PrefBlog

There seem to be a lot of people who will answer the headline question: “Yes!”

I recently responded to Menzie Chinn’s “Crony Capitalism” post, and highlighted my doubts there … now Econbrowser‘s James Hamilton has picked up on the theme (or acknowledged it, anyway) in a post about Bernanke’s Tightrope Act.

Some analysts are saying that Fed Chair Ben Bernanke is walking a tightrope– if he does not drop interest rates quickly enough, the U.S. will be in recession, but if he goes too far, we’ll see a resurgence of inflation. I am increasingly persuaded that’s not an accurate description of the situation.
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The Fed chief must be worried that a recession in the present instance would precipitate major financial instability, in which case perhaps the choice between paying now and paying later argues in favor of latter.

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

No, I don’t believe that Bernanke is walking a tightrope at all. But I do hope he’s checked out the net that’s supposed to catch him if he falls.

In a recent post about Inflation Expectations, I opined that the only way I could see to make the market data on Fed Funds and Treasuries consistent was to assume that expectations (of both the market and the Fed) were for an output gap of 5.6% … which is a shockingly fierce recession and, given that the data indicate a period of two years plus, would be labelled a depression by many. So I don’t really have any quarrels with Professor Hamilton’s deduction that the Fed is “worried that a recession in the present instance would precipitate major financial instability”; with, I presume, the major financial instability feeding back into the real economy until we find ourselves all naked and homeless.

But that’s not why I’m devoting an entire post to this response … my quarrel is with the unchallenging repetition of the assertion:

But I think the primary way in which monetary expansion could help alleviate the current credit problems was described by Brad DeLong with remarkable clinical coolness:

Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

Let’s trace this back to the source document – always a fun exercise, I love the Internet! – starting with Mark Thoma’s post on his Economist’s View blog, Brad DeLong: Three Cures for Three Crises, dated December 31. Professor Thoma doesn’t provide any commentary with this post, but does link to a supporting WSJ blog post, Liquidity Threat Eases; Solvency Threat Still Looms.

I’ll side-track a little here … the WSJ blog links to a story in the Boston Globe:

The new rules impose surcharges of 0.75 percent to 2 percent for many conventional borrowers who have credit scores below 680, and who don’t have at least 30 percent for a down payment. Fannie Mae says the lenders may pass along those fees in a variety of ways.

Those in the industry worry many will be priced out of the market. O’Neil notes that about half her customers have credit scores less than 680. “It will definitely affect our business,” she said.

And few buyers ever pay 30 percent down payments. “That’s pretty insane . . . not a lot of buyers will be able to do that,” said Alex Coon, the Massachusetts market manager for online residential real estate brokerage Redfin. “It’s certainly not going to do any favors for the real estate market.”

To me, this story simply reinforces my belief that the US Mortgage market has been incredibly loose for quite some time. I mean … a 25% downpayment in Canada is standard, for heaven’s sake! But, to return to my argument …

The WSJ noted as support for the insolvency theme stated:

Nonetheless, as Lou Crandall, chief economist at Wrightson ICAP LLC said today, “Things are unfolding smoothly.” The first quarter is likely to start much as the fourth quarter did, with reduced concerns now that the statement date has passed.

Balance-sheet strains will continue to create concerns about the price and availability of short-term funds, Mr. Crandall said. But for the most part, “We’ve moved beyond … liquidity concerns. The focus has moved to that part of the financial fallout that central banks can’t address through technical operations.”

In other words, as 2008 begins, it’s solvency, not liquidity, that threatens the economy and the financial system. And at the root of the solvency threat is a likely decline in housing prices that will further undermine credit quality. Making banks more confident of their own ability to raise funds is not going to resolve a generalized shrinkage of lending driven by declining collateral values.

“In other words”? There seems to have been a great deal of interpretation and analysis glossed over in the rephrasing! Mr. Crandall is highlighting concerns over credit quality, sure, but

• credit concerns are a far cry from insolvency crises, and
• it is not even clear that he is referring to concerns about credit quality of the banks. From the quote, he could be referring to shadow-banks, non-financial corporations, investors or consumers

The apparent leap in logic might be justified by the complete WSJ interview of Mr. Crandall, but is certainly not justified by the quotations. And even if Mr. Crandall approves of the WSJ interpretation, there is no indication that this is anything more than one economist’s opinion – there is precious little data on display.

In other words, the WSJ supporting article doesn’t withstand scrutiny all that well – there’s no data and no argument. Just an assertion which may well be nothing more than an interpretation by the reporter.

And now we get to the source of this assertion – Prof. Delong‘s opinion piece. He defines three mechanisms whereby asset prices can fall:

The first — and “easiest” — mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.
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In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.
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The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger.

… which have different ideal policy responses. A liquidity crisis is easy to address:

The cure for this mode — a liquidity crisis caused by declining confidence in the financial system — is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.

This is the rule set out by Walter Bagehot more than a century ago: Calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times.

… while the second mode requires a policy response much like that used to recapitalize the American banking sector after the S&L crisis:

This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren’t solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.

In this case, applying the Bagehot rule would be wrong.

The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away, while the Bagehot rule — with its high lending rate for banks — would make matters worse.

… while the solution to the third mode reflects the “Resolution Trust” that was used to contain the S&L crisis:

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out — and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

This is all very interesting, to be sure, but which mode are we actually in? Prof. DeLong does not venture a firm opinion, but concludes:

At the start, the Fed assumed that it was facing a first-mode crisis — a mere liquidity crisis — and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis — more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.

As Fed Vice Chair Don Kohn recently put it: “We should not hold the economy hostage to teach a small segment of the population a lesson.”

No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.

Therefore, then, the implication that we actually are in a mode 3 scenario of falling asset prices is due solely to Prof. Hamilton’s analysis (or, perhaps, is inadverdent, implied only by an imprecise framing of the quotation). Prof. DeLong is merely asserting that the current Fed operations (as of Dec. 31, remember!) are due to a Fed opinion that we are in mode 2; Prof. DeLong hints, but does not assert, that we could be in mode 3.

With respect to Prof. Hamilton’s analysis, there is no argument to support an assertion that we are in a mode 3 scenario. If I read his conclusion correctly, Prof. Hamilton is asserting that Bernanke is terrified of entering a mode 3 crisis and is therefore increasing his response to a mode 2 crisis.

Naked Capitalism also reflects on Prof. Hamilton’s post and suggests:

The only defense Hamitlon can find for the central bank’s actions is that it may be deliberately stoking inflation to erode the value of America’s debt overhang.

… which misses the point. Monetary policy under a mode 2 response aims to increase the carry on assets via lower real rates, while it is only in mode 3 that the fires of inflation are deliberately stoked.

I agree with what I conclude is the central conclusion of Prof. Hamilton’s post:

I think part of the basis for Bernanke’s optimism on inflation must be the dourness of his outlook for real economic activity. The basic macroeconomic framework in Bernanke’s textbook suggests that, for given inflation expectations, if output falls below the “full-employment” level, inflation should go down, not up.

But nowhere – nowhere! – in any of these posts is there support for the idea that financial system is insolvent. Hurt, yes. Insolvent, no.