Category: Interesting External Papers

Stop-Loss Orders have always seemed completely insane to me. They completely ignore fundamentals; they are set according to price only.

If you’re willing to sell something at $20, why wouldn’t you sell it at $21 when you have the chance? The deliberate introduction of negative convexity into a portfolio – without getting paid for it! – is something that has bothered me even before I could express the idea in terms of convexity.

I was asked a question regarding Stop-Loss orders recently, which I answered as politely as I could; but it would be helpful to have some academic references to buttress my biases … or, who knows, maybe even refute them, although that would be the complete antithesis of how I have managed money throughout my career.

So … I’m starting this post to keep my notes in. Carry on!

Positive Feedback Investment Strategies and Destabilizing Rational Speculation, J. Bradford De Long, Andrei Shleifer, Lawrence H. Summers and Robert J. Waldmann. Yep, that’s THE Larry Summers. Anyway, the argument here is that there will be a certain proportion of “positive feedback” traders in the market, no matter what – they might even be margin traders, getting margin calls in a down market. Therefore, it becomes rational for informed traders to overreact to actual news, because they know that uninformed traders will overreact even more while the informed traders liquidate. While interesting, the authors are more interested in demonstrating the variability of the market and determining “critical points” – where a decline becomes a discontinuous crash – rather than looking at empirical evidence of stop-loss profit-and-loss.

Market Liquidity, Hedging, and Crashes by Gerard Gennotte and Hane Leland has much the same theme. There’s a nice line in the conclusion: “Traditional models which do not recognize that many investors are poorly informed will grossly overestimate the liquidity of stock markets” …. I’ll have to think about how that might tie in with the Credit Cruch!

The paper Understanding the Subprime Mortgage Crisis by Yuliya S. Demyanyk and Otto Van Hemert has been previously discussed on PrefBlog, but it’s about to be published on a formal basis (forthcoming in the Review of Financial Studies) and the authors are beating the drums for it on VoxEU.

In the essay Subprime mortgages: Myths and reality, they highlight the following sources of confusion about the Credit Crunch:

• Myth: Subprime mortgages went only to borrowers with impaired credit
• Myth: Subprime mortgages promoted homeownership
• Myth: Declines in mortgage underwriting standards triggered the subprime crisis
• Myth: Subprime mortgages failed because people used homes as ATMs
• Myth: Subprime mortgages failed because of mortgage rate resets
• Myth: Subprime borrowers with hybrid mortgages were offered (low) “teaser rates”

Their conclusion is in line with what I’ve been saying for some time:

Many of the myths presented here single out some characteristic of subprime loans, subprime borrowers, or the economic circumstances in which those loans were made as the cause of the crisis. All of these factors are certainly important for borrowers with subprime mortgages in terms of their ability to keep their homes and make regular mortgage payments. But no single factor is responsible for the subprime failure.

In hindsight, the subprime crisis fits neatly into the classic lending boom and bust story – subprime mortgage lending experienced a remarkable boom, during which the market expanded almost sevenfold over six years. In each of these years between 2001 and 2007, the quality of mortgages was deteriorating, their overall riskiness was increasing, and the pricing of this riskiness was decreasing (see Demyanyk and Van Hemert 2008). For years, rising house prices concealed the subprime mortgage market’s underlying weaknesses and unsustainability. When this veil was finally pulled away by a nationwide contraction in prices, the true quality of the loans was revealed in a vast wave of delinquencies and foreclosures that continues to destabilise the US housing market even today.

Subprime is just another boom and bust story; just another example of the manner in which easy money will find an outlet. Usually, of course, easy money will express itself in terms of inflation; since there was not much inflation in the period 2001-07, the Fed missed the underlying problem. This isn’t just my thesis: it has been suggested by Ken Taylor of Taylor Rule fame and researchers from the Kansas City Fed.

Unfortunately, the politicians have taken over public discussion of the issue and find it much more convenient to blame bankers and their compensation; when, in fact, these guys are in the same position as those poor suckers who get caught by customs with a suitcase-full of heroin. Yes, they did wrong; but it is more important to find out who filled the suitcase.

The Bank of Canada has released Working Paper 2009-29 by Stephen Murchison titled Exchange Rate Pass-Through and Monetary Policy: How Strong is the Link?:

Several authors have presented reduced-form evidence suggesting that the degree of exchange rate pass-through to the consumer price index has declined in Canada since the early 1980s and is currently close to zero. Taylor (2000) suggests that this phenomenon, which has been observed for several other countries, may be due to a change in the behaviour of inflation. Specifically, moving from a high to a low-inflation environment has reduced the expected persistence of cost changes and, by consequence, the degree of pass-through to prices. This paper extends his argument, suggesting that this change in persistence is due to a change in the parameters of the central bank’s policy rule. Evidence is presented for Canada indicating that policy has responded more aggressively to inflation deviations over the low pass-through period relative to the high pass-through period. We test the quantitative importance of this change in policy for exchange rate pass-through by varying the parameters of a simple monetary policy rule embedded in an open economy, dynamic stochastic general equilibrium model. Results suggest that increases in the aggressiveness of policy consistent with that observed for Canada are sufficient to effectively eliminate measured pass-through. However, this conclusion depends critically on the inclusion of price-mark-up shocks in the model. When these are excluded, a more modest decline to pass-through is predicted.

He uses a model incorporating a Taylor Rule for policy rates and finds:

Overall, we find that for reasonable changes to the policy rule, large changes in estimated pass-through can be generated. Specifically, parameter values of between 1.6 and 2.1 on the deviation of in‡ation from target (in a Taylor rule) are sufficient cient to drive estimated pass-through to zero.

The author concludes, in part:

In particular, small changes in policy can have a profound effect on the correlation between prices and the exchange rate in the presence of mark-up shocks and this is largely responsible for the result. When mark-up shocks are excluded from the model or when pass-through is defined in terms of the response of prices to a deterministic exchange-rate shock, we conclude that more aggressive monetary policy in Canada has likely reduced pass-through by about 50 per cent relative to its level prior to 1984.

The Bank for International Settlements has released a paper by Patrick McGuire and Goetz von Peter titled The US dollar shortage in global banking and the international policy response:

Among the policy responses to the global financial crisis, the international provision of US dollars via central bank swap lines stands out. This paper studies the build-up of stresses on banks’ balance sheets that led to this coordinated policy response. Using the BIS international banking statistics, we reconstruct the worldwide consolidated balance sheets of the major national banking systems. This allows us to investigate the structure of banks’ global operations across their offices in various countries, shedding light on how their international asset positions are funded across currencies and counterparties. The analysis first highlights why a country’s “national balance sheet”, a residency-based measure, can be a misleading guide to where the vulnerabilities faced by that country’s national banking system (or residents) lie. It then focuses on banking systems’ consolidated balance sheets, and shows how the growth (since 2000) in European and Japanese banks’ US dollar assets produced structural US dollar funding requirements, setting the stage for the dollar shortage when interbank and swap markets became impaired.

The swap lines arranged by the Fed (reported on PrefBlog on 2008-9-29) have been a topic of great fascination for me as the details have been explained; most recently in the BIS Quarterly Review of March 2009.

We find that, since 2000, the Japanese and the major European banking systems took on increasingly large net (assets minus liabilities) on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off-balance sheet, the build-up of net foreign currency positions exposed these banks to foreign currency funding risk, or the risk that their funding positions (FX swaps) could not be rolled over.
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This yields a lower-bound estimate of banks’ US dollar funding gap – the amount of short-term US dollar funding banks require – measured here as the net amount of US dollars channelled to non-banks. By this estimate, European banks’ need for short-term US dollar funding was substantial at the onset of the crisis, at least $1.0–1.2 trillion by mid-2007.

Events during the crisis led to severe disruptions in banks’ sources of short-term funding. Interbank markets seized up, and dislocations in FX swap markets made it even more expensive to obtain US dollars via swaps. Banks’ funding pressures were compounded by instability in non-bank sources of funds as well, notably dollar money market funds and dollar-holding central banks. The market stress meant that the effective maturity of banks’ US dollar funding shortened just as that of their US dollar assets lengthened, since many assets became difficult to sell in illiquid markets.
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Consider a bank that seeks to diversify internationally, or expand its presence in a specific market abroad. This bank will have to finance a particular portfolio of loans and securities, some of which are denominated in foreign currencies (eg a German bank’s investment in US dollar-denominated structured finance products). The bank can finance these foreign currency positions in several ways:

• 1. The bank can borrow domestic currency, and convert it in a straight FX spot transaction to purchase the foreign asset in that currency.
• 2. It can also use FX swaps to convert its domestic currency liabilities into foreign currency and purchase the foreign assets.
• 3. Alternatively, the bank can borrow foreign currency, either from the interbank market, from non-bank market participants or from central banks.

The first option produces no subsequent foreign currency needs, but exposes the bank to currency risk, as the on-balance sheet mismatch between foreign currency assets and domestic currency liabilities remains unhedged. Our working assumption is that banks employ FX swaps and forwards to hedge any on-balance sheet currency mismatch.

So in other words, it’s just another wrinkle on the same old story: borrow short + lend long = funding risk. But it’s a good wrinkle!

Why is funding risk in foreign currencies of special interest? Banks also face the risks inherent in transforming maturities in their domestic currency market, of course. …However, in a purelydomestic banking context, the central bank can act as lender of last resort and provide sufficient liquidity to eliminate a domestic funding shortage; doing so is both time-honoured practice (Bagehot (1873), Goodhart (1995)) as well as optimal policy (Allen and Gale (1998), Diamond and Rajan (2006)). By contrast, central banks cannot create foreign currencies; their ability to meet banks’ demand for foreign currencies is constrained by the exchange rate regime or limited to available FX reserves (Chang and Velasco (2000, 2001), Obstfeld et al (2009)). Banks’ foreign currency requirements may therefore have to be met from international sources (Fischer (1999), Mishkin (1999)).

It gets better:

The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks’ international balance sheets. The outstanding stock of banks’ foreign claims grew from $10 trillion at the beginning of 2000 to $34 trillion by end-2007, a significant expansion even when scaled by global economic activity (Figure 1, left panel).…For example, Swiss banks’ foreign claims jumped from roughly five times Swiss nominal GDP in 2000 to more than seven times in mid-2007 (Table 1). Dutch, French, German and UK banks’ foreign claims expanded considerably as well. In contrast, Canadian, Japanese and US banks’ foreign claims grew in absolute terms over the same period, but did not significantly outpace the growth in domestic or world GDP (Figure 1, right Panel).

This is the Right Panel.
Click for the whole thing

The lack of foreign funding pressure might be a more precise indication of why Canadian banks were resilient during the crisis.

Then Bad Things happened:

European banks’ funding difficulties were compounded by instability in the non-bank sources of funds as well. Money market funds, facing large redemptions following the failure of Lehman Brothers, withdrew from bank-issued paper, threatening a wholesale run on banks (Baba et al (2009)). Less abruptly, a portion of the US dollar foreign exchange reserves that central banks had placed with commercial banks was withdrawn during the course of the crisis. In particular, some monetary authorities in emerging markets reportedly withdrew placements in support of their own banking systems in need of US dollars.

Market conditions during the crisis have made it difficult for banks to respond to these funding pressures by reducing their US dollar assets. While European banks held a sizeable share of their net US dollar investments as (liquid) US government securities (Figure 5, bottom right panel), other claims on non-bank entities – such as structured finance products – have been harder to sell into illiquid markets without realising large losses. Other factors also hampered deleveraging of US dollar assets: banks brought off-balance sheet vehicles back onto their balance sheets and prearranged credit commitments were drawn.

But … Fed to the rescue!

On 13 October 2008, the swap lines between the Federal Reserve and the Bank of England, the ECB and the Swiss National Bank became unlimited to accommodate any quantity of US dollar funding demanded. The swap lines provided these central banks with ammunition beyond their existing foreign exchange reserves (Obstfeld et al (2009)), which in mid-2007 amounted to $294 billion for the euro area, Switzerland and the United Kingdom combined, an order of magnitude smaller than our lower-bound estimate of the US dollar funding gap.

In providing US dollars on a global scale, the Federal Reserve effectively engaged in international lending of last resort. The swap network can be understood as a mechanism by which the Federal Reserve extends loans, collateralised by foreign currencies, to other central banks, which in turn make these funds available through US dollar auctions in their respective jurisdictions.33 This made US dollar liquidity accessible to commercial banks around the world, including those that have no US subsidiaries or insufficient eligible collateral to borrow directly from the Federal Reserve System.

The authors conclude, in part:

What pushed the system to the brink was not cross-currency funding per se, but rather too many large banks employing funding strategies in the same direction, the funding equivalent of a “crowded trade”. Only when examined at the aggregate level can such vulnerabilities be identified. By quantifying the US dollar overhang on non-US banks’ global balance sheets, this paper contributes to a better understanding of why the extraordinary international policy response was necessary.

and why it took the form of a global network of central bank swap lines.

Just a quick note here … the Kansas City Fed published a paper by Craig S. Hakkio and William R. Keeton titled Financial Stress: What Is It, How Can It Be Measured and Why Does It Matter?.

One of the coefficients is the stock/bond correlation.

Correlation between returns on stocks and Treasury bonds. In normal times, the returns on stocks and government bonds are either unrelated or move together in response to changes in the risk-free discount rate. In times of financial stress, however, investors may view stocks as much riskier than government bonds. If so, they will shift out of stocks into bonds, causing the returns on the two assets to move in opposite directions. A number of studies, some for the United States and some for other countries, confirm that the correlation between stock returns and government bond returns tends to turn negative during financial crises (Andersson and others; Baur and Lucey; Connolly and others; Gonzalo and Olmo). Thus, the stock-bond correlation provides an additional measure of the flight to quality during periods of financial stress. This correlation is computed over rolling three month periods using the S&P 500 and a 2-year Treasury bond index. Also, the negative value of the correlation is used in the KCFSI, so that increases in the measure correspond to increases in financial stress.

The authors are somewhat critical of the Bank of Canada Stress Index:

It includes some variables, such as exchange rate volatility, that are more important for a small open economy like Canada’s than for the United States. It includes the slope of the yield curve, which likely reveals more about the stance of monetary policy than financial stress. And it fails to include any measures of investor uncertainty about bank stock prices.

There appears to be some predictive value in the index:

As shown in the accompanying box, high values of the KCFSI have tended to either coincide with or precede tighter credit standards over the last 20 years. This evidence suggests that changes in credit standards provide an additional channel through which financial stress may affect economic activity.

Regretably, the authors do not dicuss whether these changes in credit standards can be better predicted by other methodologies. I have the same problem with their analysis of the predictive power of the KCFSI on the value of the Chicago Fed National Activity Index.

The authors suggest that the KCFSI could be used to help time the Fed’s exit strategy for the current crisis, but are, frankly, rather unconvincing.

Anyway, the index is down again for September, after a huge decline from the October 2008 peak, but still above July 2007.

The Federal Reserve Bank of Boston has released a Public Policy Discussion Paper by Michelle L. Barnes, Zvi Bodie, Robert K. Triest, and J. Christina Wang titled A TIPS Scorecard: Are TIPS Accomplishing What They Were Supposed to Accomplish? Can They Be Improved?:

In September 1997, the U.S. Treasury developed the TIPS market in order to achieve three important policy objectives: (1) to provide consumers with a class of assets that allows for hedging against real interest rate risk, (2) to provide holders of nominal contracts a means of hedging against inflation risk, and (3) to provide everyone with a reliable indicator of the term structure of expected inflation. This paper evaluates progress toward the achievement of these objectives and analyzes prospective ways to better meet these objectives in the future, by, for example, extending the maturity of TIPS and/or the use of inflation indexes suited to particular geographic regions or demographics. We conclude by arguing that while it is tempting to consider completing markets by introducing more TIPS‐like securities indexed to inflation rates more tailored to particular demographics, our analysis suggests that TIPS indexed to CPI do, in fact, facilitate good synthetic hedges against unexpected changes in inflation for many different investors, since the various inflation measures are very highly correlated. We do, however, argue for extending the maturity of TIPS.

The authors do not assess the cost/benefit profile of TIPS issuance to Treasury as was discussed by, for instance, FRBNY CEO William Dudley earlier this year. The organization of the paper is:

Section II describes TIPS in more detail, emphasizing how they are designed to act as protection against changes in inflation, the tax implications for investors, the demographics of holders of TIPS, and other considerations relating to whether or not TIPS should yield measures of break‐even inflation rates comparable with survey measures of consumers’ inflation expectations or future realized rates of inflation. Section III outlines and evaluates the criticisms of the CPI and speaks to whether its potential mismeasurement is relevant to the efficacy of TIPS as a hedging instrument to guarantee the real return. It also discusses whether the CPI is a good measure for everyone, and whether there might be more appropriate measures for certain heterogeneous groups, along with the costs and benefits of issuing such securities. Section IV demonstrates the efficacy of TIPS as a hedge against various ex ante and ex post inflation measures, as well as the efficacy of TIPS as a short‐term versus a long‐term hedge. The final section concludes with implications for the design of the TIPS market.

There’s rather a neat section on inflation forecasting:

All of the expected inflation measures are largely backward‐looking, moving with recent actual rates of inflation and often deviating substantially from the actual inflation rates that would be experienced over the subsequent 10 years. This is not surprising: although there was concern about the effect of an overheated economy on short‐term inflation rates during the 1960s, it would have been essentially impossible at that time to forecast the oil shocks of the 1970s, or the response of the fiscal and monetary authorities to those shocks. Moreover, the notion of a vertical long‐run Phillips curve was still controversial among economists during the late 1960s and 1970s. Even if professional forecasters had foreseen the oil shocks and policy responses, they likely would have underestimated the extent of the resulting increase in inflation.

Click for big

As a result of the unforeseen shocks, and most likely also because of errors in forecasting the response of inflation to the shocks, the actual 10‐year forward CPI growth rates were much larger than 10‐year‐forward expected inflation, starting in the mid‐1960s. Figure 11 shows the difference between the FRB/US 10‐year expected inflation variable and the actual 10‐yearforward average CPU inflation rate. Forecasts of 10‐year ahead average inflation rates increasingly underpredicted the subsequent actual experienced CPI inflation during the 1960s and early 1970s, with the underprediction of the average annual inflation rate exceeding 5 percentage points by 1972.

Click for big

The authors conclude, in part:

Finally, we draw some implications for the design of the TIPS market and related financial institutions issues. We conclude that, as is, the TIPS market provides a good hedge against inflation risk and that from a cost/benefit perspective there seems little to be gained from indexing to other inflation measures—be they broader, such as the PCE deflator, or narrower, such as regional inflation measures of the CPI‐E for the elderly. A “ladder” of TIPS, with maturities linked to when money is needed for expenses, would help investors in or near retirement hedge against their nominal expenses over time. TIPS have the potential to be the backbone asset underlying inflation‐indexed annuities, but to facilitate these annuities, the maximum duration of TIPS would need to be extended. With respect to housing as an investment as opposed to a consumption good, there is room for alternative hedging instruments and they are currently available in the form of futures contracts on S&P/Case‐Shiller Metro Home Price Indexes, or forward contracts on the Residential Property Index 25‐MSA Composite (RPX).

The Bank of Canada has released a working paper by Jean-Sébastien Fontaine and René Garcia titled Bond Liquidity Premia:

Recent asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the repo market is the key funding market. Then, the premium of on-the-run U.S. Treasury bonds should share a common component with risk premia in other markets. This observation leads to the following identification strategy. We measure the value of funding liquidity from the cross-section of on-the-run premia by adding a liquidity factor to an arbitrage-free term structure model. As predicted, we find that funding liquidity explains the cross-section of risk premia. An increase in the value of liquidity predicts lower risk premia for on-the run and off-the-run bonds but higher risk premia on LIBOR loans, swap contracts and corporate bonds. Moreover, the impact is large and pervasive through crisis and normal times. We check the interpretation of the liquidity factor. It varies with transaction costs, S&P500 valuation ratios and aggregate uncertainty. More importantly, the liquidity factor varies with narrow measures of monetary aggregates and measures of bank reserves. Overall, the results suggest that different securities serve, in part, and to varying degrees, to fulfill investors’ uncertain future needs for cash depending on the ability of intermediaries to provide immediacy.

As far as corporates are concerned, they suggest:

Finally, we consider a sample of corporate bond spreads from the NAIC. We find that the impact of liquidity is significant and follows a flight-to-quality pattern across ratings. For bonds of the highest credit quality, spreads decrease, on average, following a shock to the funding liquidity factor. In contrast, spreads of bonds with lower ratings increase. We also compute excess returns on AAA, AA, A, BBB and High Yield Merrill Lynch corporate bond indices (see Figure 3) and reach similar conclusions. Bonds with high credit ratings were perceived to be liquid substitutes to government securities and offered lower risk premium following increases of the liquidity factor. This corresponds to an average effect through our sample, the recent events suggests that this is not always the case.

Corporate spreads are dealt with in more detail:

The impact of funding liquidity extends to the corporate bond market. This section measures the impact of the liquidity factor on the risk premium offered by corporate bonds. Empirically, we find that the impact of liquidity has a flight-to-quality” pattern across credit ratings. Following an increase of the liquidity factor, excess returns decrease for the higher ratings but increase for the lower ratings. Our results are consistent with the evidence that default risk cannot rationalize corporate spreads. Collin-Dufresne et al. (2001) find that most of the variations of non-default corporate spreads are driven by a single latent factor. We formally link this factor with funding risk. Our evidence is also consistent with the differential impact of liquidity across ratings found by Ericsson and Renault (2006). However, while they relate bond spreads to bond-specific measures of liquidity, we document the impact of an aggregate factor in the compensation for illiquidity.
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First, as expected, average excess returns are higher for lower ratings. Next, estimates of the liquidity coefficients show that the impact of a rising liquidity factor is negative for the higher ratings and becomes positive for lower ratings. A one-standard deviation shock to the liquidity factor leads to decreases in excess returns for AAA, AA and A ratings but to increases in excess returns for BBB and HY ratings. Excess returns decrease by 2.27% for AAA index but increase by 2.38% for the HY index. For comparison, the impact on Treasury bonds with 7 and 10 years to maturity was -4.52% and -5.42%. Thus, on average, high quality bonds were considered substitutes, albeit imperfect, to U.S. Treasuries as a hedge against variations in funding conditions. On the other hand, lower-rated bonds were exposed to funding market shocks.

However, in extreme cases the sign of the relationship for hiqh quality bonds changes:

Adding 2008 only increases the measured impact of the common funding liquidity factor on bond risk premia. Each of the regression above leads to higher estimate for the liquidity coefficient. An interesting case, though, is the behavior of corporate bond spreads. Clearly corporate bond spreads increased sharply over that period, indicating an increase in expected returns. What is interesting is that this was the case for any ratings. Figure 8 compares the liquidity factor with the spread of the AAA and BBB Merrill Lynch index. In the sample excluding 2008, the estimated average impact a shock to funding liquidity was negative for AAA bonds and positive for BBB. The large and positively correlated shock in 2008 reverses this conclusion for AAA bonds. But note that AAA spreads and the liquidity factor were also positively correlated in 1998. This confirms our conjecture that the behavior of high-rating bonds is not stable and depends on the nature or the size of the shock to funding liquidity. Note that this does not affect our conclusion that corporate bond liquidity premium shares a component with other risk premium due to funding risk. Instead, it suggests that the relationship exhibits regimes through time.

I recently highlighted some KC Fed research on monetary policy that concluded that Fed policy was too loose in the period 2001-05.

Now, David Papell, Professor of Economics at University of Houston writes a guest-post for Econbrowser titled Lessons from the 1970s for Fed Policy Today that discusses many of the same issues.

He brings to my attention a speech by John Taylor himself, presented at a FRB Atlanta conference:

One view is that “the markets did it.” The crisis was due to forces emanating from the market economy which the government did not control, either because it did not have the power to do so, or because it chose not to. This view sees systemic risk as a market failure that can and must be dealt with by government actions and interventions; it naturally leads to proposals for increased government powers. Indeed, this view of the crisis is held by those government officials who are making such proposals.

The other view is that “the government did it.” The crisis was due more to forces emanating from government, and in the case of the United States, mainly the federal government. This is the view implied by my empirical research and that of others. According to this view federal government actions and interventions caused, prolonged, and worsened the financial crisis. There is little evidence that these forces are abating, and indeed they may be getting worse. Hence, this view sees government as the more serious systemic risk in the financial system; it leads in a different direction—to proposals to limit the powers of government and the harm it can do.

Dr. Taylor takes the opportunity to tout his new book, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Press, Stanford, California, 2009, and why not?

I argue that the primary initial cause was the excessive monetary ease by the Fed in which the federal funds rate was held very low in the 2002-2005 period, compared to what had worked well in the past two decades. Clearly such an action should be considered systemic in that the entire financial system and the macro economy are affected. My empirical work shows that these low interest rates led to the acceleration of the housing boom and to the increased use of adjustable rate mortgages and other risk-increasing searches for yield. The boom then resulted in the bust, with delinquencies, foreclosures, and toxic assets on the balance sheet of financial institutions in the United States and other countries.
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The questions about the role of government in the crisis go well beyond the initial impetus of monetary policy. The gigantic government sponsored enterprises, Fannie and Freddie, fueled the flames of the housing boom and encouraged risk taking—chain reaction style—as they supported the mortgage-backed securities market. Moreover these agencies were asked by government to purchase securities backed by higher risk mortgages. Here I have no disagreement with Alan Greenspan and others who tried to rein in these agencies at the time.
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… in my view the problem was not the failure to bail out Lehman Brothers but rather the failure of the government to articulate a clear predictable strategy for lending and intervening into a financial sector. This strategy could have been put forth in the weeks after the Bear Stearns rescue, but was not. Instead market participants were led to guess what the government would do in other similar situations. The best evidence for the lack of a strategy was the confusing roll out of the TARP plan, which, according to event studies of spreads in the interbank market, was a more likely reason for the panic than the failure to intervene with Lehman.

Assiduous Readers will remember that on November 12 I referenced previous predictions that TARP (the asset-buying part) would fail for the same reason that MLEC failed. Shamed by PrefBlog’s criticism, Paulson abandoned the idea that day. The latest resurrection of this old zombie is the Public-Private Partnership Fund which has attracted the usual roster of well-connected firms and so far looks like a fizzle.

Back to Dr. Taylor:

Some argue that the reason banks have been holding off and demanding a higher price for their toxic assets than the market is offering is the expectation that federal funds will be forthcoming to assist private purchases. If so, this may be an explanation for the freezing up of some markets and the long delay in the recovery of the credit markets.
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But mistakes occur in all markets and they do not normally become systemic. In each of these cases there was a tendency for government actions to convert non-systemic risks into systemic risks. The low interest rates led to rapidly rising housing prices with very low delinquency and foreclosure rates, which likely confused both underwriters and the rating agencies. The failure to regulate adequately entities that were supposed to be, and thought to be, regulated certainly encouraged the excesses. Risky conduits connected to regulated banks were allowed by regulators. The SEC was to regulate broker-dealers, but its skill base was in investor protection rather than prudential regulation. Similarly, the Office of Thrift Supervision (OTS) was not up to the job of regulating the complex financial products division of AIG. These regulatory gaps and overlapping responsibilities added to the problem and they need to be addressed in regulatory reform.

Going forward, he sees reckless government spending as being the number one systemic risk:

To understand the size of the risk, consider what it would take to balance the budget in 2019? Income tax revenues are expected to be about $2 trillion, so with a deficit of $1.2 trillion, a 60 percent tax increase across the board would be required. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP? Inflation will do it. But how much inflation? To bring the debt to GDP ratio down to the level at the end of 2008, it will take a doubling of the price level. That one hundred percent increase will make nominal GDP twice as high and thus cut the debt to GDP ratio in half, back to about 40 from around 80 percent. A hundred percent increase in the price level means about 10 percent inflation for 10 years. And it is unlikely that it will be smooth. More likely it will be like the 1970s with boom followed by bust with increasingly high inflation after each bust. This is not a forecast, because policy can change; rather it is an indication of the systemic risk that the government is now creating.

A second systemic risk is the Fed’s balance sheet. Reserve balances at the Fed have increased 100 fold since last September, from $8 billion to around $800 billion, and with current plans to expand asset purchases it could rise to over $3,000 billion by the end of this year. While Federal Reserve officials say that they will be able to sell the newly acquired assets at a sufficient rate to prevent these reserves from igniting inflation, they or their successors may face political difficulty in doing so. That raises doubts and therefore risks. The risk is systemic because of the economy-wide harm such an outcome would cause.
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The Fed’s calculation reported in the Financial Times has both the sign and the decimal point wrong. In contrast my calculation implies that we may not have as much time before the Fed has to remove excess reserves and raise the rate. We don’t know what will happen in the future, but there is a risk here and it is a systemic risk.
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In my view the increasing number of interventions by the federal government into the operations of private business firms represents a systemic risk. The interventions are also becoming more intrusive and seemingly capricious whether they are about employee compensation, the priority of debt holders, or the CEO. Many of these actions reverse previous government decisions, and they involve ex post changes in contracts or unusual interpretations of the law. We risk losing the most important ingredient to the success of our economy since America’s founding—the rule of law, which will certainly be systemic.

It does my heart good to hear somebody talk about “the rule of law” and mean it. In most people’s mouths it means “Crack down on people I don’t like.”

David Papell concluded his post on Econbrowser with the warning:

In the 1970s, the Fed “stabilized” overly optimistic inflation forecasts and responded too strongly to output gaps, lowering interest rates too much — especially during and following the 1970-1971 and 1974-1975 recessions, resulting in frequent recessions and the Great Inflation. What are the lessons from the 1970s for Fed policy today?

• •The Fed should respond to inflation, not inflation forecasts, especially in an environment where large negative output gaps are causing forecasted inflation to fall.
• •The Fed should not tinker with Taylor’s output gap coefficient of 0.5.

Using the rule with Taylor’s original coefficients, the experience of the 1970s suggests that, even if it could, the Fed should not lower its interest rate target below zero. If the incipient recovery takes hold and inflation stays the same or rises, it may need to raise rates sooner than many people think.