WSJ: Why Financial Reform is Stalled

Came across this excellent article today, by Peter J. Wallison. In case you haven't seen it, click here.

In a nutshell, he criticizes the standard explanation of political gridlock (an hypothesis that does not square well with the fact of resistance on both sides of the aisle in Congress).

Instead, he suggests the following entirely plausible explanation: The current proposals are not grounded in a valid (or persuasive) explanation of what caused the financial crisis. He goes on to give a lucid description of the power of moral hazard.

Should the Euro Have Slipped on Greece?

The United States and the Eurozone are both currency unions. Member states within each union are prohibited from issuing the common currency. Money creation is delegated to a central authority (the Federal Reserve in the U.S. and the ECB in the Eurozone). The US dollar and the Euro are both major world currencies.

Given these similarities, my question is this: Why is the recent Euro depreciation being explained by the fiscal problems experienced by a subset of Eurozone members?

Actually, let me put the question another way. Why are state-level fiscal problems in the American Union not associated with sharp depreciations in the USD? (California, by the way, is an economy larger than Greece, Portugal, and Spain combined).

One difference between the U.S. and the Eurozone is that the latter has no central tax authority to accommodate wealth transfers (bailouts). In fact, Article 103 of the Euro Treaty explicitly states that the EU shall not be liable for or assume the commitments of central governments.

Another difference between these two unions is that there is no counterpart to U.S. treasury debt in the Eurozone. Hence, while the Fed "monetizes" federal-level debt; the ECB "monetizes" state-level debt (in this case, sovereign debt).

So, perhaps the answer to my question is as follows. When California experiences a fiscal crisis, markets expect it to be bailed out by federal transfers; the market does not expect the Fed to monetize California state debt. This does not pose a direct inflationary concern, and hence is ignored in the FX market. The opposite holds true for the Eurozone; hence, the direct impact on the exchange rate.

There are several reasons why I am not satisfied with this answer. One has to do with my preferred theory of the exchange rate, but I'll leave this aside for now. The other has to do with the perceived credibility of the ECB. I doubt very much that the ECB will monetize Greek debt (and if it does, it will discount it heavily) and I don't think the market believes this either. The market likely believes that a bailout is coming (you don't actually believe that Article 103 is credible, do you?).

The bailout will be sold as "saving Greece;" but in fact, the bailout will in effect save the Germans and other Europeans holding Greek bonds. In short, a typical wealth transfer. Disgusting, perhaps...but inflationary, no.

Fiscal Multipliers in War and in Peace

It truly is breathtaking how certain some people are of what they know to be true about the way a macroeconomy operates. The Krugmans and DeLongs of this world really make it sound like everything we really need to know has been settled long ago. Yes, the science is "settled" (where have we heard this before?).

I recently came across this piece by Brad DeLong: A Guide for the Perplexed. Consider the following quote:

But when fiscal boost was tried on a large enough scale, it certainly did the job. And it is reasonable to infer (with all the caveats provided by the CBO) that what is true in the very large will be true in the merely large as well. Eugene Fama says that it is theoretically impossible for fiscal stimulus to boost output: World War II proves him wrong. Robert Barro says that the multiplier is zero: World War II proves him wrong. Benn Steil says that Jacques Rueff in 1947 conclusively proved that fiscal policy could not boost employment: World War II proves him wrong.

Implication: a WWII style fiscal stimulus will "do the job" in a peacetime recession. WWII "proves" it. Egad...how does he know this? Why do I not feel as confident that this is the case? Am I truly that dense? (an invite to some rather rude comments, I'm sure!)

In any case, I decided to gather my thoughts on the subject and post them here for public review and criticism. The piece is a bit too long for a blog posting; so if you're interested, please click here. Looking forward to any comments.

And the New Minneapolis Fed President is...

Narayana Kocherlakota; see here.

Hmm...his biography says that he was born in Baltimore. I seem to recall him mentioning that he was born in Winnipeg. Is he Canadian, or isn't he? Someone enlighten me!

In any case, he is an excellent choice. NK is a consummate academic: clear-thinking, articulate, and persuasive. Does he have what it takes to be a successful/influential Fed president? Yes, I believe so. Apart from his academic credentials, he has a very easy manner; not many people are likely to find him a boor. He has the gift of skewering lame-brained ideas to the wall, and then making you feel good that you've learned something useful (at least, this has been my experience).

Congratulations to NK...and good luck!

Kocherlakota on the State of Macro

A very nice piece by NK here. Unfortunately, you won't see something like this published in the NYT. But naturally, we can rely on DeLong to make a comment; see here: Narayana Leaves Me Puzzled. Consider this DeLong quote:

The models thus tell us that downturns are either the result of a great forgetting of technological and organizational knowledge, a great vacation as workers develop a sudden extra taste for leisure, or a great rusting as the speed with which oxygen in the air corrodes speeds up and so reduces the value of large things made out of metal.

This is exactly how I would expect a first-year undergraduate to interpret a model that they've seen for the first time. And DeLong claims that he has a PhD in economics. Let me help the poor lad along.

Some macro models incorporate "news shocks." A news shock is the random arrival of information that leads people to (rationally) revise their forecasts of future events. These forecasts may be made, for example, over future productivity, future riskiness of investments, future policies, etc. These news shocks do not seem like an implausible impulse mechanism; unexpected news arrives every day.

Investment demand today depends on forecasted productivity of investment. These forecasts will change with news; leading to variations in investment that an econometrician might identify as "aggregate demand shocks." As the investment matures and comes online, its actual productivity may be higher or lower than originally forecast; its realization constitutes another "shock."

There is no need to appeal to DeLong's childish "great forgetting" interpretation of a negative technology shock. A negative technology shock occurs when the realized return on investment is lower than expected. The return on an important class of investments may turn out to be terrible (think of all the fibre optic cable planted across the world's oceans in anticipation of a demand that never materialized). And as Fisher Black has stressed, these types of errors are typically correlated across agents. In short, recessions may be explained, in part, by collective mistakes on investments made in the past.

In any case, what DeLong fails to offer us what he might propose instead as the ultimate source of the business cycle? I am guessing that he might say something like "animal spirits." So why did the recession occur? Because people thought that it would. Why did that boom occur? Because people believed that it would.

There may be an element of truth to the animal spirit hypothesis; but then, there do appear to be competing interpretations as well. If DeLong would spend less time writing his blog and more time reading the literature, he might one day be less puzzled with Narayana's observations.

Why the Growing Level of U.S. Debt May Not be Inflationary

History shows that high levels of government debt are frequently associated with inflation. The reason for this seems clear enough. At some point, maturing debt needs to paid back. At high enough levels of debt, rolling the debt over is no longer feasible. Cutting back government spending and raising taxes is politically difficult. The easy way out is simply to print new money. As the money supply expands, inflation resuts.

The rough logic described above would seem to fit the experience of many smaller economies that find themselves under fiscal pressure. But things may not work so simply for a select few dominant economies. Japan appears to be one example; and the U.S. another.

Let us consider the U.S. Unlike most other economies, there appears to be a huge worldwide demand for U.S. Treasuries and U.S. dollars (which can be thought of as zero-interest Treasuries). A large scale increase in the supply of these government debt instruments need not lead to a depreciate in their value if there is a correspondingly large scale increase in the worldwide demand for these objects. What is the evidence that this may be happening?

Foreigners Snap Up Treasuries Even as US Debt Keeps Rising

But why should this be so? What accounts for what appears to be an insatiable demand for US debt, especially in the wake of the recent financial crisis?

Ricardo Caballero of MIT offers some hints in a very interesting piece entitled: On the Macroeconomics of Asset Shortages. After reading this paper, I started thinking in the following way. Tell me what you think.

There is a high and growing demand for low-risk assets, both as a store of value, and as collateral objects in payment systems (e.g., repo and credit derivatives markets). This growth has exploded over the last 20 years or so; and stems from the demand from emerging economies and innovations in the financial sector. There is a worldwide "shortage" of good quality (low-risk) assets, like U.S. Treasuries (which explains their relatively low yield). Indeed, many of the innovations in the financial sector can be interpreted as the private sector's response to this shortage: the creation of "low-risk" tranches of MBSs allowing these objects to substitute for U.S. Treasuries as collateral in the rapidly expanding repo market.

The recent financial crisis was centered in the repo market. Very suddenly, agents in the repo market were no longer willing to accept MBS as collateral (or if they did, at very large "haircuts"). The demand for U.S. Treasuries exploded (I seem to recall a day when their yields actually went negative). At the same time, there was a worldwide "flight to quality;" which again, manifested itself as large increase in the demand for (relatively safe) U.S. Treasuries.

If this is more or less true, then the implication is this: The massive increase in the supply U.S. Treasury debt may very be "socially optimal" in the sense that the U.S. government is simply supplying the world with an asset that is in very high demand (which, in turn, means that the demanders obvious find some value in the existence of such an asset). To the extent that this "new demand regime" remains stable, the added supply of U.S. Treasuries will impose no financial burden on the U.S. (indeed, they make off like bandits, as the Treasuries are ultimately purchased by exporting goods and services to the U.S.).

The million dollar question, of course, is whether the high world demand for U.S. debt will persist long into the future (and whether the U.S. government will "overissue" debt beyond what is called for by this new high-demand regime). Who knows what will happen. But it appears to me that IF the U.S. government plays its cards right, it may very well enjoy its higher debt levels without the prospect of inflation. U.S. citizens will benefit (from the sales of Treasuries for goods) and the world will be grateful to hold a stable asset.

Well, maybe. But that was a big IF. What could possibly go wrong?

William Poole on Ben Bernanke

For those of you who may not know, I have recently joined the Federal Reserve Bank of St. Louis as a VP in the research division. Will keep you posted on things that I learn (and am allowed to reveal).

We were recently asked to comment on an article written by Bill Poole, former president and CEO of the Fed here in St. Louis. He asks the question: Should President Obama reappoint Fed Chairman Bernanke? See here. His conclusion is "no." (too late, it appears).

So what's his beef? Essentially, that some of the new policies initiated by Bernanke have violated stipulations in the Federal Reserve Act (FRA) and that, in doing so, he has comprised the Fed's political independence. The relevant stipulations are section 13(3) and section 14(b).

Poole grants Bernanke some leeway in terms of the emergency measures adopted in March 2008 (Bear Stearns) and September 2008 (AIG). But he believes that the Fed's Commercial Paper Funding Facility (CPFF) violates section 13(3). He may have a point here; but there is not much a leg for him to stand on as the term "exigent" is not precisely defined.

Poole also believes that the Fed's buying program for Mortgage Backed Securities (MBS) is not authorized under Section 14(b). I beg to differ. As far as I can tell, the act does allow for purchases of assets that are guaranteed by the U.S. government. The MBS purchased by the Fed are fully insured by the Treasury (and indeed, they are generating a very nice return).

Poole makes some very good points about distancing the Fed from politics as much as possible. But I do not believe that he makes a compelling case against reappointment. Among other things, he does not propose alternative candidates (many of the apparent frontrunners would likely view Bernanke's interventions as too conservative). Bill should be careful what he wishes for.

In any case, it looks like Bernanke will be reappointed (after a good grilling in front of the Senate). Considering the alternatives, I think this was the right choice.