How the Fed Let the World Blow Up in 2008


The Fed transcripts have been released. What was going on inside the Fed was actually worse than we thought. No, they didn’t have a time machine to see exactly how bad it would be, but some members had read their history and argued for action. Sigh. And it gets worse, as the Fed continues the tight money policy into 2009. Matt O’Brien writes: 

…But the Fed was blinded. It had been all summer. That’s when high oil prices started distracting it from the slow-burning financial crisis. They kept distracting it in September, even though oil had fallen far below its July highs. And they’re the reason that the Fed decided to do nothing on September 16th. It kept interest rates at 2 percent, and said that “the downside risks to growth and the upside risks to inflation are both significant concerns.”

In other words, the Fed was just as worried about an inflation scare that was already passing as it was about a once-in-three-generations crisis.

It brought to mind what economist R. G. Hawtrey had said about the Great Depression. Back then, central bankers had worried more about the possibility of inflation than the grim reality of deflation. It was, Hawtrey said, like “crying Fire! Fire! in Noah’s flood.” 

Note the discussion re Milton (and Scott Sumner), that you can’t judge easy money by short term rates. Here’s Scott Sumner on Matt O’Brien on the Fed’s mistakes during 2008 

…A few comments:

1. The flawed monetary regime (failure to level target NGDP) made these seemingly small tactical errors in mid-2008 much worse than they would otherwise have been.

2. I am pretty sure Matt is not a market monetarist, or at least he’s more Keynesian on issues like fiscal stimulus than I am. Thus it’s heartening to see the MM interpretation of 2008 become increasingly accepted by the mainstream press. When people like David Beckworth and I were starting out on this crusade, the notion that excessively tight money was the problem was almost laughed off the stage. ”Interest rates were 2%, how can you claim money was tight in 2008?” Now the MM narrative is becoming increasingly accepted in the media. That’s great news.

3. Elsewhere Matt praises Frederic Mishkin. He also directed me to a Hilsenrath piece that said Mishkin came off looking relatively bad in the transcripts. But Hilsenrath was focusing on Mishkin’s jocular style. If you look at content of his analysis he was ahead of most of his colleagues. (In terms of forecasting Rosengren seems to have been the best.) I did a post over at Econlog a few days ago praising Mishkin’s farewell comments, but forgot that he had been equally brilliant at the final meeting of 2007.

More from Scott Sumner here:

The market monetarist view that tight money caused the recession is getting some play in the press. Here’s an excellent piece by Ramesh Ponnuru:

There’s another view of the Fed’s role in the crisis, though, that has been voiced by economists such as Scott Sumner of Bentley University, David Beckworth of Western Kentucky University and Robert Hetzel of the Richmond Fed. They dissent from the prevailing view that the Fed has been extremely loose since the crisis hit. Instead, they argue that the Fed has actually been extremely tight, and that when its performance during the crisis is measured against the proper yardstick, the central bank emerges as the chief villain of the story.

In the second half of 2008, housing prices, many commodity prices, inflation expectations and stocks all suggested deflation was coming. Fed officials, though, kept talking about backward-looking measures of inflation that made it look high. Their hawkish pronouncements effectively tightened monetary policy by shaping market expectations about its future direction. In August 2008, the Fed minutes explicitly said to expect tighter money. Even after Lehman Brothers Holdings Inc. collapsed the following month, the Fed refused to cut rates and fretted about inflation (which didn’t arrive). A few weeks later, the Fed decided to pay banks interest on excess reserves, a contractionary move. Only then did it cut interest rates.

Krugman and I were both wrong about the Fed and interest rates

Tyler Cowen:

In 2011 Krugman wrote (and here)

Like Bernanke, I don’t believe that the flow of Fed purchases has been an important factor holding bond rates down, and hence don’t believe that they will jump when the purchases end.

I don’t think I ever wrote this view up, but I was of the same opinion nonetheless.  It no longer seems this is true.  We’ve had a significant run-up in rates from mere talk about slowing down Fed purchases.

So which other views about the current macroeconomy will we need to revise?  That’s what I’ve been thinking about for most of today.  The major possibilities are not comforting.  I can’t be talked into them by a day or two of market data, but we do need to look more seriously at:

1. The low rates really have been an artifact of Fed policy, at least to a much higher degree than many of us had thought.

2. Emerging markets tanked on the Fed communication, and so we have indeed been exporting bubbles through a ‘reach for yield’ mechanism.

Yikes, and those are not mutually exclusive.  I still don’t see either of these as theoretically strong, for reasons outlined by Krugman and for further reasons outlined by me here, but of course theory has its limits.  In my post from two weeks ago I will raise my p = 0.05 to p = 0.15, at least.

One also might try to argue #3, namely:

3. Interest rates still haven’t moved ‘a lot.’  Obviously there is no fact of the matter as to what is ‘a lot,’ but I admit to being surprised and Krugman also now seems to have different views, so I don’t think we can throw out the new data as irrelevant.

All of this remains in great flux.

What really happened in Cyprus: My interview with Athanasios Orphanides, former central bank governor

Greg Ip, at The Economist, closes with this Q&A:

What will the implications be for Europe and the stabilization of the euro zone?

This is similar to the blunder in Deauville with PSI that injected credit risk into sovereign government debt. The governments have created risk in what before last week were considered perfectly safe deposits. This is going to have a chilling effect on deposits in any bank in a country perceived to be weak. This will mean the cost of funding will increase in the periphery of Europe and as a result, the cost of financing for businesses and households will increase. That will add to the divergences we already have and make the recession in the periphery of Europe deeper than it already is. This is really a disaster for European economic management as a whole

This is by far the best explanation of what has happened in Europe. Read the whole thing.


A simple point about capital controls

More on Capital controls via Tyler Cowen

John Dizard writes:

Capital controls turn into trade controls, as the locals attempt to find ways to turn hard assets or non-banking services into foreign exchange. At some price, for example, you can buy a boat in Cyprus with post-haircut, capital-controlled local deposits, sail it to Lebanon, and then sell it for real, usable money. The same with antiques, jewellery, or anything else you can think of. Even capital goods such as fork lifts can be motored off in the middle of the night.

Here is a long Cardiff Garcia post on capital controls, excellent throughout.  From Garcia, there is also this:

Reinhardt, Rogoff and Maduff did a meta-analysis in 2011 on prior studies of capital controls. The only uncontroversially (though mildly) successful use of controls on outflows they found was Malaysia in the aftermath of the Asian financial crisis. Even then, the controls were accompanied by aggressive counter-cyclical spending, bans on short-selling the currency and trading it offshore, and defending the ringgit against speculators by fixing it to the dollar.

One wonders – did the Eurogroup read Reinhardt, Rogoff and Maduff?

Fed Watch: Do Capital Controls Mean Cyprus Has Already Left the Eurozone?

(…)  If I can spend my dollar in Oregon but not in California, it is really the same dollar? I think not.

 Is this how the Eurozone experiment will end? Not with a formal “exit,” but with a return to banking dominated by national boundaries and enforced by capital controls? No longer a true common currency, but a dozen currencies sharing the same name, each with a different value?

There will be another banking crisis in Europe (just as a bank will fail in some US state) and depositors are now aware that they are fair game in any crisis response, so capital flight will intensify at an earlier stage in the crisis. As may have been noted, European policymakers find rapid crisis resolution to be something of a challenge, thus accelerated capital flight will necessitate a more rapid imposition of capital controls in the future – and with each round of capital controls, a new sub-euro will be born.

Bottom Line: Europe’s response to the Cyprus situation will have long-lasting impacts on the Eurozone experiment itself, none of the good. Indeed, the imposition of capital controls should lead one to wonder if the “solution” to Cyprus is effectively an exit from the Eurozone is everything but name. And don’t forget that the crisis also threatens to destabilize the region geopolitcally. I don’t think that “disaster” is too strong a word in this case.

Looks like the answer is yes – but the EU elites don’t have to formally recognize the exit.

Chuck Norris beats Wolfgang Schäuble

Here's excerpts from a recent post by market monetarist Lars Christensen:

So far it is has been a remarkable week in the global financial markets. The ’deposit grab’ in Cyprus undoubtedly has shocked international investors and confidence in the ability of euro zone policy makers has dropped to an all-time low.

Despite of the ‘Cyprus shock’ global stock markets continue to climb higher – yes, yes we have seen a little more volatility, but the overall picture is that of a continued global stock market rally. That is surely remarkable when one takes into account the scale of the policy blunder committed by the EU in Cyprus and the likely long-lasting damage done to the confidence in EU policy makers.

I therefore think it is fair to conclude that so far Chuck Norris has beaten German Finance Minister Wolfgang Schäuble. Or said, in another way the Chuck Norris effect has been at work all week and that has clearly been a key reason why we have not (yet?) seen global-wide or even European-wide contagion from the disaster in Cyprus.

Just to remind my readers – the Chuck Norris effect of course is the effect that monetary policy not only works through expanding the money base, but also through guiding expectations.

When I early this week expressed my worries (or rather mostly my anger) over the EU’s handling of the situation in Cyprus a fixed income trader who is a colleague of mine comforted me by saying “Lars, you have now for half a year been saying that the Fed and the Bank of Japan are more or less doing the right thing so shouldn’t we expect the Fed and BoJ to offset any shock from the euro zone?” (I am paraphrasing a little – after all we were talking on a trading floor)

The message from the trader was clear. Yes, the EU is making a mess of things, but with the Bernanke-Evans rule in place and the Bank of Japan’s newfound commitment to a 2% inflation target we should expect that any shock from the euro zone to the US and Japanese economies would be ‘offset’ by the Fed and the BoJ by stepping up quantitative easing.

Read more


The Bankers’ New Clothes – reviewed by John Cochrane

Why do banks and protective regulators howl so loudly at these simple suggestions? As Ms. Admati and Mr. Hellwig detail in their chapter “Sweet Subsidies,” it’s because bank debt is highly subsidized, and leverage increases the value of the subsidies to management and shareholders. To borrow without the government guarantees and expected bailouts, a bank with 3% capital would have to offer very high interest rates— rates that would make equity look cheap. Equity is expensive to banks only because it dilutes the subsidies they get from the government. That’s exactly why increasing bank equity would be cheap for taxpayers and the economy, to say nothing of removing the costs of occasional crises.

John Cochrane reviews The Bankers’ New Clothes By Anat Admati and Martin Hellwig Princeton, 398 pages, $29.95

(…) the clear, central argument of “The Bankers’ New Clothes”: More capital and less debt, especially short-term debt, equals fewer crises, and common contrary arguments are nonsense. More capital would be far more effective at preventing crises than the tens of thousands of pages of Dodd-Frank regulations and its army of regulators, burrowed deep in the financial system, on a hopeless quest to keep highly leveraged and subsidized too-big-to-fail banks from taking too much risk. Once the rest of us accept this central idea, the details fill in naturally.

How much capital should banks issue? Enough so that it doesn’t matter! Enough so that we never, ever hear again the cry that “banks need to be recapitalized” (at taxpayer expense)!

Do read John’s long, thoughtful review. Then do what we just did, buy the Kindle edition for yourself, and gift one to your congress-person or MP. I’m not sure politicians can read, but if they read and understand this book, there is a very small chance of change. However politicians won’t touch this issue unless there is a surefire way to get re-elected, including replacing all the campaign funds they get from the financial lobby.

Burton Malkiel: Bond buyers should be mindful of history

Prof. Malkiel has been for three months CIO of Wealthfront. His recommendations are now being integrated into much-expanded asset classes, managed by the Wealthfront software for 0.25% management fee. Of special interest to the retired cohort is what to do about the negative returns offered by bonds? In this FT essay Malkiel first outlines the history of what happened to bond holders the last time Treasury yields were 1.5% in 1946:


But does this flight to so-called havens really provide investors with the protection they desire? Or, are bond buyers making a huge mistake that is likely to guarantee them a period of negative real (after inflation) returns? The answer is almost certainly the latter. Bonds today in countries such as Japan, Germany, and the US are more expensive than at any time in history. Bond investors face virtually sure losses and equities are as attractive as they have been in a generation.

We can illustrate the fundamental unattractiveness of bonds with the US market. The buyer of a 10-year US Treasury bond at a 1.5 per cent yield to maturity will receive a nominal return well below the current rate of inflation and below the Federal Reserve’s informal target rate of inflation of 2 per cent. Thus, even if inflation does not accelerate, long-term US Treasuries will provide a negative real rate of return. If inflation does accelerate, that real rate of return will be further reduced.

It is important to remember what happened to bond investors the last time that Treasury bond yields were at 1.5 per cent, in 1946. Bond yields remained pegged at low rates until the early 1950s to enable the government to more easily finance the debts from the second world war. Therefore, bond prices remained fairly stable. But moderate inflation reduced the real value of both coupon payments and the face value of the bonds, and bondholders lost considerable purchasing power. And that was only the beginning of the pain.

Interest rates began to rise to more normal levels and bond prices started to fall. Oil and food shocks then boosted inflation further and, by the end of the 1970s, bond yields had increased to double digit levels. Thus, bond owners not only earned negative real income returns but also suffered punishing capital losses. No wonder a “bond” came to be considered an unmentionable four letter word and bond investors came to believe they had in effect been slaughtered. Investors should be mindful of history. The current era of financial repression may well lead once again to the euthanasia of the bondholding class.

All the developed countries of the world are burdened with excessive amounts of debt. As in the US, governments around the world are having an extraordinarily difficult time reining in entitlement programmes in the face of ageing populations. The easier path for the US government is to keep interest rates artificially low as the real burden of the debt is reduced and the debt is restructured on the backs of the bondholders. We reduced the debt to gross domestic product ratio in the US from 122 per cent in 1946 to 33 per cent in 1980. But it was achieved at the expense of bondholders.

Equities are reasonably priced and are downright cheap in comparison with bond alternatives. (…) 

Emerging market equities are even cheaper. (…) 

If you are a retired saver you should have a profound grasp of the meaning of financial repression by now. Please read the full Malkiel analysis at FT.

Wealthfront has added five new income-producing asset classes to improve bond diversification as follows:

  • Municipal Bonds
  • Corporate Bonds
  • Treasury Inflation Protected Securities (TIPS)
  • Emerging Market Bonds
  • Dividend Growth Stocks

Each asset class has a different set of risk, return and tax characteristics, so adding them gives us more ability to customize portfolios. Not every account will include all of the 11 asset classes we now use; a different subset of the asset classes will be used depending on account type and each client’s tolerance for risk. To read more about the rationale behind our changes please see our blog post, Burt Malkiel On Wealthfront’s Promise.

Someone Forgot to Tell California’s Bankrupt Cities About the Golden State’s Alleged Economic Revival

Libertarian editor of Reason magazine Matt Welch sprays bracing ice water on the recent optimistic articles on California’s fiscal mess.

(…) For a reality check against premature it’s-back-ulation, I recommend the relentlessly grim website Pension Tsunami, where you can see the daily nitty-gritty of blue-state interest groups (read: governments and public sector unions) fighting like wolverines over the ever-shrinking pie of available government revenue. For instance, here’s a recent article from the Riverside Press-Enterprise:

The city of San Bernardino won an important victory in its request for bankruptcy protection Friday, Dec. 21, when a judge denied CalPERS’ attempt to force payment of unpaid pension obligations through state court.

CalPERS, the state retirement system, is the city’s largest creditor. CalPERS had filed a motion for relief from the automatic protection from creditors under bankruptcy law that came with San Bernardino’s Aug. 1 Chapter 9 petition.

In order to make payroll and keep basic operations going, the city has stopped paying many of its debts, including the employer share of biweekly payments to CalPERS.

The city now owes $8.3 million and is accruing a debt of $1.7 million a month even as the agency continues to pay $3.75 million in benefits to city retirees a month, said Michael Gearin, an attorney for CalPERS, during an almost five-hour hearing in U.S. Bankruptcy Court in Riverside on Friday.

The agency depends on timely payments from its members, he said.

“Without that, the system falters, and it will ultimately fail if enough employers don’t participate,” Gearin said.

Matt ends with this:

I’ll be happier than Huell Howser tripping on acid when the Golden State makes its long-delayed comeback, but the structural problems of converting tax dollars into a guaranteed pension machine are vast and ongoing, and it’s going to take more than one month of sub-10% unemployment since January 2009 to get me busting out the Phantom Planet catalogue.

Dr. Al explains the so-called “so-called fiscal cliff”


Bob Cringely recently posted a December 14th guest essay by economist Dr. Al Wojnilower. I can’t improve on Bob’s introduction – excerpt:

(…) Dr. Al started working at the New York Fed two years before I was born and spent 22 years as chief economist at Credit Suisse First Boston. Sixty years on he’s still explaining where the financial world is going and why, somehow doing so without a supercomputer in sight. Dr Al is the best of the best when it comes to understanding those inner workings, in this case of our economy and the world’s. And that’s why he’s the author of the only guest post I’ll ever print in this rag. It’s about the so-called ‘so-called fiscal cliff’ we’re so worried about. His explanation is simple, untainted, and worth reading and he’s allowing me to reprint it here. I’ll come back at the end with a comment.  

Dr. Al begins with this:

Although most observers have long understood that fiscal policy is tightening, many may have underestimated the severity of the tightening scheduled for 2013, and the difficulty of reconciling the conflicts of ideology and personal ambition that separate the parties who would have to agree to any mitigating ‘deal.’ While the contestants joust, the economy is already falling off the fiscal cliff.

Most of the public remains blissfully unaware of the scale of the problem. They will be aghast when, soon after year-end, they experience reduced take-home pay and higher tax bills, as well as unforeseen job losses at the many entities, both public and private, that depend, both directly and indirectly, on federal funding and contracts.

Monetary policy has been hard at work to produce sharply lower long-term interest rates, an easing of credit availability, and a recovery in home and stock prices. In recent months (some three years after the end of the Great Recession), households have finally responded by stepping up sharply their purchases of homes, autos, and other durable goods. The increased spending has reduced the rate of personal saving to near its pre-recession lows. Saving will narrow further as unanticipated tax increases bite into incomes until households are forced to curtail their outlays once again, bringing on a new recession.

The improvement in business due to the increased buoyancy of the household sector has been partly offset by reductions in military and state and local government outlays. But more ominous is the fact that business capital investment, which had earlier sustained the economy by rising at double-digit rates, is now actually shrinking — notwithstanding record profit margins and the low credit spreads brought about by Federal Reserve policy. The decline reflects mounting fear that the impending setbacks to household incomes will halt or reverse the upward momentum in consumer spending, which is the chief source of business revenues. The indifference of elected officials to such a disastrous reversal is yet another reason for the widespread loss of confidence in governmental competence.

 and ends with this:

Awareness of these dangers is bound to have a major effect on the Federal Reserve’s policy decisions. Lower interest rates and easier credit have played a key role in strengthening business investment, raising real estate and stock prices, and promoting the recovery in housing starts and consumer buying. As long as stringent fiscal restraint persists, so will monetary ease. Although the current technique of ‘quantitative ease,’ i.e. the large-scale buying of Treasury and mortgage-backed securities in order to lower longer-term rates of interest, may eventually be subject to diminishing returns, it seems to be working well for now. The Federal Reserve has also announced specific thresholds of 6½% for unemployment and 2 1/2% for inflation to underline its commitment to continue aggressive ease until economic growth is satisfactory.

This suggests that, absent a benign fiscal agreement, high quality bond yields may well decline even further. Meanwhile, the cost-of-living index will be sustained by the increasing prices of utilities, transit, education, and medical care, as governmental supports are reduced.

I hope this sample motivates you to study Dr. Wojnilower’s essay carefully. I’m looking at the St. Louis Fed data on business investment and Fed statistical release Dec 6 right now.