Fed Panel Discussion at the AEI

Friday, I will be participating in a panel discussion on Fed policy at the American Enterprise Institute. Along with me will be Scott Sumner, Ryan Avent, and Jim Pethokoukis. If you are in DC and can make it, I hope to see you there. 

Update: Here is the video of the panel discussion and here is a link to my PowerPoint file.

Missing the Forest For the Trees: Cyprus Edition

The Cyprus bank heist has received a lot of coverage, but in most cases the analysis is missing the forest for the trees. The real problem facing Cyprus and the rest of the Eurozone periphery is more fundamental than who will be bailed out, who will be bailed in, and how it will happen. For these concerns are the result of a flawed monetary union--a currency area that does not meet the optimum currency area criteria--that if not fixed will continue to haunt the Eurozone.  Figuring out how to deal with Cyprus without addressing the flawed nature of the Eurozone is just kicking the can the down road. More radical reforms are needed. 

One reform is to alter ECB policy so that it actually tries to stabilize nominal spending for the entire Eurozone, not just Germany. Since it inception, ECB monetary policy has been biased toward Germany at the cost of destabilizing the Eurozone periphery. This could be fixed by having the ECB abandoned its flexible inflation target and adopt a NGDP level target. Another complementary reform, would be to create meaningful fiscal transfers in the Eurozone similar in scale and scope to the United States. Both of these options, however, would face stiff opposition from Germany. For the former would require temporarily higher inflation than Germany desires and the former would require large fiscal commitments for the Eurozone from Germany. Neither is likely to happen.

That leaves the final reform option: break up the Eurozone into austere and non-austere currency unions. This ideas has been suggested before by Ramesh Ponnuru and Ambrose Evans-Pritchard. Here is Pritchard:

My solution - like that of Hans-Olaf Henkel, the ex-head of Germany's industry federation (BDI) - is to split EMU into two blocs, with France leading a Latin Union that keeps the euro. This bloc would devalue but not by 60pc, yet uphold its euro debts intact. The risk of default and banking crises would decrease, not increase.

The German bloc could launch their Thaler, recapitalizing banks to cover losses from rump euro debt. Disruptions could be contained by capital controls at first. None of this is beyond the wit of man. My bet is that aggregate losses would be lower than the status quo, and the long term outcome much healthier. The EU might even carry on, unruffled.

This reform is very radical, but there really is no other viable alternative. The German response over this crisis has given us no reason to believe the other options of improving the existing Eurozone monetary and fiscal structures will ever happen. So why keep pretending otherwise? The current Eurozone approach is the equivalent of an economic whack-a-mole game that never truly solves the problem. The Cyprus crisis is just the latest mole to stick up its head.

Fortunately, Matthew C. Klein reports that there already is some movement in Germany to create two new currency blocks. This is a start. But there is a long way to go and there needs to be a greater sense of urgency. Who knows how long the whack-a-mole game can continue before it turns ugly. Martin Feldstein warned in 1997 that the EMU could lead to conflict. I hope he is wrong. 

P.S. Matthew Yglesias is one observer that does consider the larger Eurozone context behind the Cyprus crisis.  

P.P.S. Just how big are fiscal transfers in the United States? Here is one data point from Paul Krugman: 

[I]f Florida suffers an asymmetric adverse shock, it will receive an automatic compensating transfer from the rest of the country: it pays less into the national budget, but this has no impact on the benefits it receives, and may even increase its benefits if they come from programs like unemployment benefits, food stamps, and Medicaid that expand in the face of economic distress.

How big is this automatic transfer? Table 2 shows some indicative numbers about Florida’s financial relations with Washington in 2007, the year before the crisis, and 2010, in the depths of crisis. Florida’s tax payments to DC fell some $33 billion; meanwhile, special federally funded unemployment insurance programs contributed some $3 billion, food stamp payments rose almost $4 billion. That’s about $40 billion in de facto transfers, some 5 percent of Florida’s GDP – and that’s surely an understatement, since there were also crisis-related increases in Medicaid and even Social Security, as more people took early retirement or applied for disability payments.

Echoes of 1933: the Cyprus Heist

Bank depositors in Cyprus learned today of a planned heist on their funds. It was a well organized one that will take 6.75% of all small deposit accounts and 9.90% of all large depositor accounts. What is truly shocking about this heist is that it was planned by the EU and IMF and applied to funds, at least for the small depositors, that were supposedly government insured (i.e. risk free). This is what we call a major shock to expectations.

Now the depositors do get bank equity in exchange and some observers note this heist is not as bad it could be--the alternative could have been a complete financial collapse--but from a broader perspective these excuses miss the mark. The very reason the crisis has got to the point that bailouts or "bail-ins" are needed is because the Eurozone was a flawed monetary union from the start. It never met the criteria of an optimum currency area and its monetary policy has effectively been geared toward Germany. Thus, at the advent of the Euro, the ECB policy interest rate was close to what a Taylor rule would predict for Germany, but far too low for the periphery. Likewise, since the crisis the policy rate has been close to what a Taylor rule would predict for Germany, but too high for the periphery. In both cases, ECB policy has been destabilizing to the periphery. That is why, despite being in the midst of a crisis, the ECB explicitly tightened monetary policy in 2011 by twice raising its policy rate. It is also why the ECB has implicitly (or passively) tightened policy over the past few years as evidenced by the flatlining of the broad money supply and nominal GDP. In short, the boom-bust cycle of the Eurozone periphery that helped make the Cyprus financial crisis is largely the result of a flawed monetary system biased toward Germany.

But that part is not new. What is new is the unexpected seizing of depositors funds. As Lars Seier Christensen, Ed Conway, Felix Salmon, and Frances Coppola note, this sets a dangerous precedent for all Eurozone bank deposits.  Here is Coppola:

[T]he fact is that deposit insurance everywhere in the EU has now been undermined. The precedent has been set for insured depositors to suffer losses in order to protect Russian oligarchs and reckless banks. If the Eurogroup can impose this on Cyprus, it can do so elsewhere too.

Yes, EU leadership promised this action was a one-off event, but the fact that they had to make this promise is a sign that they no longer can be trusted. Just imagine what you would be thinking now if you were a resident of troubled periphery economy and had funds in your bank account. I suspect it would be whether my bank was next and whether I needed to get my funds out ASAP. It is almost as if the EU and IMF were trying to create a banking panic in Europe.

What the EU and IMF did to Cyprus today is poised to be a repeat of what happened to U.S. banking in 1933. In February of that year, the governor of Michigan declared a statewide banking holiday as a means to resolve an impasse on how to wind down an important bank in Detroit. Like the Cyprus action today, the governor's actions back then sent chill waves across a continent, as depositors in other states began to wonder if their governors would also call bank holidays to prevent withdrawal of funds. The fear was so poignant, that the Ohio governor made it a point to declare the bank holiday would not happen in Ohio. But it was too late, the die had been cast. By March 1933, 48 states had declared some form of bank withdrawal restrictions as the bank panic spread and fed upon itself. Only with FDR's national bank holiday and the advent of national deposit insurance in March, 1933 was the bank panic stopped.

What is crazy about the Cyprus heist today is that it has the potential to create the same self-fulfilling bank panics across Europe, but without the benefits of a unified treasury to credibly commit to Eurozone deposit insurance. I can't help but hear the echoes of 1933 now unfolding in Europe. 

Update I: Our friend Lars Christiensen, the Market Monetarist one, also weighs in with good thoughts.
Update II:  A fitting picture on the Cyprus heist:

Why Inflation with a Large Output Gap?

This is a question that observers, particularly those who are skeptical of the aggregate demand-shortfall view, often raise. Ryan Avent and Paul Krugman both answer this question in recent posts. Here is Avent:

The answer to the question of why deflation in, say, America hasn't been sustained despite little progress closing the output gap is extremely simple: the Fed has been determined not to allow that to happen...What the record shows is that disinflation below 2% inflation prompts aggressive Fed reactions, which are generally successful at reversing inflation expectations. The critical difference between the Depression and the Great Recession was that Great-Recession-era central banks were determined to avert deflation and where willing to prop up the financial system, drop rates to zero, and engage in unconventional policy in order to keep inflation positive.

I think that assessment is largely correct. The only part I would add is that once FDR took the reins of monetary policy in 1933 (by breaking the link between the dollar and gold and not sterilizing gold inflows) inflation emerged and coincided with a large output. Though the Fed didn't cause this inflation, the Fed tolerated it until 1937 as seen in the figure below:

 

 As Paul Krugman notes, this bout of inflation between 1933 and 1937 was not that different from what we have today as seen in the chart below.

Below is a table that compares the output gaps and inflation rates that occurred after the troughs of 1933 and 2009.  Again, we see that inflation rates were not that different. 

The only big difference between the periods is the output gaps. The mid-1930s output gap was far larger than the current one and yet that period had a similarly-sized rate of inflation. For me, then, the interesting question is why has inflation during the last two largest U.S. economic crisis been similar? Why were they both gravitating around 2%? Ryan Avent has an answer that I suspect is true to some extent for both periods:

[T]he Fed's observed success in averting deflation should lead one to ask whether its control over inflation expectations suddenly evaporates once those expectations hit 2%. My view is that it does not—why should it, after all?—and that the main constraint on a faster economic recovery is the Fed's reluctance to push inflation over 2%.

This makes a lot of sense for the 1930s too since it is well documented the Fed was concerned about inflation getting too high during this time. There were a few years of higher-than-normal inflation, but the average inflation rate was kept in line by the Fed. Even at the expense of creating a recession in 1937-1938. History repeats itself.

P.S. Yes, I said in my last post the next one will be Bernanke's Friday Night Special II, but it had to wait.  I hope to get it up later this week.

Bernanke's Friday Night Special: Part I

Fed Chairman Ben Bernanke gave one of his better speeches last Friday night. In it, he explained why long-term interest rates have declined over the past four years and, in so doing, provided an important rebuttal to the popular view of the Fed as the great enabler of the large government deficits. The evidence Bernanke presented in his speech should give any honest proponent of the Fed as the great enabler (FGE) view pause. Unfortunately, this speech has not received the attention it deserves and many of the FGE proponents probably missed it.¹ Therefore, it is worth reviewing and elaborating on this important speech.  

Chairman Bernanke began by his speech by observing that both nominal and real long-term interest rates on safe sovereign debt have been declining across the world, not just in the United States. Here, for example, is his chart showing the global decline in real interest rates on government bonds:

 

What is striking about this figure is that there is both a sudden, downward shift in trend beginning in 2008 and a narrowing of spreads among these interest rates. This pattern is also evident in long-term nominal yields, as I noted last year. These figures alone undermine FGE claims since they indicate something global in nature is affecting all these yields in a similar manner. Blaming the Fed for the low, long-term interest rates ignores this global phenomenon.

Bernanke then turned to the movements in long-term U.S. yields. He did so by invoking the expectation hypothesis--the theory that long-term interest rates equal the average of expected short-term interest rates over the same period plus a term premium--to explain the decline in long-term treasury yields. He also decomposes the expected average short-term nominal interest rate into an expected real interest rate and expected inflation component. Here is how this break down comes out for for the 10-year treasury:

With this decomposition, Bernanke notes that most of the the 10-year treasury decline over the past four years comes from a decline in the expected average real interest rate and the term premium.

On the former, Bernanke correctly observes that though the Fed can directly influence the expected path of short-term real interest rate over the short-to-medium term, its influence beyond that is muted by real factors. In other words, the expected average real short-term yield over the next 10 years is shaped more by the economic outlook than by the Fed².

On the later, Bernanke attributes the term premium's decline to three things: increased interest rate certainty because of the zero lower bound (makes it easier to forecast), the safe asset shortage problem, and the Fed's large scale asset purchases (LSAPs). The first two of these developments are result of the crisis. Only the LSAPs are the Fed's doing. So most of the factors driving down the 10-year treasury yields have been developments outside the Fed. This is consistent with the pattern of safe asset yields falling across the world. It is hard to find support for the FGE view here.

There is more Bernanke could have said about the LSAPs. First, contrary to the claims of many FGE proponents, the LSAPs have not been terribly large in relative terms. The stock of marketable treasuries went from about $5.13 trillion at the end of 2007 to $11.27 trillion at the end of 2012.  Over this same time, the Fed’s holding started near $0.74 trillion and reached $1.65 trillion. The Fed’s net gains, then, are approximately $0.94 trillion over this time compared to $6.14 trillion change in marketable debt. (The Fed actually has purchased a little more, but it also sold some securities in 2007.) The figure below shows the Fed's holding of marketable securities at the end of 2012:

Relative, then, to the rise of total marketable debt the Fed’s holdings have not risen rapidly. In fact, the Fed now holds about 15% of marketable treasuries, roughly the same share it has held over the past few decades. Some FGE observers like to point out the Fed purchased 77% of marketable treasuries in 2011.³ What they ignore is that the Fed also sold off a sizable portion in 2007, leaving the Fed's overall share of treasuries about the same. Therefore, the large run up in in U.S. public debt has funded largely by individuals, their financial intermediaries, and foreigners. Blame them, not the Fed, for enabling the large budget deficits.

Second, the LSAP actually stopped with the end of QE2 in mid-2011 and did not resume until late 2012 with QE3. During that time, when the Fed's treasury holdings were relatively stable, real interest rates on 10-year treasuries continued to fall. How do FGE proponents explain this development? It is easy to explain if one looks to the other factors Bernanke listed as being important determinants of the long-term interest rates.

Third, even with the advent of QE3 and its $85 billion treasury purchases per month, it is unlikely the Fed will see its share of treasuries grow to the point where one can say the Fed is truly engaged in financial repression. Here is why. The Fed's QE3 purchases can be viewed as the Fed simply increasing the supply of the monetary base to match the demand for it. To the extent the Fed overshoots--and the FGE proponents are correct--then inflation will rise and force the Fed to reverse itself since QE3 is conditional on explicit inflation thresholds being hit. If the Fed does not hit these thresholds (and assuming no positive supply shocks that create downward pressure on inflation), then the Fed's treasury purchases will simply be accommodating growing monetary base demand. And if that is the case, the economy will still be weak leading to more budget deficits and a relatively stable share of treasury holdings for the Fed.

So far from being the great deficit enabler, the Fed's policies are actually playing catch up with soaring liquidity demand. And on that point the Fed can be held accountable for not doing enough, but that is subject of my next post.

 ¹Noteable exceptions include Joe Weisenthal, Jim Hamilton, and Ryan Avent.
²In other words, the natural real interest is low and the actual real interest rate is reflecting that. 
³According to this data, the number is actually 61%, not 77%.

Update:  Below is total marketable treasuries and the Fed's share in dollars.