Tuesday, March 27, 2012

The Bernanke-Student Conversation You Missed: Part I

Somewhere in the halls of George Washington University, after Bernanke's last lecture, a conversation between the Fed Chairman and a student was overhead.  This is the first part of that conversation.
Student: Oh hi, Chairman Bernanke.  I have enjoyed your lectures.  Thanks so much for making time for us. 
Bernanke:  You are more than welcome.  You know, it has been a real treat for me to get away from the Fed and back into the classroom.  Sometimes the stress of dealing with hard-money congressmen, rogue regional Fed presidents, and bloggers who cite my Japanese work can be overwhelming.  So it really is nice to escape into the classroom.  Now tell me, is there anything in particular we have talked about that struck your fancy? 
Student:  Actually, yes.  When you explained that China's currency peg to the dollar means China effectively has it monetary policy set by the Fed I was shocked--1.3 billion Chinese have their monetary conditions set by a few Americans holed up in a secretive, old building on the other side of the world.  Wow, talk about fodder for conspiracy theories! Anyhow, this got me thinking: are there other countries that have their monetary policy determined by the Fed too?  So I did some research and learned that almost half of the world's currencies are tied in some way to the dollar.  This translates into about a third of world GDP. That means you guys at the Fed are like a monetary mafia, right? 
Bernanke:  Well, uhm, I would not phrase it that way but... 
Student:  But you do influence monetary conditions for about a third of the global economy, right? 
Bernanke: Yes.
Student:  Okay, let's say the Fed eased monetary policy for a third of the world economy. That would imply that the currencies of these dollar-pegging countries would depreciate  relative to the rest of the world.  And that, in turn, would make the ECB and the Bank of Japan mindful of U.S. monetary policy lest their currencies becomes too expensive, right?
 Bernanke:  Probably, but...
Student:  So the Fed, then, is also shaping monetary policy to some extent at the ECB and the Bank of Japan. That explains figures like this one and this one that until now I did not understand.  Wow, you guys really are the monetary mafia.  So does this mean the monetary mafia thinks about the implication of the FOMC's actions for these other economies when doing monetary policy?
Bernanke: Actually no, we have a domestic mandate so we don't really worry too much about them unless they create problems for the U.S. economy. And besides, they don't have to peg to our currency.  No one is forcing them to do so.  We may exert a lot of influence on global monetary conditions, but we are not a monetary mafia!  Please quit using that name!
Student: Okay, no more monetary mafia references.  But, if you do exert a lot of influence on global monetary conditions, then can't it explain, at least in part, why there was a global housing boom?  The Fed lowered global interest rates and sparked off a global housing boom, right? 
Bernanke: You need to read my papers on the saving glut. They show that it wasn't  U.S. monetary policy, but excess savings from rest of the world that created the demand for safe assets that in turn drove down global interest rates. This development combined with the securitization of finance, poor internal governance, misaligned creditor incentives, and other private sector failings is what caused the global housing boom. 
Student:  Doesn't that sound a bit self-serving, blaming only foreigners and private sector failings for the housing boom?   
Bernanke: Look, as I said, read my papers on the saving glut.  The answers are all there.
Student: Well, I have read your saving glut papers, but I still have questions.  It seems to me that in those papers you are focusing on the structural component driving the global demand for safe assets, but ignore the cyclical ones.    
Bernanke: What do you mean?
Student: The structural component is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets.  The cyclical component, on the other hand, is that because of the Fed's monetary superpower status, U.S. monetary policy accentuated the demand for safe assets during the housing boom. 
Bernanke:  Oh really?
Student:  Really.  Here is why. First, in the early-to-mid 2000s, those dollar-pegging countries were forced to buy more dollars when the Fed loosened monetary policy with its low interest rate policies.  These economies then used the dollars to buy up U.S. debt. This increased the demand for safe assets.  To the extent  the ECB and the Bank of Japan also responded to U.S. monetary policy, they too were acquiring foreign reserves and  channeling  credit back to the U.S. economy.  Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.  
Second, when the Fed pushed interest rates low, held them there, and promised to keep them there for a "considerable period" in 2003 it created new incentives for the financial system.  First, via the expectations hypothesis (which says long-term interest rates are simply an average of short-term interest rates over the same period plus a term premium) these developments pushed down medium to longer yields as well, as seen in this figure.   This drop in yields caused big problems for fixed income fund managers who were expected to deliver a certain return. Consequently, there was a "search for yield" or as Barry Ritholtz says the managers of pension funds, large trusts, and foundations had to "scramble for yield."  They needed a higher but relatively safe yield in order to meet their expected return.  The U.S. financial system meet this rise in demand by transforming risky assets into safe, AAA-rated assets.  The Fed's low interest rate policies also increased the demand for safe assets for hedge fund managers.  For them the promise of low short-term interest rates for a "considerable period" screamed opportunity. These investors saw a predictable spread between low funding costs created by the Fed and the return on higher yielding but safe assets.  They too wanted more AAA-rated assets to invest in so that they could take advantage of this spread that would be around for a "considerable period."  Here too, the U.S. financial system responded by  transforming risky assets into safe assets.  So what do you think Mr. Chairman?
Bernanke: Well, what do you know, I am out of time. We will have to continue this conversation next time after my next lecture on the financial crisis.
Student: Speaking of the financial crisis, I also think that since late 2008 the Fed has erred the other way.  By failing to first prevent and then restore aggregate nominal income to its expected path, the Fed allowed the large scale destruction of many privately-produced safe assets far beyond that needed to correct for the housing boom.....
Bernanke:  I am outta here! 
1Okay, this conversation did not really happen, but I wish it had.


  1. David, I absolutely loved ths post, made me chuckle. If you haven't, you should have a read over the FSA's Turner report from 2008/2009 I think. Very much along the lines of your discussion here.

  2. Thanks Jason. I have been enjoying your blogging too. Keep up the good work.

  3. It's an interesting theory that it is somehow Bernanke's fault that Greenspan's low interest rate policies forced the hedge fund managers to create bogus AAA "safe assets" that ran the economy into the ditch.

  4. Stickler, the conversation did not imply it was Bernanke's fault for the low interest rates rather the Fed's fault in general. However, many observers think Bernanke's 2002 speech on deflation provided the academic/intellectual justification for it.

  5. How much of the bogus AAA "safe asset" created during the housing boom can be attributed to the cyclical versus the structural causes?

  6. Great post.

    A reservation: Is it the fault of central bankers if lenders do not require good underwriting on real estate?

    A further inquiry: If we provide FDIC insurance (we the taxpayer), should we not also require good underwriting standards?

    And finally: If Bernanke is right---the globe generates huge boatloads of capital, for reasons not tied to interest rates (people save for homes, retirement, college, to buy a business, security etc, an do not stop savings when rates go down) then what should central banks do?

    Perhaps QE has to become the first resort, not the last resort.

    Interest rates might be "naturally" low otherwise. Remember, you cannot dissuade savers by going to negative interest rates.

    I am not sure the Fed overstimulated up 2008. I think the financial system, for both commercial and residential real estate, failed to require large enough down payments. Ironically, the financial system should require larger down payments into real estate rallies, and less after dumps. They do the opposite.

  7. Clarifying note:

    I am referring not only to USA but global savings rates. Additionally, there is a lot of saving in the USA (through insurance) not counted as savings. Seems like there is gobs of capital n the world, probably surfeits from Asia.

  8. Benjamin, am one of the few who thinks the Fed was too loose during the housing boom and and too tight during the bust. That might help clear things up.

    To answer your question, no. The Fed did not create the lower lending standards or transform risky assets into "safe" ones, but it created the incentives to do so as outlined above.

  9. Is this how we meaningfully contribute to policy discussions now? With puerile and immature straw man constructs like this?

    BRB, I am off to win the presidency and fix the global economy by taking sophomoric straw-man digs at my ideological challengers.

  10. I am sceptical of the idea that contemporaneous Fed easing in the early 2000s led to foreign central bank treasury purchases that created a shortage of AAA assets, which in turn motivated financial innovation. If that had been the mechanism, it seems to me ( http://reservedplace.blogspot.co.uk/2008/05/enigma-inside-conundrum.html ) that bond spreads to treasuries should have widened, not narrowed as they in fact did. The idea that investors were trying to meet a target yield makes some sense, but note that spreads did not widen back out as yields generally rose from 2004.

    No; I suspect that financial innovation (which arguably the Fed could have done more to restrain or at least protect against) came first. The resulting increase in credit supply expanded access to mortgage lending and consequently increased spending. This irresistible force met the immovable object of the hard and soft dollar pegs to which David refers, and drove the increased central bank treasury purchases for foreign exchange reserves.

  11. Bernanke: By the way, those guys name Sumner and Beckworth are always screaming about me failing to generate nominal gdp growth at 5%. Well, they should brush up on their arithmetic and check, for example, the data here:


  12. Anonymous #1: Where is your sense of humor? Care to elaborate on the straw man arguments? These aren't exactly new arguments that I make in this conversation. See here for example: http://macromarketmusings.blogspot.com/2011/12/why-global-shortage-of-safe-assets.html

    Rebel Economist: I am not sure that we are that far apart. There are a number of empirical studies that show (and are ignored by Bernanke) that the financial innovations combined with loose monetary policy were behind the boom. I will put links to these studies up in a subsequent post.

    Anonymous #2: What Scott Sumner and me really want is level targeting. NGDP growth might hit 5%, but in order to return to a 5% trend path that we have fallen far short of, the Fed will need to do far more than 5% NGDP growth. In other words, the Fed needs some catch-up growth to return trend.

  13. David,

    We agree that the Fed bears much responsibility for the boom, but I would associate that more with a lack of attention to financial stability (especially the "Greenspan put") than contemporaneous easy monetary policy.

  14. David-

    I think the global capital glut creates incentives for risky lending, and I think this is a long-term "problem," as income globally rise.

    It is a high-class problem to have. Throughout history, capital was scarce. Now it is abundant.

    I agree with you the Fed is very important, even to one-third of the globe n terms of money supply---but there is the rest of the world, doing its thing---saving, buying gold, etc., sending alerts of signals that are generated by US microeconomic policies.

    I don't think the Fed causes high savings rates in China and Japan, and other Asian nations. Jut as the fed does not influence savings rates in Africa. I think the Chinese and Indians buy gold for traditional gifts and now they have the income to do so.

    In short, capital will be abundant going forward. What should the Fed do?

    I think Market Monetarism, of which QE is a major and "conventional:" component. We have to start thinking of QE as a tool, not an emergency measure.

  15. I'm sorry, but claiming the concept of global economic growth outpacing the ability of the world economy to generate safe assets is putting the cart before the horse. Increased growth by default generates safe assets, the issue is re-aligning beliefs. These tend towards stability, typically through the inertia associated with preferred state-of-the-world heuristics employed by bankers, policymakers and industrial investors.

    The absence of a mechanism to ensure novelty in production of physical assets was reasonably matched with the identity-associated novelty in production of financial assets is a solvable policy failure.

    The rest of your story is enjoyable and broadly persuasive, but lacks equilibrium effects associated with governments' foreign reserves and their central banks' currency management actions: Singapore Q3/4 2011, China 2009-11 and Japan Q1 2012 being interesting examples in terms of intertemporal profit-making, mopping-up and pseudo-credible money-pumps respectively.