time was the result of its extensive branch banking system, something that was absent from the U.S. banking system. Allowing a bank to have branches gives it a more diversified portfolio of assets as well as making it able to draw on reserves across many branches. Branch banking, therefore, makes a banking system more capable of handling economic shocks.

I bring this up, because the Washington Post is reporting that the Canadian banking system is still ahead of the U.S. banking system when it comes to branch banking (ht Tyler Cowen). As a result, the current financial crisis has had less of an impact on Canadian banking system:

TORONTO, Oct. 15 -- While the United States reels from the global financial crisis, with credit markets still frozen and stock prices careening from highs to lows, Canada has remained relatively insulated.

Canadian banks have not gone shaky like their American counterparts, economists and other experts said. There is no subprime mortgage or home foreclosure mess. And while the United States fears a prolonged recession, Canadians have remained relatively sanguine, convinced that they are in a good position to weather the economic tsunami from the south.

[...]

According to the Canadian Banking Association, one reason for the system's solidity is that banks are national in scope. Each of the largest five institutions has branches in all 10 Canadian provinces, meaning they are less susceptible to regional downturns and they can move capital from region to region, as needed. "As far as I am aware, no American bank has branches in all 50 states," banking association spokesman Andrew Addison wrote in an e-mail.

The article also mentions better bank regulations as another factor. Still, what is so striking to me is that 70+ years after the Great Depression we still do not have the level of branch banking found in Canada.

Update: Here is a figure from Mark Perry's discussion on the Canadian vs. U.S. banking system during the Great Depression:

Share of Home Mortgage Market

Below I have reproduced the figure first made by Jim Hamilton and Richard Green and then later popularized by Mark Thoma. This figure suggests the following: (1) Fannie and Freddie (the GSEs) gained market share beginning in the 1980s from the saving institutions (presumably from the Saving & Loan debacle fall out); (2) Fannie and Freddie lost market share beginning around 2002 to the asset-backed security issuers. As noted by the above observers, this latter point supports the notion that at least some of the problems at Fannie and Freddie emerged in response to their declining market share during the housing boom. In other words, what happened to Fannie and Freddie may have been a symptom rather than a cause of the housing boom-bust cycle. (Click on figure to enlarge.)

Source

Update: This article from the National Journal argues that Fannie and Freddie played a larger role than I outline above.

The Federal Reserve: Lender of Last Resort for the World

Bloomberg reports today that Fed will provide an unlimited amount of dollars to the major central banks in Europe:

Oct. 13 (Bloomberg) -- The Federal Reserve led an unprecedented push by central banks to flood the financial system with as many dollars as banks want, backing up government efforts to revive confidence and helping to reduce money-market rates.

The European Central Bank, the Bank of England and the Swiss National Bank will offer European banks unlimited dollar funds with maturities of seven, 28 and 84 days at fixed interest rates against ``appropriate collateral,'' the Washington-based Fed said today. Previously, the Fed had capped at $380 billion the currency it would swap with the three central banks.

[...]

The ECB, the BOE and the Swiss National Bank ``can provide U.S. dollar funding in quantities sufficient to meet their demand'' into 2009, the Fed said today. The Bank of Japan may introduce ``similar measures.''

The aim is to keep the financial system flowing with the world's reserve currency. Banks are hoarding cash for fear they will lose the money if it's loaned or held elsewhere, or because they need it for their own funding needs.

``Central banks will continue to work together and are prepared to take whatever measures are necessary to provide sufficient liquidity in short-term funding markets,'' the Fed's statement said.

What began last December as a $24 billion arrangement between the Fed, the ECB and Swiss central bank was boosted over the past year to $620 billion and broadened to additional countries. The Fed didn't announce changes to the $240 billion of swap lines with six other central banks, including those in Japan, Canada, Denmark, Norway, Sweden and Australia

Like I said earlier, the Federal Reserve is a monetary hegemon.

Paul Krugman at His Best

Paul Krugman has been awarded the Nobel Prize in Economic Sciences for 2008. No matter what you think about his political views--he can be overly shrill at times and sometimes wrong (e.g. his assessment of Milton Friedman's legacy)--he is a first-rate economist with a remarkable academic record as noted by Tyler Cowen and Alex Tabarrok. Krugman also does a great job explaining complex economic issues to laypeople in his popular writings. For example, Slate magazine today, in recognition of his Nobel prize, reposted his Slate article titled "Baby-Sitting the Economy." Another great column, in my opinion, is his 2005 "Running Out of Bubbles" piece in the NY Times. When Krugman sticks to economics, as he does in these articles, he is at his best.

The Decline of America?

In a previous posting I discussed the impact of the financial crisis on American hegemony. David Leonhardt has a nice follow-up piece on this issue.

At the turn of the 20th century, toward the end of a brutal and surprisingly difficult victory in the Second Boer War, the people of Britain began to contemplate the possibility that theirs was a nation in decline. They worried that London’s big financial sector was draining resources from the industrial economy and wondered whether Britain’s schools were inadequate. In 1905, a new book — a fictional history, set in the year 2005 — appeared under the title, “The Decline and Fall of the British Empire.”

The crisis of confidence led to a sharp political reaction. In the 1906 election, the Liberals ousted the Conservatives in a landslide and ushered in an era of reform. But it did not stave off a slide from economic or political prominence. Within four decades, a much larger country, across an ocean to the west, would clearly supplant Britain as the world’s dominant power.

The United States of today and Britain of 1905 are certainly more different than they are similar. Yet the financial shocks of the past several weeks — coming on top of an already weak economy and an unpopular war — have created their own crisis of national confidence.

Leonhardt does bring up the resiliency of the American economy as a reason for hope, but at the same time mentions the burden of debt (or the cost of "financial overreach" as compared to Britain's "imperial overreach" per Niall Ferguson) cannot be escaped anytime soon.

Where Are Our Leaders?

Paul Krugman points us to this disturbing quote from a Bloomberg article:

Finance ministers and central bankers from the Group of Seven nations signaled reluctance to adopt a coordinated effort to shore up banks, risking a deeper crisis of confidence after this week's crash in global stock markets.

Are you kidding me? This is the worst global financial crisis since the 1930s and our leaders cannot agree on a coordinated policy effort? The last time there was a financial crisis this pronoucned and global leaders failed to come together the Great Depression emerged leading to the rise of Hitler. We are very fortunate that the IMF/World Bank meetings are taking place now, bringing all the financial leaders of the world together in one place. If nothing meaningful comes out of these meetings than we can also blame a crisis of leadership for the financial crisis. I was really hopeful after Wednesday's coordinated interest rate cuts by central bankers--even though it appeared to inspire more fear than confidence--that there would be more coordinated policy actions across the globe to follow. Don't let me down G7!

Update: See Paul Krugman's column.

Update II: The G7 release their plan of action. Here is more from Bloomberg. Paul Krugman is not impressed.

Global Liquidity Glut or Global Saving Glut?

I have argued here many times that the "liquidity glut" view of the global economic imbalances has as much merit as the "saving glut view". Many prominent observers, however, completely ignore the "liquidity glut" view and only buy into the "saving glut" view (or a variant of it--the "investment drought view"), even when it puts them in an awkward position. Fortunately, there is now a paper by Thierry Bracke and Michael Fidora of the ECB that puts these competing views to a test. Here is the abstract from their paper:

Global Liquidity Glut or Global Saving Glut? A Structural VAR Approach
Since the late-1990s, the global economy is characterised by historically low risk premia and an unprecedented widening of external imbalances. This paper explores to what extent these two global trends can be understood as a reaction to three structural shocks in different regions of the global economy: (i) monetary shocks (“excess liquidity” hypothesis), (ii) preference shocks (“savings glut” hypothesis), and (iii) investment shocks (“investment drought” hypothesis). In order to uniquely identify these shocks in an integrated framework, we estimate structural VARs for the two main regions with widening imbalances, the United States and emerging Asia, using sign restrictions that are compatible with standard New Keynesian and Real Business Cycle models. Our results show that monetary shocks potentially explain the largest part of the variation in imbalances and financial market prices. We find that savings shocks and investment shocks explain less of the variation. Hence, a “liquidity glut” may have been a more important driver of real and financial imbalances in the US and emerging Asia than a “savings glut”.

Bottome line: monetary policy via the global liquidity glut matters for global economic imbalances.

60 Minutes on the Shadow Banking System

The Fed's Contribution to the Financial Crisis

Mark Thoma points us to an interesting take by Nick Rowe on the origins of the financial crisis. Among other things, Rowes' account speaks to the role the Federal Reserve played in creating the financial crisis. Here is a key excerpt:

So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high.

So Rowe has drank the "saving-glut" Kool Aid and sees no culpability for the Fed. His justification for this conclusion is that since inflation was not accelerating in the early 2000s it must be that the Fed did not push interest rates below the natural interest rate level. A stable inflation rate, however, is not a sufficient condition for macroeconomic stability. This is evident when one considers that the inflationary effects of an overly accommodative monetary policy--a positive aggregate demand shock--can be temporarily masked by gains to aggregate supply. A close look at the data seems to indicate this was case in 2003-2005: productivity growth accelerated just as the fed pushed interest rates to floor. The figure below illustrates this point. It shows the year-on-year growth rate of productivity versus the real (ex-post) federal funds rate (click on figure to enlarge):

It is worth noting that higher productivity growth rates are typically associated with higher real interest rates, not lower ones. When productivity growth--which provides a proxy for profitability--diverges so far from the real federal funds rate--the cost of borrowing to invest in this profitability--as it did during this time a credit boom is inevitable. Given the Fed's monetary hegemon status, this credit boom went global and created a global liquidity glut.

Clearly, there was more than just loose monetary policy behind this financial crisis (see Barry Ritholtz for a nice summary). But as I have argued here on this blog and elsewhere, inordinately loose monetary policy between 2003-2005 played a key part in stoking the coals of the housing boom during that time.

The Financial Crisis on SNL

Here is Saturday Night Live's take on the financial crisis:



Update: the video clip seems to have vanished from the SNL website, but for now you can find it on You Tube:



Update II: Apparently this skit was too politically sensitive for NBC and thus was pulled. See here for the details and the transcript of the clip.

Update III: Greg Mankiw directs us to this site where the video clip is still up.

How Bad Could it Get?

Dr. Doom (i.e. Nouriel Roubini) says we may soon see the mother of all bank runs.

The next step of this panic could be the mother of all bank runs, i.e. a run on the trillion dollar-plus of the cross-border short-term interbank liabilities of the U.S. banking and financial system, as foreign banks start to worry about the safety of their liquid exposures to U.S. financial institutions. A silent cross-border bank run has already started, as foreign banks are worried about the solvency of U.S. banks and are starting to reduce their exposure. And if this run accelerates--as it may now--a total meltdown of the U.S. financial system could occur.

What Presidential Candidate Do Economists Prefer?

Paul Krugman had a recent column in the NY Times titled The 3 A.M. Call. Here is the lead paragraph:

It’s 3 a.m., a few months into 2009, and the phone in the White House rings. Several big hedge funds are about to fail, says the voice on the line, and there’s likely to be chaos when the market opens. Whom do you trust to take that call?

Krugman makes clear his preference, but what about other prominent economists? Who would they want to take the call? The Economist magazine now has a tentative answer. The magazine polled the economists associated with the National Bureau of Economic Research (NBER), an association of leading research economists. The poll was not favorable to McCain. Here is the summary figure from the article (click to enlarge):


I found this paragraph from the article to be interesting:

A candidate’s economic expertise may matter rather less if he surrounds himself with clever advisers. Unfortunately for Mr McCain, 81% of all respondents reckon Mr Obama is more likely to do that; among unaffiliated respondents, 71% say so. That is despite praise across party lines for the excellent Doug Holtz-Eakin, Mr McCain’s most prominent economic adviser and a former head of the Congressional Budget Office. “Although I have tended to vote Republican,” one reply says, “the Democrats have a deep pool of talented, moderate economists.”

McCain, however, did edge Obama on free trade and globalization issues. McCain also did better in a survey given to industry economists back in May. I wonder if industry economists still favor McCain today.

Read the rest of the article.

Credit Crisis Hits Higher Education

From the New York Times:

In a move suggesting how the credit crisis could disrupt American higher education, Wachovia Bank has limited the access of nearly 1,000 colleges to $9.3 billion the bank has held for them in a short-term investment fund, raising worries on some campuses about meeting payrolls and other obligations.

[...]

Wachovia’s action was perhaps the most tangible signal yet that the credit crisis could have a powerful impact on higher education. Another sign came on Tuesday as Boston University, saying it needed to respond to the financial crisis with cautionary steps, announced an immediate hiring freeze and a moratorium on new construction projects.

[...]

Colleges have used the fund, formally called the Commonfund Short Term Fund, almost like a checking account, depositing revenues including tuition payments and withdrawing funds daily to finance payrolls, maintenance expenses, small construction projects and other short-term needs, college officials said.

Gulp. Did I mention I, a tenure-track assistant professor, am the lowest on the food chain in academia?

Redefining the "Bailout": A Hedge Fund for the Masses

Does the bailout have you down? If so, Daniel Gross of Slate and John Berry of Bloomberg have the perfect cheer-me-up tonic in their clever redefining of the bailout. First, Daniel Gross tells us that the bailout is like a hedge fund for the masses:

The Wall Street bailout is alive again...What's most interesting about the Emergency Economic Stabilization Act of 2008 is just how much it reads like a prospectus for a hedge fund. In the past, hedge funds—secretive pools of capital—were open only to qualified (read: rich) investors. But with the stroke of a pen, President Bush will soon make all American citizens investors in the world's biggest fund—and a democratic one at that. Taxpayers won't just be the investors. We'll own the management company, too. Best of all? For at least a few months, we'll have the former CEO of Goldman Sachs run our investment for a very small fee. Call it the "Universal Hedge Fund."

Hedge funds use leverage: That is, they borrow money to amplify their returns. The Universal Hedge Fund will use massive leverage, borrowing up to $750 billion, which it will use to buy up distressed assets. The Universal Fund might best be described as a multi-multistrategy fund. Its stated goals are to maximize returns to its investors while promoting general market stability and bolstering the crippled housing market.

Universal hedge fund coverage for people like me. I love it! But wait, it gets better. Not only is this endeavor a hedge fund for the masses, it may just be one of the more successful ones in history. John Berry tells us how this is possible:

There might be a gem in the Treasury's plan to buy $700 billion of dubious mortgage-related assets.

Call it the biggest carry trade in history. It might just put as much as $60 billion a year in the government's coffers.

[...]

The government will get the $700 billion by selling a range of Treasury securities to the public with yields of 3 percent to 4 percent. With investors around the world clamoring to buy risk-free Treasuries, the market should be able to absorb the jump in supply without a significant increase in yields.

Contrast that with likely yields on the troubled assets for which there currently is no market. No one can be sure how big a haircut there will be on the assets Treasury buys, though if it's 50 percent or more, their yields should be 10 percent or higher.

That is, the government will be borrowing at 3 percent to 4 percent to buy assets yielding 10 percent or even 12 percent. Conservatively, that spread on an investment of $700 billion should generate income of $40 billion to $60 billion annually.

Now that it music to my ears! I just hope that if this investment income does appear it is not earmarked for new spending, but used to reign in the existing structural budget deficit.