Tuesday, May 4, 2010

The Latest Fed Smackdowns

Here are the latest critiques of Fed policy in the early-to-mid 2000s. First up is Roger Lowenstein:
[A]s it still does today, the Fed continued to concentrate on inflation in consumer goods such as cars and computers while all but ignoring speculation in investment assets.

By focusing so zealously on inflation, the Federal Reserve is essentially fighting the last war. The United States' most recent bout of serious inflation occurred in the 1970s and early '80s; in response, then-Fed Chairman Paul Volcker moved aggressively to raise rates in order to curb prices. Since then, asset bubbles have been inflating and popping ever more often.

Excesses that in the past would have produced inflation now cycle back into the economy through the financial markets.
It sounds like Lowenstein has been reading some of William White's work, maybe even his classic "Is Price Stability Enough?" My own answer to White's question is no, price stability is not enough. As I have said before, the Fed's focus should not be on stabilizing inflation but on stabilizing aggregate demand. Given current institutional arrangements, I would also like to see some form of macroprudential policies implemented as well. After all, the period of the Great Moderation was one with relatively stable aggregate demand growth but still experienced unsustainable expansions of credit and debt.

Next up is Barry Ritholtz. I am not sure what motivated this outburst today at the Big Picture, but I liked it:
I Direct Your Attention, Mr. Fed Chairman, to Exhibits 1 through 10:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

I hate having to repeat myself, but it is apparently, necessary.

Well said Barry!

1 comment:

  1. "8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas."

    Is this saying that AIG wrote a huge amount of credit default swaps?

    Is risk exposure counted as debt to calculate some kind of leverage ratio?

    I don't think that AIG's risk exposure should be counted as an increase in debt. It rather motivated those purchasing the default "insurance" to lend into a riskier area than they otherwise would