The Legacy of TARP

Today, Simon Johnson considers the long-term implications of TARP:

TARP was an essential piece of a necessary evil – that is, it saved the American financial system from collapse, but it was put in place in a way that was excessively favorable to the very bankers who had presided over the collapse. And this sets up exactly the wrong incentives as we head into the next credit cycle.

A couple of weeks Ryan Avent reached the same conclusion:

[G]overnment interventions, of which the TARP was a key part, prevented what leaders in the early 1930s did not—a cascade of wealth-destroying, money-supply shrinking bank failures. And because the interventions successfully halted the cycle of fear in financial markets, the programme ended up costing practically nothing... The truth is that the TARP, despite the profit, has come with significant negative costs. It has preserved the structure of the banking system in its current, over-concentrated, too-big-to-fail form. And it has created an absolutely massive moral hazard problem. And so in a way, we're all still paying the cost of TARP, because the legacy of that intervention continues act as a de facto subsidy to size and risk. And one day that bill may come due, in the form of another costly crisis.

 There are other observers, on the other hand, who sing nothing but praise for TARP. If it were possible, it would be useful to look at the difference between (1) the net present value of  future costs created by TARP and (2) the costs that would have been incurred in 2008 and 2009 had there been no TARP.  Of course, such a calculation is not possible because (1) requires knowledge of the future and (2) requires knowledge of a counterfactual.  One thing, though, does seems sure to me: the moral hazard problem is now bigger than ever. 

The Passive Tightening of Monetary Policy in 2008

Ryan Avent is sounding a lot like Scott Sumner:

 I like to point out that in June of 2008 the Federal Reserve forecast real GDP growth in 2009 of 2.0% to 2.8%, when in fact the economy shrank in 2009 by over 2%. Of course, this doesn't mean that central banks have no basis on which to make policy. All they need do is look at the evidence in front of them... In late 2008, the Fed might have taken comfort from its forecasts. Had it been looking at market signals—falling equity and commodity prices, a rising dollar, and movements in bond yields—the need for aggressive monetary easing would have seemed clear.

In other words, beginning around  mid-2008 the Fed passively allowed market conditions to deteriorate and did so all the way up to the financial blow-up in September.  The Fed's actions during this time were not enough to stem the growing demand for liquidity.  The Fed, therefore, was effectively tightening monetary policy by failing to accommodate this growth in money demand.  This passive tightening by the Fed prior to the crisis can be seen below:  (Click on figure to enlarge.)

This figure shows the spread between the nominal and real yield on 5-year treasuries.  It fell about 170 basis points during the period leading up to the collapse of Lehman in September.  Normally, this spread is interpreted as the expected inflation rate.  In this case, it shows a decline in inflation expectations that in turn suggests a deterioration in expected aggregate spending (assuming no big increases in expected productivity). It is likely that this spread was also reflecting a heightened liquidity premium during this time. Here, the implication is the same. A heightened liquidity premium indicates increased demand for highly liquid assets like treasuries and money that, in turn, also imply less aggregate spending.  Both interpretations point to the Fed allowing monetary policy to passively tighten during this time. This passive tightening was unfortunate and most likely contributed to the severity of the financial crisis.  That being said, it pales in comparison to the passive tightening of monetary policy that occurred after the Lehman collapse.  Thus, I have classified the July-September period in the figure as the passive mild tightening of monetary policy and the September-December period as the passive sharp tightening of monetary policy.

Martin Wolf, the Paradox of Thrift, and the Excess Demand for Money

Martin Wolf reminds us why good macroeconomic analysis is not always intuitive:

Analysis of the economy is not the same thing as analysing a single household. What is true of the latter is not true of the former. The unwillingness to recognise this truth will lead to serious policy mistakes.

The policy mistake to which Martin Wolf is referencing is the call for more economic austerity.  He notes that though increased austerity may be a good idea for a given household it is not necessarily true for the entire economy. He is alluding here to the Paradox of Thrift, the idea that if everyone tries to save--which makes sense individually--during a recession, then aggregate spending will fall.  In turn, this will lower both aggregate income and total saving (i.e. there would be less income from which to save). As a result, the economy will tank even more making it harder to service the existing debt.  Thus, Martin Wolf concludes more borrowing may be just what the economy currently needs.  

While provocative, the paradox of thrift idea is really nothing more than another way of saying there is a monetary disequilibrium created by  an excess demand for money.  And, of course, an excess demand for money is best solved by increasing the quantity of money.  The painful alternative is to let the excess money demand lead to a decline in total current dollar spending  and deflation  until money demand equals money supply.  Another way of saying this, is that the paradox of thrift requires the Fed to be asleep on the job.

Let me explain why the Paradox of Thrift is really just an excess demand for money problem.  First, individual households can save three ways: (1) by cutting back on consumer spending and hoarding  money, (2) by spending income on stocks, bonds, or real estate and (3) by paying down debt.  In the first  case, all households attempt  to increase their holdings of money by cutting back on expenditures.  However, if there is a fixed amount of money  this will create an excess demand for it and a painful adjustment process will occur.  If , on the other hand, the Fed adjusts the money supply to match the increased money demand then the painful adjustment is avoided and  monetary equilibrium is maintained.  In the latter two cases where assets are bought and debt is paid down the money is passed on  to the seller of the assets or to the creditor.  Here, the only way to generate the painful adjustment is for the seller or creditor--or any other party down the money exchange line--to hoard the money.  If the creditor or seller does not hoard the money then  it continues to support spending  and price  stability. All is well.  Increased austerity, then, only becomes an economy-wide problem when it leads to an excess demand for money. Bill Woolsey sums it up best:

[S]aving can only generate the sort of cumulative rot that would create a paradox of thrift if it either directly or indirectly creates an excess demand for money. There is nothing to the paradox of thrift other than a distorted version of the fundamental proposition of monetary theory.  

The fundamental proposition of monetary theory is that an individual household can adjust its money stock to the amount demanded, but the economy as a whole cannot.  The economy must adjust its money demand to the given stock of money and this can be very painful.  The question then is how best to maintain monetary equilibrium. My answer is to have the Fed stabilize aggregate spending.

Update I: Nick Rowe responds in the comment section.  Along with Bill Woolsey, he is one of the resident experts in blogosphere on the importance of money as  a medium of exchange and its implications for monetary disequilibrium. For example, see this post and this one on his blog. 

Update II: If you hang around long in the economic blogosphere you likely to get the famed Brad DeLong smackdown applied to you.  I got my own today and it actually was quite pleasant. Here is Brad:

The hole in David's argument is, I think, where he says "the Fed adjusts the money supply" without saying how... So, yes, Beckworth is right in saying that there is an excess demand for money. But he is wrong in saying that the Federal Reserve can resolve it easily by merely "adjust[ing] the money supply. The problem is that--when the underlying problem is that the full-employment planned demand for safe assets is greater than the supply--each increase in the money supply created by open-market operations is offset by an equal increase in money demand as people who used to hold government bonds as their safe assets find that they have been taken away and increase their demand for liquid cash money to hold as a safe asset instead.

Increasing the money supply can help--but only if the Federal Reserve does it without its policies keeping the supply of safe assets constant. Print up some extra cash and have the government spend it. Drop extra cash from helicopters. Have the government spend and by borrowing to finance it, create additional safe assets in the form of additional government debt. Guarantee private bonds and make them safe. Conduct open market operations not in short-term safe Treasuries but in other, risky assets and so have your open market operations not hold the economy's stock of safe assets constant but increase it instead.

I agree with Brad's concern that something more than normal monetary policy is needed here to accommodate the excess money demand.  I have discussed some of these ideas before on this blog. Interestingly, Brad's discussion takes us full circle back to Martin Wolf's solution of more government borrowing.  All I would add is that fundamentally this is still an excess money demand problem.

More Inflation Yes, Inflation Targeting No!

Scott Sumner has two new posts up that speaks to something that has been bugging me lately: the increasing popularity of an explicit inflation target for the Fed.   Many bloggers, including myself, have been calling for the Fed to create more inflation or at least stabilize inflation expectations.   I have been particularly vocal on the latter point.  Others have been  more forceful in their call for an explicit inflation target as a means to increase the inflation rate.  All along, my reason for arguing for the Fed to stabilize inflation expectations is that doing so would indicate the Fed is stabilizing expectations of future  aggregate demand (given that productivity does not appear to be contributing to drop in inflation expectations).  Such actions, in turn, would also serve to stabilize current aggregate demand as  well.  

Now, I have never been enthusiastic about stabilizing inflation as an end in itself.  The reason being is straightforward: inflation is a symptom, not an underlying cause.  More generally,  the percentage change in the price level could be the result of shocks to  aggregate demand (AD), aggregate supply (AS), or both.  Currently, it seems clear that the drop in inflation expectations and the drop in core inflation are reflecting faltering aggregate demand.  Thus, it makes sense to talk about the need to arrest these drops.  However, it need not always be the case--low inflation could also be the symptom of a positive AS shock (e.g. productivity boom).   Imagine, for example, aliens land and give us new technology that makes our computers faster, gives us clean energy, and allows us to travel to  distant galaxies.  Such an alien encounter would create mother of all productivity booms.  Among other things, this productivity boom would imply a higher neutral interest rate, lower inflation rate, and robust AD growth (given  the increase in expected future income).  In such a case a rigid inflation target of say 4%, as some have proposed, would not make  sense here.  Most likely it would be too high an inflation rate to keep AD stable.   

Another way of saying all of this is that monetary policy should focus only on that over which it has meaningful control:  total current dollar spending or AD.  It should ignore AS shocks, both the good and the bad, because all it can do by responding to such shocks is to make matters worse  as alluded to above.   Focusing too narrowly on an inflation target--which assumes every shock is an AD one--can cause a central bank to make this very mistake.  I made this case before in  more detail in this post which got some play time in the economics blogosphere (e.g. Mark Thoma reposted it here).  My hope was that this post would help folks see that the stabilization of AD rather than inflation targeting should be the key  objective of monetary policy. 

So what kind of monetary policy would serve to consistently stabilize AD?  The answer is one that directly targets a stable growth path for AD. This could be a NGDP target or a final sales of domestic output target or any measure that directly aims to stabilize the growth of total current dollar spending.  Scott Sumner outlines its advantages in a recent post, but let me add a few thoughts.  First, an AD target is easy to implement.  All it requires is a measure of the current dollar value of the economy.  It does not require debates over the proper inflation measure, inflation target, output gap measure, and coefficient weights that plagued inflation targeting and the Taylor Rule.  Second, it can easily be made into a forward-looking rule by having the Fed targeting the market's forecast of AD.  This would require some innovations such as  NGDP futures market, but it is within the realm of possibilities as shown by Scott Sumner.  Finally, it could be easily communicated to and understood by the public by labeling it along the line of a "total cash spending target." 

Let me end by noting some of the famous observers who have called in the past for some form of AD targeting: Bennet McCallum, Greg Mankiw, Robert Hall, Menzie Chinn, Jeffrey Frankel, Martin Wolf, Samuel Brittan, and Frederick Hayek. I like this crowd, how about you?

Update: Karl Smith replies to Scott Sumner and me on this issue.  One point Karl brings up is the possibility that a NGDP target could increase macroeconomic instability.  Bennett McCallum addressed this issue a while back and showed that this need not be the case if there is forward looking behavior.  More recently, Kaushik Mitra showed that even with adaptive expectation-type behavior NGDP targeting can work well. 

One-Size-Fits-All Monetary Policy Does Not Work

Many times I have discussed here how the Eurozone is far from an optimal currency area--its member countries have different business cycles and insufficient economic shock absorbers in place--and the problems that this reality creates for the ECB in conducting monetary policy.  One of the key problems is that the ECB is applying a-one-size-fits-all monetary policy to vastly different economies.  For example, consider the case of Ireland and Germany.  When the Euro was adopted in 1999 Ireland was growing close to 10% while Germany was growing around 3%.  Should the ECB be responding to Ireland, Germany, or the average in setting its target interest  rates?  As the figure below shows, up through the end of the housing boom period Ireland was consistently growing faster than Germany. (Click on figure to enlarge.) 

Via Ralph Atkins we learn of Barclays Capital report that looks closely at this issue. Unsurprisingly, it finds the following:

ECB interest rates have generally corresponded more to economic conditions in Germany - the eurozone’s biggest economy - than the eurozone as a whole.

This means ECB monetary policy was well-suited for the low-growth German economy, but way too easy for the hot Irish economy.  Easy monetary policy, therefore, must have been an important contributor to the housing boom in Ireland during this time. I think Josh Hendrickson would agree.

How to Stimulate Aggregate Spending

There has been an uptick in the discussion of what exactly the Fed should do to stabilize aggregate spending.  Folks like Kevin Drum and Matthew Yglesias love it since it gives cover for the Fed to be more aggressive.   Well, it seems the folks behind the Wizard of Id comic strip have been reading these blogs because today they came up with their own radical proposal: (Click on figure to enlarge.)

Actually, this proposal is not that new as it was recently promoted by Greg Mankiw and William Buiter.  This approach does create some serious problems as noted by Rajiv Shastri, but it would be highly effective in stimulating aggregate spending.  My preference is to go with Scott Sumner's proposal.

The Fed is Awakening From Its Slumber

You may have missed it, but this afternoon a slumbering giant with a formidable arsenal of economic weapons began to awake. That giant is the Fed and its formidable arsenal is its ability to further expand its balance sheet and shape nominal expectations. Though the Fed did not fully awake today, it showed signs of awareness that have been absent in the past few months. Specifically, this excerpt from the FOMC press release reveals the Fed is becoming more concerned about the low levels of inflation:

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

The Fed is finally getting concerned that inflation--a symptom of aggregate spending--is not where it should be.  As Colin Barr notes, this is the Fed's first explicit acknowledgment of this worrying development and it implies the Fed is one step closer to a further loosening of monetary policy.  Ryan Avent agrees on this point.

So the slumbering giant is awakening.  However, there seems to be quite a bit more awakening to do because the excerpt above claims that "long-term inflation expectations are stable." Take a real close look at my previous post.  Using different measures, this post shows that long-term inflation expectations are not stable.  This part of the statement leaves me puzzled.   

Overall, though, this is an improvement over the outcome from the last FOMC meeting.  Maybe Santa Claus Bernanke will grant me my Christmas wish after all.       

Update:  A number of Wall Street economists also view this statement as a step closer toward further monetary easing. It will be interesting to see if the market via changes in expected inflation, value of the dollar, and other asset prices agrees.