Wednesday, September 17, 2008

Ultimatum by Paulson Sparked Frenzied End

One of the most tumultuous weekends in Wall Street's history began Friday, when federal officials decided to deliver a sobering message to the captains of finance: There would be no government bailout of Lehman Brothers Holdings Inc.

Complete Coverage

Finding a Buyer

Saturday morning, the CEOs and their closest advisers reconvened at about 9 a.m. and broke into groups to discuss various scenarios. Lehman representatives weren't present.

One group focused on the possible dismantling of Lehman; it included both government officials and Wall Street representatives. Among the things the group discussed was having every bank borrow from the Fed under an emergency lending provision it has offered since the collapse of Bear Stearns. With that borrowed money, the banks would buy up Lehman's assets, preventing it from filing for bankruptcy.

The other main track focused on finding a buyer. Either Barclays or Bank of America would buy Lehman's "good assets," such as its stock-trading and analysis business, people familiar with the matter say. Lehman's more toxic real-estate assets would be placed in a "bad" bank containing about $85 billion in souring assets. Other Wall Street firms would inject some capital into the bad bank to keep it afloat. The goal would be to avoid a flood of bad assets pouring into the market, pushing prices even lower.

But getting Wall Street firms to cooperate among themselves, without government assistance, was proving tough. Several CEOs openly questioned why they should bear the cost of Lehman's problems when others who also face exposure -- such as institutional investors, hedge funds and foreign investors -- aren't being asked to do the same.

Morgan Stanley CEO John Mack raised serious questions, saying that this time it was Lehman and next time it would be Merrill, according to people in attendance. "If we're going to do this deal, where does it end?" he said, according to a person familiar with the matter. Other bankers in the room felt the same way, this person added.

By noon on Saturday, Bank of America hadn't budged from its position that it needed government support to consummate a deal. The bottom line: It was effectively out of the running.

Outside the Fed's downtown New York headquarters, a fortress-like building of stone and iron, a fleet of black limousines waited for the bankers inside. At one point, they blocked the narrow streets around the building, causing a traffic jam that had to be broken up by the Fed's uniformed guards.

Bankers and Fed staffers milled outside, smoking cigarettes and talking on their cell phones about subjects such as counterparty risk, a normally arcane matter of contract law, suddenly front and center. On one occasion, in the men's bathroom, a trio of bank CEOs debated the merits of a rescue plan.

The bond- and derivative-trading heads of major investment banks, assuming that a deal to save Lehman was a diminishing possibility, gathered to discuss how to deal with their exposure to minimize havoc Monday when markets opened.

Shortly after 5 p.m., a clutch of Fed staffers left the building. The day hadn't gone well. The government and potential buyers remained miles apart, mainly due to the bailout issue. Wall Street executives left in cars parked in a garage to avoid being photographed by the waiting press.

One person in the Fed meetings Saturday night described them as "the world's biggest game of poker."

With different doomsday scenarios being batted around the meeting rooms, some participants felt the government would blink and do a bailout. "This is going to go down to the last second," one participant said.

With Bank of America backing away from a deal, the enormity of a potential bankruptcy filing by Lehman started settling in. Even understanding Lehman's current trading positions was tough. Lehman's roster of interest-rate swaps (a type of derivative investment) ran about two million strong, said one person familiar with the matter.

Overnight, the outlines of possible deals started to crystallize. The idea that Wall Street firms would fund a "bad bank" full of Lehman's problematic assets was dead. Unlike when Wall Street firms stepped in to bail out hedge fund Long-Term Capital Management a decade ago, today's banks are much weaker. Some were loathe to provide support when a rival like Barclays might still buy Lehman.

By Sunday morning, the U.K.'s Barclays looked like the sole potential buyer. That further minimized the chances of a government bailout: If the Bush administration wouldn't help to fund a Wall Street solution, aiding a foreign buyer was even less likely.

Lehman employees followed their firm through news reports. One manager said he was encouraging his staff to show up Monday and hang tough for a few more days. "It is not like there are a million jobs to go to," he said.

The Chance to Transform

Barclays pushed ahead, eager at the chance to transform itself into a U.S. powerhouse at potentially a fire-sale price. Its advisers thought the U.S. Treasury could be persuaded to support a foreign buyer. By Sunday morning in London, after working around the clock for three days, the British bank -- whose roots date to the late 1600s as a goldsmith banker in London -- thought it had a shot. Documents were drawn up to pitch the deal to investors and journalists.

During the afternoon on Sunday, two Fed policeman wheeled a large, double-decker cart filled with cakes, cookies, sandwiches, chips and bottles of water into the Fed building.

But soon after, Barclays was threatening to walk as it argued with the Fed and Treasury over seemingly mundane matters, such as whether it would have to hold a shareholders' meeting to ratify any deal. Barclays was still insisting on some kind of federal financing.

By the middle of Sunday afternoon, Barclays was out. Its plan -- to buy Lehman's subsidiaries -- was contingent on government support, which wasn't coming.

At a meeting held at the Fed offices, Mr. Paulson, Mr. Geithner and Securities and Exchange Commission Chairman Christopher Cox addressed a group of about one dozen banking chiefs. Their message was steadfast: They would not put up money to assist in salvaging Lehman. In the meetings with Mr. Paulson were his chief of staff, Jim Wilkinson, and two advisers, Dan Jester and Steve Shafran, both of whom used to work at Goldman Sachs.

Somber Mood

The mood turned somber as it became clear that the group would have to turn its attention to dismantling Lehman in a way that didn't seriously disrupt the financial system. Soon the group began discussing the mechanics of such a plan.

A sense of foreboding descended over the rival bankers. They focused on the fear that drove down shares in Lehman, worried that would now spread to Merrill, another storied name facing losses from mortgage-related holdings, despite the reputation of its wealth-management business.

"I think the government is playing with fire," said a top executive of a big bank.

The worry for Merrill, said people briefed on the conversations, was that as its stock tumbles, its credit rating could change, increasing its cost of borrowing. Faced with rising borrowing costs -- a key expense for giant Wall Street financial firms -- its business might be severely crimped. As well, as concerns mount, its trading partners might stop doing business with it.

Many in the room began to wonder when Merrill would sell itself. "Tonight, or tomorrow?" said one of these people in an interview. In fact, within a few hours, the bankers learned that Merrill was in talks to be acquired by Bank of America.

As word that a Barclays deal was off filtered across Wall Street, traders scrambled to extricate themselves their various financial transactions with Lehman. Traders at many Wall Street firms were told to come to work immediately.

The European Central Bank was also in a state of high alert on Sunday, with employees in divisions from money-market operations to financial stability camped out in the bank's 37-story glass-and-steel tower in Frankfurt, preparing for what Monday might bring. "We are in the hands of the Americans," said one employee.

Monday, September 08, 2008

Mixed Economic Data Show A Changing Business Cycle

By JON HILSENRATH and KELLY EVANS

September 8, 2008; Page A2, WSJ

The U.S. economy looks like it is traveling along two tracks.

If you look at output -- the amount of goods and services Americans produce -- the economy has been rising at a decent clip. But people aren't feeling it in their wallets because the factors driving their own incomes -- such as jobs and wages -- are under strain.

The point has been underscored by a slew of economic reports released in the past few weeks. The government's measure of inflation-adjusted gross domestic product expanded at a surprisingly robust 3.3% annual rate in the second quarter. Exports were a big driver, in particular exports of industrial supplies and capital goods.

Yet employment has fallen for eight straight months by a cumulative 605,000 jobs. More than half of the losses have been in manufacturing. You might expect manufacturing employment to hold up better during an export boom. But it isn't.

With job losses mounting, companies are cutting back on hours and getting tough on wages. Year-to-year personal income growth has slowed from more than 7% a couple of years ago to a little more than 4% in July, not enough to keep up with inflation.

In theory, output and income should go up and down together. If the economy is still expanding, why are so many households being squeezed?

One answer is that the business cycle itself is changing. Recessions in the past used to follow a predictable script. Business would slow or inventories would go up too much and catch companies flat-footed. As their own productivity dropped, they would belatedly respond by cutting back on workers. Then, as the process fed on itself, everything would go down together -- output, employment, income and productivity.

The 2001 recession changed the script -- productivity held up surprisingly well throughout. Companies cut back ahead of the business slowdown and kept doing it even after demand started rising again. The productivity they managed to squeeze out of existing workers bolstered output, even as it strained households.

The same thing seems to be happening again: To the surprise of many economists, worker productivity is rising, not falling.

"There seems to be a change in how businesses operate," says Dean Maki, economist for Barclays Capital. With better technology, businesses get ahead of inventory buildups or demand slowdowns more quickly. The declining influence of unions is also putting management in a position to fire workers more quickly.

Associated Press

A customer holds his wallet as he pumps gas at a Shell gas station in Menlo Park, Calif.

The result: While incomes are getting squeezed, the output per hour of workers was up at an annual rate of more than 3% in the first half of the year.

More than ever, it seems, this puts the brunt of a downturn on workers. But there are important upsides to the shift. Better productivity helps bolster corporate profits, so while the stock market is weak it hasn't collapsed as have stock markets elsewhere in the world this year. It also helps restrain inflation and give the Federal Reserve leeway to keep interest rates low and help the economy heal.

It also makes it harder to read a business cycle. The collection of economists at the National Bureau of Economic Research who date recessions debated for months about the beginning and end of the last downturn because of the striking disconnect between output and income.

"If you dated it based on the labor market you'd have it be one of the longest recessions in history, and that didn't feel right," says Christina Romer, an economics professor at the University of California, Berkeley. The group finally decided November 2001 -- when output growth restarted -- was the point at which the recession ended, making the eight-month slowdown one of the shortest on record.

But the debate hasn't gone away. "What matters to individuals more than anything else is the behavior of the labor market," says John Lonski, chief economist at Moody's Investor Service. "If I were the NBER I would simplify the entire process and focus on the labor market. From the perspective of the economy and social welfare it's labor-market behavior that matters the most."

There are other factors at play now, including confusion about how statisticians measure all of these trends. Some economists are skeptical of the 3.3% annualized increase in gross-domestic-product growth registered in the second quarter. The figure, produced by the government's Bureau of Economic Analysis, is out of line with another BEA figure called gross domestic income -- a measure of the income earned by businesses and households.

In theory, the two figures should go up and down together. But gross domestic income expanded at a much smaller 1.9% annual rate in the second quarter, after contracting the two previous quarters. The income number might have been skewed as government statisticians try to make sense of the massive write-offs being recorded by banks. The output number might also have been skewed, for instance by big shifts in the trade environment and the price of oil. Data revisions could ultimately show output wasn't as strong as it now appears.

Statistics aside, it is also possible output won't hold up under the pressures building against the U.S. economy, even with better productivity. Exports have been the bright light in the growth picture. But the global economy is slowing.

Neil Soss, a Credit Suisse economist, notes that three quarters of the economy's growth in the past year came from an improved trade position. "How much can I count on that for the future?" he asks.

Meantime, the strain on incomes might finally be catching up to households. They will clearly be helped by the drop in gasoline prices, but tax rebates have run their course and the housing and credit squeezes run unabated.

Adjusted for inflation, consumer spending -- the biggest driving force of growth -- contracted in June and July. It hasn't contracted for an entire quarter since late 1991. That 17-year run is now being put to the test. If consumers crack, output and income might finally meet up again -- in recession.

Tuesday, August 19, 2008

How Low Interest Rates Contributed to the Credit Crisis

WSJ: ETHAN PENNER

"What inning are we in?" How many times have we all heard that inane question asked and answered in the credit-driven downturn that we've been suffering through for over a year now?

We've heard many answers from financial industry and government leaders, such as "the worst is behind us," or "we'll not need to raise any further capital" -- only to learn in short order that our leaders really did not have the ability to make the market bend to their will.

To understand exactly what is happening, one needs to properly understand what occurred in the late stages of the prior cycle. Interest rates had been driven to historical lows in the U.S. and throughout the world. The cause of this can be debated. However, it is clear that economic globalization, with the migration of jobs to low-wage nations, had a profound impact on inflation, and thus on interest rates.

In general, low interest rates are beneficial, as the low cost of capital encourages business borrowing for research and development, capital investment or expansion initiatives, which lead to job growth. Low interest rates also reduce the cost of homeownership, and, in fact, the cost of servicing any debt at all, thereby freeing up capital for more productive uses.

The flip side of a low-interest rate environment is that it reduces the absolute level of returns that are available to investors. This has significant implications for the massive wave of baby boomers, which holds many billions of dollars in retirement savings, either through direct investment or through managed pension-fund systems.

It is estimated by those in the pension-fund world that in order to meet the retirement needs of those baby boomers, their investments will need to yield a minimum of 8% per annum. When their money was set aside with this yield target in mind, rates on U.S. Treasuries hovered at high levels. However, in our most recent low-rate period, with U.S. Treasuries yielding 4% and below, achieving 8% became quite a challenge. The threat of not achieving it became both real and quite frightening for those whose retirement livelihood depends upon their pensions.

With a large portion of pension-fund asset allocations directed toward fixed-income investments that were yielding closer to 4%, the pressure to achieve an overall 8% on their portfolios drove investment managers to allocate large pools of capital to the strategies that promised higher returns. Even beyond the pension investment world, the global investor base had become comfortable in the last cycle with the notion that achieving an annual 20% or greater yield was possible. Thus huge amounts of investment capital migrated to funds promising lofty returns, and fund managers were pressured to advertise a 20% targeted yield or risk not attracting any capital.

It can be argued that it was the low interest-rate environment that actually fueled the huge boom in the hedge-fund and private-equity world that we've witnessed in the past decade. A major flaw in all this was that targeted returns became disconnected from the risk-free U.S. Treasury yield benchmark, to which all investments are implicitly pegged.

There is a direct relationship between returns and risk. If a five-year U.S. Treasury bond is yielding 8%, as it once did, a five-year corporate AAA-rated bond must provide a yield higher than 8% for it to be attractive to an investor, given its increased credit risk. And, further out on the risk spectrum, a five-year investment in a closed-end private equity fund must provide a much higher yield still -- perhaps as high as 20%.

If, however, the yield on the five-year Treasury bond falls to 3%, then the competitive market is set up such that yields on the more risky assets move down in relation, and a AAA-rated, five-year corporate bond will surely no longer be available at a yield above 8%. By extension, the yields available/achievable by the private equity fund, without taking heightened risk, must also fall to a number far below 20%.

Yet, in a low-rate environment, investors still insisted on this high yield target, and, in competing for capital, investment managers strived to achieve it -- mostly through the use of increased leverage or the acquisition of assets with greater risk profiles.

The system became burdened with the need to produce high returns, with many investors chasing that magic 20%, in spite of the fact that the yield targets had little to do with the realities of the low-rate environment.

The preferred formula for manufacturing high returns in a low-rate environment is actually quite simple: utilize large amounts of leverage. If, for example, you can buy an asset that produces a cash-flow yield of 6.5%, and leverage that 9:1 at a cost of borrowing of 5%, you've achieved your 20% target. This use of excessive leverage to capitalize upon low rates, and the easy availability of credit, began in the period after 9/11. Policy makers moved assertively to counteract the potentially devastating effect that tragedy might have had on our economy.

As investors scoured the market for assets with yields of 6.5%, the competition drove prices higher and yields lower. Investors started to buy assets with yields of 5%-5.5%, just barely above the cost of debt. They would justify the price by either borrowing still more or by creating a pro forma budget that reflected a plan for increasing revenues in time to levels that would achieve and surpass that 6.5% level, and that would ultimately produce the magic 20%.

The risk became that those ambitious growth goals would not be met -- and the buyer of the asset would be stuck with an overpriced and overleveraged investment, and a suboptimal yield.

As the market became more frenzied and prices continued to escalate in this competition to find yield, opportunistic buyers stepped in to buy an asset, almost without regard for its ability to create a suitable yield. They figured that someone flush with capital and in need of assets would buy it from them shortly at a quick-flip profit. These asset flippers, or traders, employed very little equity, and were granted large amounts of leverage for their activity, which had proved to be quite brilliant for a time.

Ultimately, as is always the case, there comes a time when someone rears his or her head and questions the sanity of a deal, and by implication, the entire market. At that moment, when everyone is fully invested and market participants have become most complacent about risk-management concerns, everything turns and the party ends abruptly. And thus begins the reversing of the leverage-driven run-up in asset values, with valuations ultimately returning to a level that is sensible and not predicated upon either excessive leverage or pro forma assumptions that everything will work out just perfectly.

Today, the pendulum has clearly swung very hard. Credit availability and cost have moved from one extreme to the other. In time, credit spreads will moderate, as lenders, whoever they will be in the next cycle, motivated by the need to earn revenue, will begin competing for good credits once again. Sadly, the benefits of this reduction in spread will more than likely be offset by an increase in the levels of real rates as the signs of inflation continue to appear.

In the meantime, we are still in the midst of what some analysts have dubbed "The Big Unwind," during which our system unwinds the excessive leverage of the past half-decade. We will likely see asset levels continue to adjust lower in order to come into alignment with today's more conservative lending environment and produce yields that would attract investment capital. There is no silver bullet that government or the financial community can shoot to bring this to a quick end.

Monday, April 28, 2008

Bagehot's Lessons for the Fed

By RONALD MCKINNON

Source: WSJ

No one needs to be reminded about the bad financial-market news. Sharp cuts in the federal funds rate down to 2.25% have provoked a flight from the dollar, and a weakening of the dollar against most foreign currencies. Every day brings word of new write-downs and write-offs, and the Federal Reserve has rolled out a bewildering variety of stratagems to help. But the economy is not responding positively.

What strategy or rule should the Fed be following to help the economy recover from recession, or curb what is now a spectacular inflation in commodity markets?

Walter Bagehot

For a decade before 2003, the Fed more or less did follow a rule, which was formulated by my colleague John Taylor of Stanford University. The Taylor Rule specifies how the fed funds interest rate by itself can smooth mild business cycles.

It presumes that the Fed aims for 2% annual inflation in the CPI. Thus, with an average short-term real interest rate of 2%, the fed funds rate should average about 4% in the "steady state."

At the top of the business cycle, or to combat a surge in inflation, the rate should be raised by 1.5 percentage points for every one percentage point of inflation above the 2%. It should be lowered during a cyclical downturn accompanied by deflation. The Taylor Rule worked well in facilitating high, noninflationary growth through the two-term Clinton presidency and most of the first term of George W. Bush.

Then – with CPI inflation at the putative target of 2% and moderately robust real economic growth of 2.7% – the Fed began cutting the fed funds rate in 2003. It was down to 1% at the end of the year and into early 2004 – a full three percentage points less than what the Taylor Rule would have prescribed. Worse, the Fed failed to raise interest rates fast enough or far enough in 2005 into 2006, even as inflation gained momentum, with a surge in output from unsustainable household spending stimulated by the housing bubble.

Now with rising inflation, falling output and the flight from the dollar, the U.S. economy has been knocked off the moorings that the Taylor Rule had provided. Although the Taylor Rule still correctly shows that the Fed cut interest rates too much in 2007-2008, it understates the appropriate level of the interest rate. Moreover, its two key implicit assumptions – that equilibrium interest rates can always be found to clear markets, and that the foreign exchanges can be ignored – are no longer valid. At least temporarily, when so many financial markets have now seized up, Taylor's Rule has lost its ability to provide an unambiguous guide to the Fed.

But all is not lost.

Fast backward 135 years to 1873, when Walter Bagehot, the eminent Victorian institutional economist and constitutional scholar, wrote "Lombard Street." The London capital market was the center of world finance under the gold standard. Bagehot described the intricacies of how money markets worked, including counterparty risks and all that – but he also prescribed how the Bank of England should confront major financial crises.

Bagehot called a seizing up of internal markets "a domestic drain" (of gold), and the flight of capital abroad "an external drain." He wrote that "The two maladies – an external drain and an internal – often attack the money market at once." And what, he asked, should be done when this happens?

"We must look first to the foreign drain, and raise the rate of interest as high as may be necessary. Unless you can stop the foreign export, you cannot allay the domestic alarm. . . . And at the rate of interest so raised, the holders – one or more – of the final bank reserve must lend freely.

"Very large (domestic) loans at very high rates," Bagehot advised, "are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain. Any notion that money is not to be had, or that it may not be had at any price, only raises alarm to panic and enhances panic to madness. But though the rule is clear, the greatest delicacy, the finest and best skilled judgment, are needed to deal at once with such great and contrary evils."

How does Bagehot's Rule apply to today's credit crunch? Bagehot was worried about gold losses to foreigners that would cause domestic credit markets to seize up even more and, worse, weaken the pound in the foreign exchanges. Now, foreigners are disinvesting from private U.S. financial assets, which itself worsens conditions in American markets. Additionally, foreign central banks, to stem the appreciations of their currencies against the dollar, are building up large dollar exchange reserves – much of which are invested in U.S. Treasury bonds.

But U.S. Treasurys are the prime collateral for borrowing and lending in the multitrillion dollar U.S. interbank markets. Thus there is a foreign "drain" of prime collateral from the already-impacted private U.S. markets. The depreciating dollar also greatly exacerbates inflation in the U.S.

Consequently, there is a strong case for raising the fed funds rate as much as is necessary to strengthen the dollar in the foreign exchanges – as Bagehot would have it – and to cooperate with foreign governments to halt and reverse the appreciations of their currencies against the dollar.

By slashing interest rates too much in 2007-2008, the Fed has accentuated the foreign drain and thus made the alleviation of the domestic drain more difficult. Yet, despite this mistake, Bagehot would approve of other actions the Fed has taken to deal with the domestic drain by unblocking specific impacted domestic markets. These include (1) swapping Treasury bonds for less safe private bonds, (2) opening its discount window to shaky borrowers, and (3) maybe even rescuing Bear Sterns. He would also approve of the relaxation of capital constraints on Fannie Mae, Freddy Mac and so on, for mortgage lending. Yet these measures will be insufficient if the foreign drain continues.

To repeat Bagehot's Rule: "very large (domestic) loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain." The Fed, and the U.S. government more generally, have so far got it only half right.

Wednesday, April 23, 2008

Housing Prices and Monetary Policy

Governor Frederic S. Mishkin

At the Forecaster’s Club of New York, New York, New York

January 17, 2007

Enterprise Risk Management and Mortgage Lending

Over the past ten years, we have seen extraordinary run-ups in house prices. From 1996 to the present, nominal house prices in the United States have doubled, rising at a 7-1/4 percent annual rate.¹ Over the past five years, the rise even accelerated to an annual average increase of 8-3/4 percent. This phenomenon has not been restricted to the United States but has occurred around the world. For example, Australia, Denmark, France, Ireland, New Zealand, Spain, Sweden, and the United Kingdom have had even higher rates of house price appreciation in recent years.

Although increases in house price have recently moderated in some countries, they still are very high relative to rents. Furthermore, with the exception of Germany and Japan, the ratios of house prices to disposable income in many countries are greater than what would have been predicted on the basis of their trends. Because prices of homes, like other asset prices, are inherently forward looking, it is extremely hard to say whether they are above their fundamental value. Nevertheless, when asset prices increase explosively, concern always arises that a bubble may be developing and that its bursting might lead to a sharp fall in prices that could severely damage the economy.

This concern has led to an active debate among monetary policy makers around the world on the appropriate reaction to the run-ups in house prices that we have recently seen in many markets: Should central banks raise interest rates? And how should they prepare themselves to react if housing prices decline? These are the issues that I will address today. The views I will express are my own and not necessarily those of my colleagues on the Federal Open Market Committee.

Home prices, like other asset prices, have important effects on output and inflation. Home prices affect the economy in two primary ways. First, when they begin rising, the expectation of further appreciation tends to become built into the market. That expectation boosts demand for homes, which stimulates new construction and aggregate demand. Of course, the sustained rise in prices can simultaneously sow the seeds of a market correction by making houses progressively less affordable relative to income, thereby limiting the demand for them and restraining additional construction. Second, higher home prices increase household wealth, thus stimulating consumer spending, another component of aggregate demand.

Because central banks are in the business of managing total demand in the economy so as to produce desirable outcomes on inflation and employment, monetary policy should accordingly respond to home prices to the extent that these prices are influencing aggregate demand and resource utilization. The issue of how central banks should respond to house price movements is therefore not whether they should respond at all. Rather, the issue is whether they should respond over and above the response called for in terms of objectives to stabilize inflation and employment over the usual policy time horizon. The issue here is the same one that applies to how central banks should respond to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices might be highly damaging to the economy, as they were in Japan in the 1990s, should the monetary authority try to prick, or at least slow the growth of, developing bubbles?

I view the answer as no.

I will outline some conventional arguments for and against reacting to asset prices over and above their direct and foreseeable effects on inflation and employment. I will also discuss some additional reasons why central banks should not overly emphasize house prices in particular. Although I come down squarely on the side of those who oppose giving a special role to house prices in the conduct of monetary policy, I do think that central banks can take steps to ensure that sharp movements in the prices of homes or other assets do not have serious negative consequences for the economy.

There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. For example, if home prices rise above what the fundamentals would justify, too many houses will be built. Moreover, at some point, bubbles burst and asset prices then return to their fundamental values. When this happens, the sharp downward correction of asset prices can lead to a sharp contraction in the economy, both directly, through effects on investment, and indirectly, through the effects of reduced household wealth on consumer spending.

Despite the clear dangers from asset price bubbles, the question remains as to whether central banks should do anything about them. Some economists have argued that central banks should at times "lean against the wind" by raising interest rates to stop bubbles from getting out of hand. They argue that if a bubble has been identified, then raising interest rates will produce better outcomes. For instance, William White, of the Bank for International Settlements, has said that "monetary policy might rather be used in a highly discretionary way to respond to growing imbalances that were judged by policymakers to threaten financial instability."² Although central banks have generally not argued that interest rates should be raised aggressively to burst asset price bubbles, statements suggest some central bankers believe some leaning against the wind might be warranted. For example, in the second half of 2003 and the first half of 2004, a minority of members of the Monetary Policy Committee of the Bank of England argued for raising interest rates more than could be justified in terms of the Bank of England's objectives for inflation over its normal policy horizon. They said that such a move would help lower the probability of house prices rising further and make it less likely that a house price collapse would occur later. Mervyn King, the Governor of the Bank of England, did not advocate leaning against the wind but did suggest that, to prevent a buildup of financial imbalances, a central bank might extend the horizon over which inflation is brought back to target. Statements from officials at the European Central Bank also have suggested that the possibility of an asset boom or bust might require longer than the usual one to two years in assessing whether the price stability goal was being met.

The recent case of the Sveriges Riksbank, the Swedish central bank, is particularly interesting. I studied the Riksbank in a report on monetary policy written with Francesco Giavazzi for the Swedish parliament before I came to the Federal Reserve Board.³ We found that communications by the Riksbank suggested to market participants that it was actually adjusting monetary policy to lean against the wind of rapid increases in home prices. On February 23, 2006, the Executive Board of the Riksbank voted to raise the repo rate 25 basis points (0.25 percentage points). This monetary policy action was accompanied by a statement acknowledging that the inflation forecast was revised downward. In fact the Inflation Report published on the same day also showed that inflation forecasts had been revised downward and were below the 2 percent target at every horizon. The Executive Board's statement pointed out that "there is also reason to observe that household indebtedness and house prices are continuing to rise rapidly."⁴ It then said: "Given this, the Executive Board decided to raise the repo rate by 0.25 percentage points at yesterday's meeting." Not surprisingly, market participants took this statement to mean that the Riksbank was setting the policy instrument not only to control inflation but also to restrain house prices. A similar reference to house prices in explaining the decision to raise rates was made in the press release of January 20, 2006.

The above statements suggest that some central bankers advocate that asset prices, and in particular, house prices, should have a special role in the conduct of monetary policy over and above their foreseeable effect on inflation and employment. There are several objections to this view.

A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress. I find this assumption highly dubious because it is hard to believe that the central bank has such an informational advantage over private markets. Indeed, the view that government officials know better than the markets has been proved wrong over and over again. If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further.

A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed. Asset price crashes can sometimes lead to severe episodes of financial instability, with the most recent notable example among industrial countries being that of Japan. In principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. Yet there are several reasons to believe that this concern about burst bubbles may be overstated.

To begin with, the bursting of asset price bubbles often does not lead to financial instability. In research that I conducted with Eugene White on fifteen stock market crashes in the twentieth century, we found that most of the crashes were not associated with any evidence of distress in financial institutions or the widening of credit spreads that would indicate heightened concerns about default.⁵ The bursting of the recent stock market bubble in the United States provides one example. The stock market drop in 2000-01 did not substantially damage the balance sheets of financial institutions, which were quite healthy before the crash, nor did it lead to wider credit spreads. At least partly as a result, the recession that followed the stock market drop was very mild despite some severely negative shocks to the U.S. economy, including the September 11, 2001, terrorist attacks and the corporate accounting scandals in Enron and other U.S. companies; the scandals raised doubts about the quality of information in financial markets and ultimately did indeed widen credit spreads.

There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small. The loan-to-value ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than the value of the house and because, in conventional mortgages, loan-to-value ratios decline over the life of the loan. Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. In the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble.

Many have learned the wrong lesson from the Japanese experience. The problem in Japan was not so much the bursting of the bubble but rather the policies that followed. The problems in Japan's banking sector were not resolved, so they continued to get worse well after the bubble had burst. In addition, with the benefit of hindsight, it seems clear that the Bank of Japan did not ease monetary policy sufficiently or rapidly enough in the aftermath of the crisis.

A lesson that I draw from Japan's experience is that the serious mistake for a central bank that is confronting a bubble is not failing to stop it but rather failing to respond fast enough after it has burst. Deflation in Japan might never have set in had the Bank of Japan responded more rapidly after the asset price crash, which was substantially weakening demand in the economy. If deflation had not gotten started, Japan would not have experienced what has been referred to by economist Irving Fisher as debt deflation, in which the deflation increased the real indebtedness of business firms, which in turn further weakened the balance sheets of the financial sector.

Another lesson from Japan is that if a burst bubble harms the balance sheets of the financial sector, the government needs to take immediate steps to restore the health of the financial system. This should involve structural improvements in the way banks operate, not bailing out insolvent institutions. The prolonged problems in the banking sector are a key reason that the Japanese economy did so poorly after the bubble burst.

A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy is that a central bank actually knows the appropriate monetary policy to deflate a bubble. The effect of interest rates on asset price bubbles is highly uncertain. Although some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, others suggest that raising interest rates may cause a bubble to burst more severely, thus doing even more damage to the economy. An illustration of the difficulty of knowing the appropriate response to a possible bubble was provided when the Federal Reserve tightened monetary policy before the October 1929 stock market crash because of its concerns about a possible stock market bubble. With hindsight, economists have viewed this monetary policy tightening as a mistake.

Given the uncertainty about the effect of interest rates on bubbles, raising rates to deflate a bubble may do more harm than good. Furthermore, altering the trajectory of interest rates from the path predicted to have the most desirable outcomes for inflation and employment over the foreseeable horizon has the obvious cost of producing deviations from these desirable outcomes.

Because I doubt that any of the three assumptions needed to justify a special monetary policy focus on asset prices holds up, I am in the camp of those who argue that monetary policy makers should restrict their efforts to achieving their dual mandate of stabilizing inflation and employment and should not alter policy to have preemptive effects on asset prices.

However, there is a further reason why I believe that a central bank should not put too much focus on asset prices. Such a focus can weaken its public support, making it harder for it to successfully conduct monetary policy to stabilize inflation and employment.

A central bank that focuses intently on asset prices looks as if it is trying to control too many elements of the economy. Part of the recent successes of central banks throughout the world has been that they have narrowed their focus and have more actively communicated what they can and cannot do. Specifically, central banks have argued that they are less capable of controlling real economic trends in the long run and should therefore focus more on price stability and damping short-term economic fluctuations. By narrowing their focus, central banks in recent years have been able to increase public support for their independence. A central bank that expanded its focus to asset prices could potentially weaken its public support and may even cause the public to worry that it is too powerful and has undue influence over all aspects of the economy.

Too much focus on asset prices might also weaken support for a central bank by leading to public confusion about its objectives. When my co-author and I conducted our evaluation of monetary policy in Sweden, I directly observed this problem. I heard over and over again in interviews with participants from different sectors of Swedish society that the statements about house prices by the Riksbank confused the public about what it was trying to achieve.

My discussion so far indicates that central banks should not put a special emphasis on prices of houses or other assets in the conduct of monetary policy. This does not mean that central banks should stand by idly when such prices climb steeply. Rather my analysis suggests that central banks can take steps to make it less likely that sharp movements in asset prices will have serious negative consequences for the economy.

Instead of trying to preemptively deal with the bubble--which I have argued is almost impossible to do--a central bank can minimize financial instability by being ready to react quickly to an asset price collapse if it occurs. One way a central bank can prepare itself to react quickly is to explore different scenarios to assess how it should respond to an asset price collapse. This is something that we do at the Federal Reserve.

Indeed, examinations of different scenarios can be thought of as stress tests similar to the ones that commercial financial institutions and banking supervisors conduct all the time. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can minimize the damage from a collapse of an asset price bubble without having to judge that a bubble is in progress or predict that it will burst in the near future.

Another way that a central bank with bank supervisory authority can respond to possible bubbles is through prudential supervision of the financial system. If elevated asset prices might be leading to excessive risk-taking on the part of financial institutions, the central bank, as in the case of the United States, can ask financial institutions if they have the appropriate practices to ensure that they are not taking on too much risk. Working through supervisory channels has the advantage not only of helping make financial institutions better able to cope with possible asset price declines but possibly also of indirectly restraining extreme asset prices if they have been stimulated by excessive bank financing. Also, reminding institutions to maintain risk-management practices appropriate to the economic and financial environment could potentially help lessen a buildup of excessive asset prices in the first place.

Even if the central bank is not involved in the prudential supervision directly, it can still play a role through public communication, particularly if it has a vehicle like the financial stability reports that some central banks publish. In these reports, central banks can evaluate whether rises in asset prices might be leading to excessive risk-taking on the part of financial institutions or whether distortions from inappropriate tax or regulatory policy may be stimulating excessive valuations of assets. If this appears to be happening, the central bank's discussion might encourage policy adjustment to remove the distortions or encourage prudential regulators and supervisors to more closely monitor the financial institutions they supervise.

Large run-ups in prices of assets such as houses present serious challenges to central bankers. I have argued that central banks should not give a special role to house prices in the conduct of monetary policy but should respond to them only to the extent that they have foreseeable effects on inflation and employment. Nevertheless, central banks can take measures to prepare for possible sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to the economy.

Footnotes

1. House prices are measured with the repeat-transaction price index of the Office of Federal Housing Enterprise Oversight. Return to text

2. William R. White (2004), "Making Macroprudential Concerns Operational," speech delivered at the Financial Stability Symposium sponsored by the Netherlands Bank, Amsterdam, October 25-26 (www.bis.org/speeches/sp041026.htm). Return to text

3. Francesco Giavazzi and Frederic S. Mishkin (2006), "An Evaluation of Swedish Monetary Policy between 1995 and 2005" report published by the Riksdag (Swedish parliament) Committee on Finance; refer to Sveriges Riksbank (2006), "Assessment of Monetary Policy," press release, November 28, www.riksbank.com/templates/Page.aspx?id=23320. Return to text

4. Sveriges Riksbank (2006). "Repo Rate Raised by 0.25 Percentage Points," press release, February 23, www.riksbank.com/templates/Page.aspx?id=20502. Return to text

5. Frederic S. Mishkin and Eugene N. White (2002), "U.S. Stock Market Crashes and Their Aftermath: Implications for Monetary Policy," NBER Working Paper Series 8992. Cambridge, Mass.: National Bureau of Economic Research, June; also in William Curt Hunter, George G. Kaufman, and Michael Pomerleano, eds., Asset Price Bubbles: The Implications for Monetary, Regulatory, and International Policies. Cambridge, Mass.: MIT Press, pp. 53-80. Return to text

Friday, January 18, 2008

We're all Keynesians now

Source: WSJ

So famously declared Richard Nixon back in 1971, in what we thought was a different economic era. But after yesterday, we're not sure what decade we're in. With Federal Reserve Chairman Ben Bernanke and President Bush both endorsing temporary tax cuts and more federal spending as "fiscal stimulus," an inflation-adjusted version of Jimmy Carter's $50 rebate can't be far behind.

Appearing before Congress, Mr. Bernanke told Democrats what he thought they wanted to hear. The former academic economist blessed a "fiscal stimulus package," as long as it is "explicitly temporary." How new federal spending can be "temporary," he didn't say, as if a dollar collected in taxes or borrowed and then spent can be recalled.

The "temporary" line was thus a dagger aimed directly at the heart of Mr. Bush's desire to make his tax cuts permanent. The Fed chief did aver that, "Again, I'm not taking a view one way or the other on the desirability of those long-term tax cuts being made permanent." But of course refusing to endorse something is itself a point of view -- a point Democrats were already joyfully repeating yesterday.

Instead, Mr. Bernanke embraced the explicit Keynesian notion that the government should write checks to "low and moderate income people," who will spend it quickly and thus lift consumer demand. In the academic literature, this is called having a higher "marginal propensity to consume" than the more affluent, who tend to save more.

We're all for putting more money in the hands of the poor and moderate earners, especially via stronger economic growth that will give them better paying jobs. But the $250 or $500 one-time rebate check they may now receive has to come from somewhere. The feds will pay for it either by taxing or borrowing from someone else, and those people will have that much less to spend or invest themselves. We are thus supposed to believe it is "stimulating" to take money from one pocket and hand it to another.

To put it another way, when the government calculates gross domestic product, it expressly omits transfer payments. It does so because GDP is the total of goods and services produced in the economy, and transfer payments produce no goods and services. The poor will spend those payments on something, but the amount they thus "inject" into the economy will be offset by whatever the government has to tax or borrow to fund the transfers. No wonder stocks sold off yesterday after Mr. Bernanke endorsed this 1970s' economic show.

A fiscal stimulus that really stimulates would change incentives, and do so permanently so workers and investors can know what to expect and take risks accordingly. One problem with the increasingly "temporary" nature of the Bush tax cuts is that they are beginning to introduce new political risk into economic decisions. Though they expire in 2010, everyone understands that a new President and Congress could act to raise taxes as soon as next year. Mr. Bernanke could have educated the public about this business expectations problem, but then Democrats would have been upset.

And Mr. Bernanke has his own political problems -- namely Congressional and Wall Street demands that he rescue mortgage assets by easing money even further, despite an already weak dollar and Wednesday's December inflation report that prices rose 4.1% in 2007. Yes, "core" inflation rose only 2.4%, but don't tell that to Americans who are paying the higher food and energy prices that the Fed excludes from "core" readings. As the nearby table with recent polling results shows, three of the four main economic issues cited by Americans are price-related. The public thinks we have an inflation problem even if the Fed doesn't.

Mr. Bernanke can expect to get pressure no matter what he does, and perhaps he figured the way to get more monetary running room was to give Congress what it wants on spending. If so, it doesn't inspire much trust in us that he can hold fast on monetary policy either. And speaking of the 1970s, what markets may really fear is that we are entering another period of "stagflation," slower growth with rising prices, and without political or economic leaders who understand what to do about it.

One truth that Mr. Bernanke did speak yesterday is that it is a mistake to rely on monetary policy alone to spur economic growth. It's a shame, then, that his testimony makes it that much less likely that we'll get any genuine "stimulus" from fiscal policy.

Wednesday, December 12, 2007

The Roots of the Mortgage Crisis

WSJ: Alan Greenspan
On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. ... Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction.

The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.

A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers ... to unleash explosive economic growth. ...

The surge in competitive, low-priced exports from developing countries ... flattened labor compensation in developed countries, and reduced the rate of inflation expectations..., including those inflation expectations embedded in global long-term interest rates.

In addition, there has been a pronounced fall in global real interest rates since the early 1990s, which, of necessity, indicated that global saving intentions chronically had exceeded intentions to invest. ... Asset prices accordingly moved dramatically higher. Not only did global share prices recover from the dot-com crash, they moved ever upward. ...

After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria...

I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, ... may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.

Demand in those days was driven by the expectation of rising prices -- the dynamic that fuels most asset-price bubbles. If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. ...

I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.

In mid-2004, as the economy firmed, the Federal Reserve started to reverse the easy monetary policy. I had expected ... a consequent increase in long-term interest rates, which might have helped to dampen the then mounting U.S. housing price surge. It did not happen. We had presumed long-term rates, including mortgage rates, would rise, as had been the case at the beginnings of five previous monetary policy tightening episodes, dating back to 1980. But after an initial surge in the spring of 2004, long-term rates fell back and, despite progressive Federal Reserve tightening through 2005, long-term rates barely moved.

In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century... More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.

Although central banks appear to have lost control of longer term interest rates, they continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created. Thus central banks retain their ability to contain pressures on the prices of goods and services, that is, on the conventional measures of inflation.

The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. ... Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.

Wednesday, November 07, 2007

ECB, After Hard Birth, Comes of Age in Crisis

ECB, After Hard Birth,
Comes of Age in Crisis

Europe Bank Gets Points
For First-Response Role;
War Games in Frankfurt

By JOELLEN PERRY, WSJ, Nov 6, 2007.

FRANKFURT -- At 12:32 p.m. on Thursday, Aug. 9, just past its ninth birthday, the European Central Bank grew up.

The summer's mounting financial crisis, sparked by rising defaults on U.S. subprime mortgages, had fully crossed the Atlantic that morning. European banks feared their counterparts were exposed to risky investments linked to these mortgages, and became unusually reluctant to lend to each other. Financial institutions were paralyzed.

Tasked with stopping such a meltdown was the European Central Bank, which sets monetary policy for 13 countries from Ireland to Greece. The institution has been dogged since inception by criticisms that it valued consensus over decisiveness. Early on, it had been called slow-footed, disorganized and prone to miscommunicating its intentions.

But that day, the ECB swooped to the rescue. The bank offered unlimited overnight loans at its policy rate of 4%. By day's end, it had lent €94.8 billion -- about $131 billion -- which was more than it had put into money markets the day after Sept. 11, 2001. The first response by a major central bank to the summer's crisis, it stunned markets for its size. It also surprised counterparts at the U.S. Federal Reserve, who followed the ECB's injection with a smaller $24 billion one of their own later that day.

Observers credit the ECB and its head, Jean-Claude Trichet, with making a trenchant decision that calmed markets. The move shored up confidence in the bank's ability to keep markets functioning for the U.S. dollar's most significant rival. With its boosted credibility, the ECB could enhance the euro's standing in world markets. Continued confidence in the currency could ultimately come at the expense of the dollar, the current favorite of big world investors thanks in part to the size, liquidity and stability of U.S. markets.

"There were always worries that the ECB would be a stereotypical European institution, slow to decide and going off in multiple directions at once," says Adam Posen of the Peterson Institute for International Economics, a Washington think tank. "Mr. Trichet has put that to rest in this situation."

The ECB now faces fresh challenges. Global stock markets are swooning as the credit-market fallout deepens, with big write-downs and CEO departures at Citigroup Inc. and Merrill Lynch & Co. spurring fears that other banks could post more big losses. European bank shares fell yesterday, helping to bring down major indexes. And, as in the U.S. and United Kingdom, the gap between the rates euro-zone institutions charge each other for longer-term loans and the ECB's target rate remains unusually wide, suggesting markets remain tense.

A FORMER BANKER COMMENTS

"When 9/11 happened, there was some skepticism that we weren't prepared, because we were too new. We knew we could do it, but we had no track record. I think the ECB has done a perfect job."
-- Read more from former ECB board member Otmar Issing's interview with The Wall Street Journal.

This complicates the picture for ECB policy makers, who meet Thursday. Prior to the summer's credit-market unrest, robust euro-zone growth had the bank set for at least one more interest-rate rise this year. Now policy makers are caught between worries that inflation pressures are building, while the economy has yet to feel the full effect of credit-market turmoil, bank-sector write-offs and the euro's surge. In contrast to the Fed, which has cut rates by 3/4 of a percentage point since September, the ECB is likely to keep its key rate on hold Thursday. Investors see a protracted pause, but some policy makers have said the rate still could rise.

A portrait of the ECB's August response to the financial crisis emerges from documents, public statements and people familiar with the bank's workings. The ECB had been primed for a liquidity lockup, running Pentagon-style war games with such scenarios as early as April 2005. Its president, long-time French central banker Mr. Trichet, had warned loudly that investors were underestimating the danger of risky holdings. After market tremors earlier in the summer, ECB staffers who monitor markets were on high alert.

Some observers criticized the ECB for inciting panic with its intervention, saying the scope of its response suggested the bank was bracing for a catastrophe. A few still say the ECB overreacted, arguing that the offer of unlimited funds at the ECB's target rate -- the central-bank equivalent of a fire sale -- rewarded the type of risky investments that spurred the subprime debacle to start with.

The ECB still has vulnerabilities, of course, as separate events over the past three months have demonstrated. A communication gaffe by the bank left financial markets confused for days in mid-August about whether the ECB intended to raise rates. A fragmented system of bank supervision left it without detailed information about bank balance sheets at a moment of crisis. And it faces persistent sniping from politicians as it refuses to restrain a rise in the euro on foreign-exchange markets that is provoking yelps from some exporters.

Derided From Start

The ECB was established on June 1, 1998. Critics derided the institution as unworkable from the start. To shore up credibility, the ECB modeled itself after Germany's inflation-phobic Bundesbank. Like the U.S. Federal Reserve, the ECB sets a target for interest rates on overnight loans between banks. But unlike the Fed, whose dual mandate makes it attentive to both inflation and growth, the ECB's prime focus is on keeping prices stable. It aims to keep inflation at just under 2% in the 13 countries that now share the euro currency.

The ECB's rate-setting body includes the six members of its Executive Board, who oversee the bank's day-to-day operations, plus the 13 heads of the euro-zone's national central banks. Rather than voting on interest-rate decisions and publishing the minutes of their meetings, as Fed officials do, the ECB's 19 Governing Council members make decisions by consensus. The bank explains its thinking in a news conference after each decision.

The euro debuted with fanfare, and an initial value of $1.17, in 1999. Although the ECB's primary focus is inflation, not the exchange rate, a falling currency can be read as a market vote of no-confidence in an economy and its managers. Over the next 22 months, amid scattershot communication from ECB policy makers, the euro deteriorated to 83 cents.

The bank's now-deceased first president, Wim Duisenberg, initially reinforced the perception of disorganization. Although he had been an accomplished former Dutch central-bank head, the lanky policy maker with a mop of white hair became known at the ECB for a colloquial candor, uncommon in central-banking circles, that repeatedly steered markets the wrong way. British tabloids dubbed him "Dim Wim."

War Games

Since late 2003, the ECB's public face has been Mr. Trichet. A poetry buff who studied economics and mining engineering, the 64-year-old Mr. Trichet is long on practical experience, from the French Treasury to the World Bank. He was president of the Paris Club of creditor nations from 1985 to 1993, an era in which Latin American, African and Russian debts were restructured, and head of the French central bank for a decade.

By 2005, the ECB was preparing for potential market chaos. That April, at its 37-story glass-and-metal headquarters in Frankfurt, 65 participants spent two and half days in exercises aimed at honing their response to a future crisis. About a year later, some 150 people took part in a conference from their home countries to play out shocks to the financial system. In 40 teleconference calls over half a week, the group responded to various scenarios, including a prescient case in which banks sought emergency loans but policy makers didn't know whether the banks were solvent. Top policy makers were barraged by rumors, sometimes contradictory, and by actors playing inquisitive journalists.

The real thing arrived this summer. For months, U.S. homeowners with subprime mortgages -- high-interest loans extended to high-risk borrowers -- had been defaulting in rising numbers. Investors who had bought opaque securities backed by these mortgages ran into trouble as the securities became difficult to value and thus potentially hard to trade.

By late July, there were mounting clues that continental European banks were vulnerable. On July 27, the little-known German IKB Deutsche Industriebank AG revealed it had major exposure to the U.S. subprime-mortgage market, prompting an emergency weekend €3.5 billion bailout organized by Germany's financial regulator, with contributions from major German banks.

Markets lurched into early August. Even as European business slowed for vacation, the ECB's team of market monitors -- usually about 15 people, whittled to around a dozen because of vacations -- was on alert. Working on the second floor of the bank's high-rise, the team watches everything from global stock-exchange movements to copper prices.

Some five members of the team monitor money-market rates, the interest banks charge each other for loans. In the afternoon of Tuesday, Aug. 7, rates on loans ranging from overnight to a year started rising. This was puzzling: Just that morning, the ECB had conducted its regular weekly refinancing operations. That should have provided banks with enough cash to last them the week -- and, by extension, kept the rates between banks relatively flat.

In phone calls with the market monitors, commercial bank treasurers confirmed their banks were antsy.

Wednesday brought more jitters. Though the ECB had set its target rate at 4%, overnight money-market rates continued rising above that. Investors were fleeing to havens such as two-year German government bonds. Data showed commercial banks' reserves with the central bank had fallen, another sign that banks might be hoarding cash.

U.S. VS. EURO ZONE

Projected 2007 GDP*:
U.S.: $13.794 trillion
Euro zone: $11.905 trillion

Unemployment:
U.S.: 4.7% (October)
Euro zone: 7.3% (September)

Consumer prices, growth from year earlier:
U.S.: 2.8% (September)
Euro zone: 2.6% (October)

Current account deficit as % of GDP, second quarter:
U.S.: 5.5%
Euro zone: 0.1%

Population, 2006
U.S.: 299.4 million
Euro zone: 316.7 million**

*Converted to U.S. dollars at current rate.
**Includes population of Slovenia, admitted to the euro zone Jan. 1, 2007.

Sources: IMF World Economic Outlook database, Eurostat, Bureau of Labor Statistics, Commerce Department, U.S. Census

By Wednesday evening, staffers had suggested that the six-member Executive Board consider taking the unusual step of injecting cash to restore calm. By then, Mr. Trichet and Lucas Papademos, the ECB's vice president, were in touch with U.S. Fed governors.

The ECB prefers to stage major interventions before noon, when commercial-bank treasurers are sure to be at their desks. The bank decided to wait until the morning and act if markets were still tense.

They were. At 8:30 a.m. on Thursday, Aug. 9, major French bank BNP Paribas announced it was suspending withdrawals from three investment funds because it couldn't value them amid the subprime crisis. Rumors flew that other banks were in trouble.

"I've never experienced anything like it," says Christoph Rieger, interest-rate strategist at Dresdner Kleinwort in Frankfurt. The fear "ground the market to a halt."

Extraordinary Tension

Interest rates on overnight loans between European banks soared. Typically, market monitors snap to attention if the overnight rate moves a few hundredths of a point away from the bank's policy rate. Now, rates hit 4.7%, far above the ECB's 4% target, signaling extraordinary tension.

Convening at 8:45 a.m., the ECB liquidity group decided to recommend intervening that morning and taking the unprecedented step of pre-announcing that the bank would honor every bid it received. To send a clear signal that the bank was covering the market's back, the committee settled on offering funds at the bank's 4% policy rate rather than a variable rate or a higher penalty rate. Taken together, the moves would show the ECB just how high the demand for cash was, because banks, in principle, would bid for exactly what they felt they needed. The ECB could use the information to judge future injections more accurately.

The six Executive Board members approved the move within 90 minutes.

At 10:26 a.m., the bank told markets it stood "ready to act." At 12:32 p.m., it flashed its decision on trading screens across the euro zone. The notice said the ECB would accept bids for funds until 1:05 p.m. Response was immediate. At 2 p.m., the ECB publicized the total take of €94.8 billion. The overnight rate fell back down to around 4%. In subsequent days and weeks, the ECB continued to add funds to money markets to keep the market liquid.

But challenges continued to arise, in part because the ECB doesn't have detailed insight into the euro zone's banks. While the Fed effectively supervises most of the biggest U.S. banks and has access to detailed information on these banks' books, the ECB cedes banking supervision to each member country.

Days after its Aug. 9 fund injection, the central bank sent commercial-bank supervisors across the euro zone a questionnaire asking about their subprime exposure. The basic question: Were banks basically sound and just having a problem with short-term liquidity? Or were some of them in deeper trouble?

Some responses were returned quickly and fully. Others came back late or without sufficient numbers. In the end, the ECB learned enough to be confident that banks were sound. But some people in and out of the ECB are unsure that the bank would get the information it needs in a bigger crisis.

In the following weeks, another old ECB problem resurfaced -- communicating intentions clearly to the market. Mr. Trichet had been getting high marks for predictability, but that changed on Aug. 22.

On the back of the ECB's continuing cash injections, overnight lending rates had fallen back to around the 4% target. But three-month interbank rates still hovered around 4.7%, a sign that banks were reluctant to lend to each other for longer periods.

At 3:34 p.m. that day, the ECB released a surprise statement saying it would hold an auction the following day, accepting bids for €40 billion in extra three-month funds. Markets greeted the announcement with relief. But the statement's last sentence caused confusion. "The position of the Governing Council of the ECB on its monetary policy stance was expressed by its president on 2 August 2007," it read.

That was a reference to a briefing held by Mr. Trichet weeks earlier, at which he indicated that the bank, at the time, was inclined to raise short-term rates at its next meeting on Sept. 6. In the intervening turmoil, however, markets had steadily revised down expectations of an ECB interest-rate rise. The late August statement seemed to put a hike back in play.

"To say markets didn't know how to interpret it is putting it mildly," says Dresdner Kleinwort's Mr. Rieger.

Crossed Signals

The communication problem was compounded two days later, on Aug. 24. Anonymous sources at several national central banks leaked word to Reuters that markets had misinterpreted the sentence about the ECB's monetary-policy intentions: ECB policy makers were not set on raising rates. Speaking in Budapest a few days later, Mr. Trichet intervened to clarify the message, essentially telling markets that policy makers hadn't decided whether to move rates.

On Sept. 6, the bank kept its policy rate unchanged at 4%.

Observers say that while the bank proved its chops with its early August moves, it still has room to master the subtle art of communicating its intent. "It's as important as moving rates well," says Luigi Buttiglione, a former Bank of Italy economist, now with New York-based investment fund Fortress Investment Group in London, who praised the August intervention. "You not only have to do the right thing, but you have to explain why this is the right thing. If you're not able to do that, then markets can take a different direction -- and you can achieve the opposite result."

Monday, November 05, 2007

Gulf States and the Dollar Link

Andrew Critchlow, WSJ:

PEGGED DOWN

• The News: Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.
• Background: The Gulf states' exchange rates are pegged to the dollar, whose decline has diluted the benefit of record oil prices.
• What's Next: Rampant inflation in the region has increased pressure, particularly on the U.A.E., to sever ties with the dollar, which could further add to the dollar's woes.

DUBAI, United Arab Emirates -- Oil-rich Arab sheikdoms, risking new inflation pressure, followed the U.S. Federal Reserve's lead by lowering official interest rates to keep their currencies aligned with the dollar.

Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain followed the Fed's decision to cut interest rates by a quarter percentage point.

Because their exchange rates are pegged to the dollar in fixed trading ranges, monetary policy in the Persian Gulf states must mirror U.S. moves to avoid pressures from capital drifting to the currency with the most favorable interest rates.

The moves came despite concerns over rampant inflation in the region, which suggest central banks should be raising, instead of lowering, rates. Bankers said the policy conflict is building pressure on the Gulf states to unbind from the dollar.

In European emerging markets, meanwhile, the Central Bank of Iceland raised its key rate 0.45 percentage point to a record 13.75% in an effort to slow annual inflation, running at a 4.5% rate, down closer to its 2.5% target rate. It was the 19th time since 2004 that the Icelandic central bank has raised rates to keep its economy from overheating. The Romanian central bank Wednesday raised its key rate by one-half percentage point to 7.5%, fighting a 6% inflation rate the bank blamed on soaring household income and rising public spending.

In Asia, meanwhile, sharper-than-anticipated consumer-price inflation last month -- 3% above year-earlier levels -- prompted speculation the Bank of Korea will raise its policy rate, now at 5%, in the first quarter next year. The Hong Kong Monetary Authority, also struggling to balance domestic considerations with pressures from overseas investors, has been intervening to keep its currency from rising above publicly set bands.

Nowhere in the Middle East are the strains more acute than in the U.A.E., where investors are betting on a "depegging" of the dirham as domestic inflation pressures increase.

"Speculators are definitely bidding on a depegging, and that's why they're increasing their dirham deposits," Henry Azzam, Middle East chief executive at Deutsche Bank AG, told Zawya Dow Jones Newswires in an interview.

Attracting that money are chances of a quick profit once the peg snaps. Deposits held in the emirates' banks have exceeded one trillion dirhams ($272.3 billion) for the first time, more than is deposited in the region's largest economy, Saudi Arabia, latest central-bank figures show.

"The probability of depegging has increased," said Kamran Butt, Dubai-based chief economist at Credit Suisse Group. "The market consensus is for the U.A.E. to depeg." A decision by the U.A.E. to sever ties with the dollar could alienate the U.S. and add to the dollar's woes at a time of economic uncertainty and record oil prices.

The dollar, which fell to all-time lows against the euro and 26-year lows against sterling in the aftermath of Wednesday's rate cut, was at $1.4437 against the euro, from $1.4486 Wednesday. The U.K. pound was at $2.0787, from $2.0793 Wednesday.

The dollar's slump has pushed up the cost of imports to the Gulf, fueling inflation. The dollar's decline has watered down the benefit of record oil prices in the region that is expected to accrue a surplus in excess of $500 billion this year, according to Saudi lender Samba Financial Group.

Kuwait, the region's third-largest Arab oil producer, was the first to break ranks with its Gulf peers in May when it shunned its peg with the dollar by allowing the dinar to float against a basket of currencies and in a range against the dollar. It retains a loose dollar peg and joined other states in cutting rates yesterday.

The seven emirates are Abu Dhabi, 'Ajman, Al Fujayrah, Sharjah, Dubai, Ra's al Khaymah and Quwayn.

With inflation expected to exceed 10% for a second consecutive year in the U.A.E., the emirates' ruling sheiks face the region's greatest fiscal policy challenge since the U.K. devalued sterling in 1967, forcing Gulf states to turn to the dollar as a benchmark.

When the emirates created the dirham in 1973 they linked it effectively to the dollar. Now bankers such as Deutsche's Mr. Azzam are unsure whether the U.A.E. is ready for another such change. "I don't think a depeg will happen because that's a regional decision and it has served the U.A.E. so far," he said.

Fed Policy and Moral Hazard

Harvey Rosenblum, WSJ:

Accusations of moral hazard have been tossed around quite a bit since the Federal Reserve lowered the federal-funds rate by half a percentage point a month ago today. Moral hazard, if you’re neither an actuary nor a practitioner of the “dismal science,” occurs when investors or property owners are protected from the downside risks of bad investment decisions, thus encouraging them to take still more unwise risks in the future.

[Chart]

As entertaining as this discussion of the nexus between the Federal Reserve and moral hazard has been, the analysis is incomplete because it lacks one key element — something called the Taylor Rule. The namesake of this bit of economic wisdom is John Taylor, perhaps the best scholar on monetary policy in our times. His rule, a description of monetary policy decision-making formulated a decade and a half ago, has a good deal of relevance to any discussion of Fed policy and moral hazard.

So what exactly is Taylor’s Rule? Put simply, it prescribes higher interest rates when inflation crosses certain thresholds and the economy is near full employment; and lower rates when the opposite is true. When these goals are in conflict the Rule provides guidance on how to adjust rates accordingly.

But before we get to why Mr. Taylor’s work matters, we’ve got to better understand moral hazard, which, as Mr. Bernanke defined it in a textbook he coauthored, is “the tendency of people to expend less effort protecting those goods that are insured against theft and damage.”

Why has moral hazard reared its head after the Federal Open Market Committee cut interest rates at a time of turmoil and uncertainty in financial markets? If the FOMC decision has provided an insurance policy that protects investor portfolios against damage, and if investor behavior takes this insurance into account in advance, then the FOMC, I will argue, does create a moral hazard each and every time it makes a monetary policy decision. This proposition is equally true whether the FOMC lowers rates, raises rates, or leaves them unchanged. Moral hazard goes with the territory.

Some writers go a step further and blame the Fed for intentionally creating moral hazard with the “Bernanke put,” an updating of the “Greenspan put.” A “put” cushions an investor against a decline in the price of a security through an option to sell at some specified price before the put’s expiration date. Former Fed Chairman Alan Greenspan’s name was attached to the concept in the mid-1990s, when stock-market investors supposedly began to believe that the FOMC wouldn’t raise the federal-funds target rate to restrain a rising stock market but would lower rates — quickly, vigorously, and intentionally — to stem stock-market declines.

If the Fed practiced such one-sided intervention, stock-market investors would suffer little or no downside risk. Sounds too good to be true and it is, as any investor who rode the roller coaster of the 80% drop in the Nasdaq in 2000-2002 would verify.

Greenspan or Bernanke “puts” make good copy, but they’re at odds with how the FOMC operates. By law, the Fed has a dual mandate to promote maximum employment and price stability. In practice, the FOMC seeks to foster an economic environment characterized by low and steady inflation, a low unemployment rate and a sustainable rate of economic growth. To carry out its mandate, the Fed needs a healthy, smoothly functioning banking and financial system.

After all, this financial infrastructure constitutes the conduit — or plumbing — through which the early actions of monetary policy flow to the rest of the economy. If the flow of money and credit is blocked, the Fed’s ability to achieve its mandates is compromised.

Financial turmoil is an impediment that must be addressed as a prerequisite to achieving the FOMC’s other goals. In a modern, credit-dependent economy like ours, a sharp reduction in the willingness or ability of lenders to grant, extend or renew credit can set off a contraction of economic activity and employment. Imagine the reduced spending in our economy if the electricity went off and we couldn’t use our credit cards for a week.

The Fed’s mandate makes no mention of the stock market, bond market, housing market or any other asset market. But these markets matter for their financial flows and for their psychological and wealth impacts on consumers and businesses. The stock market and other asset markets matter for monetary policy only insofar as they impact consumer and business spending, employment and inflationary pressures.

The Federal Reserve does not conduct monetary policy to influence stock prices, regardless of whether the stock market is rising or falling. The Fed does, however, try to create the macroeconomic stability needed to achieve its mandates — and this is where Mr. Taylor’s work comes in. Over the past couple of decades, the FOMC’s interest-rate behavior has been replicated closely by a forward-looking Taylor Rule, developed by my Dallas Fed colleague Evan Koenig.

Mr. Koenig’s version of the Taylor Rule suggests that the FOMC boost the federal-funds rate by roughly two percentage points if inflation is expected to rise by one percentage point or if the unemployment rate is expected to fall by one percentage point. Other things equal, the FOMC should raise the federal-funds rate by 0.7 percentage points if GDP growth is expected to rise by one percentage point. Without ever taking any account of the stock market or other asset markets, this version of the Taylor Rule, using publicly available forecasts, mimics quite closely the setting of federal-funds rates by the FOMC over the last 20 years.

Over the last two decades, when FOMC actions correlate strongly with a forward-looking Taylor Rule, the economy has been remarkably stable. Inflation has trended down, and recessions, while unavoidable, have been short, mild and infrequent. The chart nearby depicts one measure of the macroeconomic stability tied to the FOMC’s systematic reference to a Taylor-type rule. As the chart clearly points out, because of the Taylor Rule and students of it, the U.S. economy spends a lot less time mired in recession.

To the extent that the FOMC sets the federal-funds target rate in accordance with some form of the Taylor Rule, there is no central-bank “put.” There is, however, a gain in macroeconomic stability, which can be thought of as an insurance policy that reduces the risk of recession for every worker, employer and investor.

If there is any true moral hazard in our economy right now, this is its source: Americans spend, save and invest in the belief that recessions, if they occur, will be short, mild and infrequent. People believe that unemployment is something that happens to someone else. Indeed, the younger generation in the work force has, for all intents and purposes, had almost no experience with the unpleasantness of a recession. To them, it’s just a word that begins with “R” but they cannot define it or describe it. That’s real moral hazard, because it drives their consumption and investment behavior.

So what’s the bottom line? Simply that moral hazard is an inevitable, inescapable and unavoidable byproduct of the FOMC’s provision of macroeconomic stability. The better the FOMC’s job performance, the greater the recession insurance and the moral hazard that accompanies it. And the closer we are to price stability, the fewer resources we need to expend to protect ourselves from the theft of purchasing power that stems from inflation.

So let’s stop the complaints about moral hazard and the “Bernanke put.” Who wants to be the first to volunteer to live in a world like the first quarter of the Fed’s post-World War I history, when the economy was in recession over 40% of the time? There was a lot less moral hazard then, but there was also a far more volatile economy. As long as Taylor’s Rule reigns, Fed easing should be regarded as a macro blessing, not a hazard to be avoided.

A Chronology of Financial Crises

Wednesday, September 17, 2008

Ultimatum by Paulson Sparked Frenzied End

Complete Coverage

Finding a Buyer

The Chance to Transform

Somber Mood

Monday, September 08, 2008

Mixed Economic Data Show A Changing Business Cycle

Tuesday, August 19, 2008

How Low Interest Rates Contributed to the Credit Crisis

Monday, April 28, 2008

Bagehot's Lessons for the Fed

Wednesday, April 23, 2008

Housing Prices and Monetary Policy

Governor Frederic S. Mishkin

At the Forecaster’s Club of New York, New York, New York

January 17, 2007

Enterprise Risk Management and Mortgage Lending

Friday, January 18, 2008

We're all Keynesians now

Wednesday, December 12, 2007

The Roots of the Mortgage Crisis

Wednesday, November 07, 2007

ECB, After Hard Birth, Comes of Age in Crisis

ECB, After Hard Birth,
Comes of Age in Crisis

Monday, November 05, 2007

Gulf States and the Dollar Link

Fed Policy and Moral Hazard

Followers

Wednesday, September 17, 2008

Complete Coverage

Finding a Buyer

The Chance to Transform

Somber Mood

Monday, September 08, 2008

Tuesday, August 19, 2008

Monday, April 28, 2008

Wednesday, April 23, 2008

Governor Frederic S. Mishkin

At the Forecaster’s Club of New York, New York, New York

January 17, 2007

Enterprise Risk Management and Mortgage Lending

Friday, January 18, 2008

Wednesday, December 12, 2007

Wednesday, November 07, 2007

ECB, After Hard Birth,Comes of Age in Crisis

Monday, November 05, 2007

ECB, After Hard Birth,
Comes of Age in Crisis