Friday, July 8, 2011

How Should the Fed Prepare for the Eurozone Fallout?

Nick Rowe is concerned that the collapse of the Eurozone could lead to another Lehman-type event for the global financial system.  He is also wondering what central banks should be doing in preparation for such an event.  Nick is not the only one concerned.  Others have expressed concerned that financial contagion could arise from credit default swaps on Greek bonds or U.S. money market funds that are indirectly linked to the Greek economy through investments in the core Eurozone countries.  Even Fed Chairman Ben Bernanke expressed concern in his last press conference about the indirect exposure the U.S. economy has to Greek crisis:

 Answering a question during Wednesday's press conference about the U.S. financial system's exposure to Greece's problems, Bernanke went to great lengths to explain how U.S. institutions had very little "direct exposure" to Greece but considerable "indirect exposure" via their loans to European banks that have loaned to Greece. He drew attention to U.S. money market funds' "very substantial" holdings of European bank-issued commercial paper, which others have estimated to represent a whopping 40% of their assets
[M]emories of the chaos that followed the demise of Lehman Brothers in 2008 are strong and tend to color how investors, including U.S. money funds, respond to troubling events, such as the Greek crisis...The fear is that a default by Greece or a disorderly restructuring of the nation's debt could create contagion in the bond markets of other troubled sovereigns, thereby doing damage to the balance sheets of banks that have loaned to those governments. This could then raise fears about counterparty credit risks in short-term lending markets and, in a worst-case scenario, the paralysis of this vital source of bank funding. 
So what can the Fed do? Here is a suggestion: the Fed could say if total current dollar spending begins to plummet because concerns about the financial system are causing investors to rapidly buy up safe money-like assets (time and saving accounts, money market accounts, treasuries, etc.) then the Fed would begin buying up less-safe and less-liquid assets until the investors' demand for money-like assets is satiated such that they return total current dollar spending to its previous level. The Fed would need to stress the "until" part means it would purchase as many trillions of dollars of assets as necessary to restore total current dollar spending. Since this  process would take place over time, the Fed would also want to set a target growth rate for where it wanted the level of total current dollar spending to go.    

If the above sounds reasonable to you, then you should be a fan of nominal GDP level targeting.  It is exactly what the U.S. economy needed in early 2008 when inflation expectations and velocity started falling.  And it is exactly what the  U.S. economy needs now.  


  1. how should the Fed choose which "less safe and liquid assets" it should purchase? should the Fed precommit to some policy about that (which would raise the value of the identified categories of assets ex ante, by clipping their downside during systemic events), or should it have discretion (which means the Fed will create discretionary winners and losers, as valuations shift and some losses are transferred from would-be private sector holders to the Fed).

    from a macro perspective, these things might seem like details, but from a social and political perspective i think they matter a great deal.

  2. Those safe assets, at least in part, represent funds shifted away from shrinking shadow bank liabilities: ABCP, overnight repo, and ABS.

    Meanwhile, there is plenty of speculative enthusiasm reflected in stocks, credit spreads, and booming bond issuance. The corporate weighted average cost of capital is at relatively low levels, but corporations have not unleashed a wave of "Tobin's Q"-driven investment. Small businesses, on the other hand, still face high borrowing costs and a shortage of start-up capital due to falling home equity values.

    This begs the question of how the Fed should buy risk assets. Should the Fed buy equities to drive the large-corporate WACC even lower? Finance/guarantee a dramatic expansion in SBA and FHA loans? Or perhaps just write cheap puts on the Case Shiller house price index in the hope of reconstituting shadow bank balance sheets?

  3. Friedrich von BlowhardJuly 9, 2011 at 8:01 PM

    I've long been a fan of your basic premise. However, this is the first time I've realized how you would operationalize the injection of money in order to stabilize nominal GDP. The mechanism as you describe it troubles me, as it appears to be one more bailout of those invested in financial assets. Why should they get the first, second, third, and essentially all rounds of assistance from the Fed? If you want to stimulate nominal dollar spending, couldn't you, um, just give money to people who are likely to go out and spend it? Issue gift cards with an expiration date on them? I'm sure there are many ways to get money into the economy without handing it over to panicking investors trampling each other as they seek the exits from the Wall Street casino.

  4. All,

    My "less safe and less liquid assets" part could have been said more clearly. So two things on this point:

    (1) The Fed would first start incrementally buying up the term structure of government debt. Since tbills at the zero bound effectively become equivalent to money, the Fed would need to buy increasingly longer-dated Treasuries until the demand for money and other liquid assets become satiated and spending resumed. In theory, if the Fed bought up all the public debt and money demand was still not satiated then it would have start buying private assets at which point we get into the some of the problems mentioned above.

    (2) However, if the Fed precommitted to this strategy and the public believed it, it is unlikely the Fed would ever have to buy up a lot of securities. Just by managing expectations--creating the belief that nominal spending will never be allowed to collapse in the first place (i.e. keeping the expected path of real interest rates low enough)--would cause investors and the public to avoid the kind of rush to money and money-like assets in the first place. Unfortunately, the Fed didn't do that in late 2008, early 2009 and it is not doing it today.