Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Thursday, February 20, 2014


Like many people out there, I am eagerly awaiting the release of the full transcripts of the Fed's monetary policy meetings for 2008. When they come out (and it should be very soon), you will be able to find them here.

I expect that the media will have a field day with these. No doubt a number of Fed officials will have said things that, with the benefit of hindsight, they wish they had not said, or said somewhat differently.

Jim Bullard, president of the St. Louis Fed, recently gave a speech on the subject titled: The Notorious Summer of 2008. The slides associated with that speech are available here.

Bullard makes some very good observations.

First, many people think of the financial crisis as beginning in the fall of 2008, with the collapse of Lehman and AIG. In fact, the crisis had been underway for more than a year at that point (August 2007). The fact that the crisis had gone on for over a year without major turmoil suggested to many that the financial system was in fact relatively stable--it seemed to be absorbing various shocks reasonably well. Throughout this period of time, the Fed reacted with conventional monetary policy tools--lowering the Fed Funds target rate from over 5% to 2% over the course of a year.

So what happened? Essentially, an oil price shock. By June 2008, oil prices had more than doubled over the previous year. The real-time data available to decision-makers turned out to greatly underestimate the negative impact of this shock (and other factors as well). The rapidly slowing economy served to greatly exacerbate financial market conditions.

The Bear Sterns event occurred in March 2008. The firm was purchased by J.P. Morgan with help (bailout, depending on one's perspective) from the Fed. Bullard identifies two problems with that deal. One, it suggested that all financial firms larger than Bear could expect some form of insurance from the Fed. Two, while the deal was successful in calming down markets, it possibly had the effect of lulling them into a false sense of security.

Of course, we then had the infamous Lehman event in the fall of 2008. But as Bullard points out, everyone knew that Lehman's was in trouble for at least a year--surely investors were prepared for this. And in any case, investors would have properly insured themselves, no?

Well, no. The big insurer, of course, turned out to AIG. Evidently, very few people had any idea about the potential problems with AIG at the time (which, by the way, was outside the scope of Fed supervision). And so, it was the Lehman-AIG event that brought all financial firms under heightened suspicion--and it was this event that drove the financial crisis from September 2008 and onwards.

We all know how the Fed reacted at the time, and since then. The interesting question here is what the Fed might have done differently in the time leading up to the start of the crisis in 2007 and beyond? It is important to answer this question, I think, in the context of policy making that is constrained to operate with the use real-time data (that is frequently subject to significant revisions as time unfolds).

In any case, it will be interesting to eavesdrop on the discussions that occurred in 2008.


  1. David: The interesting question here is what the Fed might have done differently in the time leading up to the start of the crisis in 2007 and beyond? It is important to answer this question, I think, in the context of policy making that is constrained to operate with the use real-time data (that is frequently subject to significant revisions as time unfolds).

    Don't you want to suggest an answer David?

    I'm also curious to know how the minutes really help answer that question? It will tell us of some of the things that were suggested in the meetings but not what the actual best response would have been.

    1. Yes, Adam P, I would like to suggest something. In time. Once I have absorbed it all sufficiently. :)

  2. David,
    Finding it hard to defend this claim:

    "The fact that the crisis had gone on for over a year without major turmoil suggested to many that the financial system was in fact relatively stable".

    That is like saying Argentina's financial system was relatively stable until it abandoned convertability. As a veteran of multiple financial crises in the emerging markets, Japan, etc, I can tell you that financial crises don't happen when everyone expects instability; they happen when everyone mistakenly expects stability. Bullard's comment, I think, shows willful ignorance of this dynamic.

    One could argue that the Bear Stearns bail out increased systemic risk by confirming the existence of a policy "put" on credit. The GSE preferred haircuts in September brought this put into question (preferreds are quasi-credit), especially since subordinate bond haircuts were briefly considered. Then, when Lehman seemed to have little support for a creditor bail out, all hell broke loose.

    We went from a financial system mostly build on insured deposits to one mostly built on uninsured repo's and ABCP. To claim this system was "stable" in 2008 is to lack understanding of the dynamics of this shift. A classic lemons problem was being created, and Gorton and the NY Fed, Shin, Adrian, etc, have all done great research in understanding it. My small, and admittedly non-formal contribution was a chapter in David Beckworth's book on the crisis.

  3. Diego, you are being too harsh with that allegation, I wish you would retract it.

    The point, I think, is simply that the financial system had been hit by several major shocks and had absorbed them pretty well. How would you have updated your beliefs, if you are a Bayesian, and if this had happened? This is no excuse for complacency of course. But I don't think you are accusing Bullard of this, are you?

    Let me ask you: Do you think everyone is expecting stability now? And if so, are you worried? If not, then please elaborate.

    Another question: It seems clear to everyone that Mt. Vesuvius has a demandable claim on Naples. What would you be doing right now to prevent the inevitable redemption event?

  4. David,
    Ha! Good question on Vesuvius. It is probably exhibiting "stability" now.

    On Bullard, yes, I regretted writing that, and I retract it. The question is whether one is capable of predicting something that the market is not predicting. Market Monetarists are an extreme form, but anyone ascribing to EMH would have a hard time accepting that stable asset prices are compatible with an underlying condition of instability. My point is that this dilemma is central to crises. Agents hedge against known probability distributions; unstable countries can have more stable financial systems because agents anticipate that instability and protect themselves. Brazil in the 90's is a great example. So financial crises require the perception of stability in order for agents to raise their risk preferences in a way that results in the build up of systemic risk that eventually causes the crisis. Robust systems benefit from disorder; artificially stable systems can suffer from fragility. When Roger Farmer says markets are inefficient and there are welfare gains from preventing asset price volatility, he leaves out the 2nd order effects of agents raising risk preferences in the presence of a free policy put.

    Yes, I think most are expecting stability now in certain key pockets. Almost no one expects bond yield volatility and the system is rife with carry (duration) trades. This same idea (low bond vol) underlies investor buy-to-rent purchases, and these account for a large portion of current housing demand. This is just one example of how the Fed induces investors to align along homogenous strategies in a way that makes the system more fragile as it gains in the perception of stability.

    As far as Vesuvius, this is a hedgeable event. Earthquake codes, evacuation plans, etc, all form part of that hedge. The longer the volcano goes without a major eruption, the greater the perception of stability, and the bigger the damage will be as hedges are seen as sub-optimal.

  5. Yep, some blogger sites have had a field day with those transcripts. And rightly so, even here we imply the feds actions were to lull the markets into a sleepy stuper by substituting/confusing liquidity with solvency on a massive, massive scale. I still say that if in our nation we had a system that encouraged imdividuals to be savers (as opposed to reserve replicating banks playing that role) this credit crisis would not have happened.

  6. I have an interesting observation (at least to me). We are all interested in the 2008 transcripts for obvious reasons....the start of bailout mentality and fed balance sheet growth. In the infamous conspiracy theory book "the creature of jekyll island", written around 1987 I believe, the second chapter is "bailouts are part of the plan".

    1. I can give you two.

      Bernanke's definition: aggressive and creative lending and swap facilities extended to otherwise insolvent institutions.

      G. Edward Griffin's definition: using the federal government as an agent to transferr the inevitable losses of the banks onto the taxpayer.

      The first definition implies everything is just a liquidity issue, and ignores overall debt and prior management performance. The second definition implies the unique police powers and taxing powers of the state are viewed as a business mechanism by monetary policy makers, in stark contrast to how an average citizenmay see a fundamental issue of their freedom under the current government.

    2. What was the actual value of the Federal Reserve "bailouts"?

      According to the 2011 audit of the Fed by the Government Accountability Office (GAO), there were $16.115 trillion in Fed "bailouts" to banks and corporations around the world between the financial meltdown in 2008 and July 26, 2010.
      Page 131:

      Now to see how silly the $16.115 trillion dollar figure is let's focus on the largest component, the $8.951 trillion lent out under the Primary Dealer Credit Facility (PDCF). Those were overnight loans made over the period from March 17, 2008 through February 1, 2010. Thus the average amount of loans under the program on any given night was $13.1 billion.

      The peak amount of loans under PDCF was $130 billion (fourth page of the GAO audit) and occured in early October 2008. In fact nearly a third of all the loans (by amount) were made in October 2008. An Excel file containing details about the loans can be downloaded from here:

      The peak spread between the Libor rate:

      and the rate paid on a PDCF loan was 3.07% on October 10, 2008 when the PDCF rate was 1.75% and the Libor rate was 4.82%. Thus the value of the subsidy under PDCF was less that 3.07% of the average daily amount of $13.1 billion over 1.88 years or $756 million.

      Why is the subsidy on $8.951 trillion in loans so small? Because it's a flow and not a stock.

      The peak stock amount under the emergency lending programs was $1,067 billion on December 18th, 2008:

      A graph of the stock amounts is depicted on page 137 of the GAO Audit. The program with the largest stock amount was the Term Auction Facility (TAF) which peaked at $493 billion in early March 2009. At the time the interest rate paid on a TAF loan was 0.8%:

      when the Libor rate was about 1.3%. The average amount of loans on any given day during the life of the program was $142 billion:

      Thus the subsidy under TAF might have been about 0.5% (the spread) of $142 billion over 3.35 years or $2.38 billion.

      And in fact if one totals up the estimated subsidies for the $16.115 trillion loaned under the emergency lending programs it comes to about $4 billion.

    3. Thanks for the info and the effort in posting it here. I guess I can't tell if "silly" is used in a vein of sarcasim here or not.

      If you think it silly in a serious manner, I guess I wonder....its a "silly" number in relation to what? To me, if the banking system in fact could not have survived without the bailout, the figure wasnt silly regardless of how large or small it was.

  7. A billion us dollars offered today to ukraine. Wonder where that money is coming from?

    In response, russia threatens to dump its ust paper, worth about two months of fed pomo. Im sure we can absorb it, as long as we all believe every FRN created is just as valuable as the last.

    I think 2014 will be an extremely interesting year. Have a good day everybody.

  8. I reject your $4 billion estimate of the total subsidies for the "emergency lending" programs, as neither the Federal Reserve nor the GAO have any credibility or transparency. Furthermore, the Federal Reserve has been engaged perpetually in bailouts since it's 1913 inception. Every single asset purchased, and every single loan issued is done via the power to create money ex nihilo, the same power that counterfeiters seek to obtain, and it is done exclusively for the benefit of a very narrow set of elite bankers. The Fed is undoubtedly the greatest cause of misery, poverty, and injustice in the world, and needs to be abolished immediately, with all of its proponents, shills, and defenders put in jail or worse. This blog and the academics who frequent it are a joke.

    Read for at least some semblance of the truth.