Asking too much of monetary policy

I remember a Federal Reserve economist once recounting a conversation with his young daughter, who asked him, “What do you do at work, Daddy?” He answered, “I help make important decisions.” “What kind of decisions, Daddy?” “Oh, things like how much money the government needs to print.”

Which is an important decision, don’t get me wrong. By creating too little money, a nation’s central bank has the power to generate sustained deflation (a fall in the price level), such as the U.S. Federal Reserve did in 1931-33, greatly aggravating the Great Depression, or the Bank of Japan permitted in the late 1990s, undoubtedly prolonging the economic misery of that episode. These were outrageous policy errors, but ones that I am extremely confident that the well-trained fathers and mothers currently employed by the Federal Reserve System would never allow the United States to repeat.

The central bank also unquestionably has the power, by printing too much money, to create ferocious inflation– just ask Gideon Gono, head of the central bank of Zimbabwe.

I happen to be among those macroeconomists who further believe that the Fed can do a great deal more than just cause too much deflation or inflation. The choice for the time path of money creation ultimately determines the time path of short-term nominal interest rates, and indeed the modern Federal Reserve quite appropriately conceives of its primary operating decision as basically choosing the current value for the overnight interbank interest rate, known as the fed funds rate. I would readily agree that careful exercise of this choice could help mitigate– though in my opinion, not entirely eliminate– the ups and downs of real economic activity associated with the business cycle.

I would also quickly point out that an injudicious choice for the short-term interest rate has the potential to exacerbate those ups and downs. Not just the potential, I dare say, but in practice has often been observed to exert exactly that effect. The cycle is an extremely familiar one. The Fed, frustrated by the low level of economic activity, tries to engender an artificial boom through lower interest rates, only to discover soon afterward that this has created more inflation than the public is willing to tolerate. The Fed then has no option other than contract to try to bring inflation back down. But that contraction in turn may prove to be one factor contributing to the next downturn, to which the central bank wants to respond with yet another stimulus. In my opinion, this same pattern has been repeated many, many times in U.S. history, most recently with a Fed that was too expansionary in 2003-2004, which caused the Fed to have to contract in 2006, and that policy-induced boom-bust cycle is part– though in my opinion, only part– of the cause of the problem we find ourselves in today.

So, I am certainly a believer in the potential real effects, sometimes for good, sometimes for ill, of monetary policy. But I just as certainly do not believe, nor should any reasonable person believe, that no matter what the economic problem might be, you can always solve it just by printing more money.

What’s an example of a problem you can’t solve with monetary policy? Suppose you were convinced that house prices in the United States were at the moment substantially higher than they should be relative to the price of other goods and services. How could that have happened, an economist would want to ask, and let’s suppose that the answer is that a credit market profoundly distorted by moral hazard problems loaned vast sums to households that could not reasonably be expected to be repaid if real estate prices stopped rising. The purchase of the properties financed by those loans drove up the price of housing relative to what it would have been (and should have been) with a correctly functioning credit market, so now the relative price of housing must fall.

And why doesn’t the price fall instantly to the appropriate equilibrium value now that these problems are fully revealed, an economist would then reasonably inquire? To which the answer might be, home sellers reduce prices only gradually in a down market, as a consequence of which further price declines are presently quite predictable, as are the additional new defaults that would result from those price declines, as are the consequences of those yet-to-be foreclosed homes coming back for resale onto the market.

The problem then is many hundreds of billions of dollars in loans that are not going to be repaid, the prospect of whose default could completely freeze the market for credit.

That, it seems to me, is a problem you can’t solve by lowering the fed funds rate. Even if the nominal yield on Tbills were driven all the way to zero, the same is never going to happen to the risky long-term housing loans we’re discussing, nor to the rates charged for loans to the financial institutions exposed to the underlying default risk. And even if you could successfully engineer a further reduction in the nominal interest rate charged to home buyers, if the expected real estate price depreciation is large, that would dwarf the effect of the nominal interest rate itself in terms of the attractiveness to a buyer contemplating purchasing a home at today’s prices.

You could in principle solve the problem of overvalued house prices by printing so much money that you bring the price of everything else up to that of housing, generating the necessary adjustment in the relative price of housing without going through the painful cycle of bankruptcies and foreclosures. Whether that is an action you’d want to contemplate might depend on the magnitude of the price adjustment you think is necessary. If we are talking about just 1 or 2% more inflation, I personally would regard the inflation as worth it. But if house prices are today overvalued by 10-30%, for which our proposed remedy is to bring about a corresponding increase in the price of everything else of that magnitude, we would surely want to bear in mind the recent caution from Federal Reserve Governor Frederic Mishkin:

Empirical evidence has starkly demonstrated the adverse effects of high inflation.

Now, reasonable people can and do differ on how likely it is that further Fed rate cuts would help mitigate the current problems. You might reasonably argue that even if the chance of success is small, the cost of letting the economy slip into the cascading defaults that a further 20% decline in real estate prices would precipitate is so large that it’s worth trying anything.

And perhaps it is. But I would nevertheless caution that we need to be open to the possibility that no matter how low the Fed brings its target rate, it may not arrest the unfolding financial disaster. Unless the intention is to go all the way with enough inflation to avert the defaults, that means we need an exit strategy– some point at which we all admit that further monetary stimulus is doing nothing more than generating inflation, and at which point we acknowledge that the goal for monetary policy is no longer the heroic objective of making bad loans become good, but instead the more modest but also more attainable objective of making sure that fluctuations in the purchasing power of a dollar are not themselves a separate destabilizing influence.

I am worried that everyone now seems to be looking to the Federal Reserve for a solution, and the Fed seems to be signaling that it is going to provide one.



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41 thoughts on “Asking too much of monetary policy

  1. Jake Miller

    I’m scared too. It seems the solution to this mortgage and credit mess is just to keep pumping money into it. The dollar has already shown the signs of this, as have other commodity prices and pretty much anything not in housing or wages. So what if the Dow went up 400 on speculators today if the dollar’s worth nothing and it drops back down tomorrow when the underlying fundamentals don’t change.
    I think the stagflation trap has been set, and instead of making us take our medicine for careless fiscal and monetary policy in the 2000s, Bernanke and company seem to want to avoid dealing with the reality. This will just make the ultimate adjustment worse, and a “Dubya” shaped recession from 2008-2009 or 2010 seems to be a lot more likely than a short V.

  2. One Salient Oversight

    The role of a central bank is vital to the functioning of an economy – yet it cannot prevent or solve every problem that comes along.
    I believe in Absolute Price Stability – that the central bank keep both inflation and deflation in check so that the consumer price index neither rises nor falls over the course of the business cycle.
    Absolute Price Stability should replace the “inflation target” that so many central banks use. Keeping inflation between 0-3% may seem prudent but it has yet to prevent the creation of an investment bubble.
    All things being equal, Absolute Price Stability should flatten out growth to such an extent that peaks and troughs in economic performance could be kept to a bare minimum – so much so that even cyclical recessions can be avoided all together. Sure, growth will be slowish, but at least the cycle of growth will be gotten rid of, ensuring sustainable economic growth year after year after year.
    But, then again, all things aren’t equal. A reduction in oil supply (what we are facing now) will cause a recession no matter what sort of monetary policy is used. Nevertheless I would argue that the best conditions to survive such a recession would be an economy in which neither inflation nor deflation exist.

  3. HZ

    The Fed isn’t printing money yet. It is more concerned with putting out the fire in a credit market threatened by cascading forced liquidation of “good” credits at this moment. It doesn’t have the power to keep the housing market itself stable. That will have to come from some kind of fiscal rescue plan.

  4. kdp

    I think the Fed is rightfully scared that the financial companies will just stop lending to anyone because the situation is so out of control that the financial companies can no longer assess the risk. We’re getting dangerously close to that right now with the continued tightening of credit and high consumer interest rates.
    My guess is that the Fed is inching its way towards bypassing the banks and accepting the risk of loans to “large enough” institutions of any type. The Fed is about the only organization that is willing to accept the risk of even systematic failure across industries because the alternative is a full nationwide failure for everyone.

  5. esb

    Central banks are supposed to be conservative institutions but what we are witnessing here are the wildest unrestrained and experimental actions of any central bank in a the USA in the entire post-WWII period.
    Miller and even Burns would be stunned.
    This ends badly, very badly,
    and when it does, the maniacal architect, Benjamin Bernanke, should not be permitted to slip out the back door and return to the “academy”
    without the equivalent of a scarlet “I” being affixed permanently to his reputation,
    so that his victims, one and all, shall know him as the cretin responsible for their woes.

  6. Stuart Staniford

    It has seemed to me that there is only one exit door from this situation that we are going to want to take, and that is some version of bailout/nationalization. My working hypothesis is that a material fraction of large banks would be insolvent once prices had equilibriated. Add to this momentum, panic-sellling of securities, margin calls, etc, which have now begun to set in with a vengeance, and there seems potential for even more banks to fail as financial asset prices undershoot the fundamentals for a while.
    I again encourage study of the Swedish precedent in the early nineties:
    http://www.riksbank.se/templates/speech.aspx?id=1722
    http://www.sns.se/document/securum_eng.pdf
    http://www.sns.se/document/occasional_paper_82.pdf
    It seems clear that the alternatives to nationalizing insolvent banks are all much too dreadful to contemplate. At some point, if banks are allowed to start going under, we are going to have instances of folks waking up to find their employers can no longer pay them because the employer’s bank has gone under (FDIC protection not applying to large accounts, and the FDIC is in any case of an irrelevant scale to this crisis).
    Once this kind of thing becomes something ordinary executives can credit as an actual possibility, real world companies will begin to start moving funds around in the hopes of finding a stronger bank, etc. More banks will fail in the panics and the thing will spiral out of control. That way lies a repeat of the great depression.
    On the other hand, throwing the dollar to the wolves by inflating our way out of the mess, and performing that inflation fast enough to save the banks, will cause lasting massive damage to the reputation of the United States as a place to do business and hold assets. Some such damage is inevitable, but I shudder to think what a 30% inflation in the space of a year or less would do to investor perceptions. And then what will it take to stop that level of inflation once it has been unleashed?
    I simply cannot see that there is any remotely reasonable alternative to nationalization of insolvent institutions (and subsequent disposal of the institutions and assets back into the private sector as time and circumstances permit). Such nationalization should protect all depositors and debt holders of banks – anything less will not avoid panics, as the Northern Rock incident makes clear, but wipe out their equity holders (to address the moral hazard problem).
    In this comment, I have a different question to raise: how long does the government have to act? It seems to me possible that there is a point of no return here. Given the very strong interlinkages between financial institutions, there may be a single institution or small combination of institutions who’s failure to keep operating would cripple the entire system and create a situation that was almost impossible to unwind. One recalls Warren Buffett’s comments on the difficulties of unwinding derivative portfolios.
    As another example of moving beyond the “elastic limit” of the system, once a bank fails that causes very visible symptoms beyond the financial sector – crippling a real world company that sells pizza or mines iron, or whatever, I think we will create the conditions for generalized panic about the solvency of the financial system. Panics about banks tend to be self-fulfilling prophecies. If the public loses confidence in the financial system generally, enormous lasting harm will be done – far far worse than a few tens of percent decline in housing prices.
    My sense is that the government only has months here to act, not years. I sincerely hope that task forces are meeting, contingency plans are being drawn up, etc, etc.

  7. RebelEconomist

    It has never been clear to me how central banks are supposed to control interest rates (without taking huge losses). Since it seemed to be obvious to my colleagues in the central bank I used to work at, I doubted my own sanity, until I read papers like Ben Friedman’s NBER WP 7420! I wonder whether the current crisis is revealing the weakness of central banks’ influence.
    I do of course understand how central banks can control the price level, and I can easily imagine that the Fed under Bernanke would be prepared to stoke up 20% inflation to fix the housing bust, including by outright purchases of MBS if necessary. And of course, the Fed are going to deny that this is their plan, because it will be harder to implement if the bond market sees it coming.
    But inflationary repudiation of debt would not be the end of the story. Except in the unlikely event that the US stops borrowing, it will have to pay a cripplingly high risk premium on its debt for years afterwards. It might well be better let the bust happen and focus on controlling it.
    However the current dilemma is resolved, my suggestion for avoiding a repetition is that monetary policy should include asset prices in its target. It is argued, eg by Woodford, that monetary policy should aim at stabilising sticky prices, because the costs of inflation are mostly associated with price stickiness. As JDH points out, house prices are sticky.

  8. kharris

    We don’t really know that the Fed could bring down the real price of houses by printing money. We can assume that other prices would rise faster than housing prices now, but it is at least possible that housing prices would, once again, bubble up in response to too much money.

  9. andiron

    finally, prof. hamilton comes home.
    The FED miserably failed in its mandate. The fact that it now aspires to mitigate one in the century credit orgy by engaging in ill advised strategy.

  10. TexFinecon

    Thank you, Professor Hamilton, for presenting one of my favorite lectures. My students will appreciate your erudite presentation. The anecdote I use to accompany this lecture was how throughout the early 1990s the Fed had leaned against the recessionary wind by setting the fed funds rate at a level that meant excess money was flowing into the economy. This Fed monetary policy had helped make the early 1990s recession relatively mild. The real economy, however, remained sluggish. Banks, adjusting to the new post 1980s Savings and Loan forbearance financial environment, were particularly hesitant to lend. In December 1993 the real economy took off in what became the spectacular 1990s economic expansion. The Fed was quick to realize that in a rapidly expanding economy the current fed funds rate would lead to inflationary money supply growth. In February 1995, unexpectedly (a brief note of the impending February FOMC meeting was buried in the back pages of the Wall Street Journal), the Fed raised the federal funds rate. This unexpected new direction of monetary policy led to overnight losses of billions of dollars. Orange County California bankruptcy was one the more noteworthy consequences. The fed fund rate increases that accompanied the tighter monetary policy did not slow the booming real economy; soon to display irrational exuberance. The new direction of monetary policy was the event that pricked the bubblet that was the Mexican economy based on an overvalued pegged Mexican peso exchange rate. Before the U.S. real economy took off the excess US money supply was sloshing around the world providing private financial capital for many developing economies. In the U.S. financial resources were expanding to support the now rapidly growing U.S. real economy. The tighter money policy may have limited the inflationary impact of the booming U.S. economy but also may have aggravated the financial crisis in Mexico and other Latin American economies.

  11. Markg

    Why is monetary policy preferred over fiscal policy? Looking at the history of public debt to gdp ratio (fiscal policy) shows that everytime the ratio drops below about 40% the economy runs into trouble. From the end of WWII though the 1960s the ratio was above 40%. Most would say the economy was good during that period. The ratio was below 40% during the stagflation of the 70s. Reagan deficits returned the ratio to above 40% by the early 80s and the economy and stock market did well. Along comes George “read my lips no new taxes” Bush tax increases and the ratio briefly dropped below 40% coinciding with the 1990-1991 recession. The ratio then went back above 40% (reaching almost 50% in 1995) until the Gingrich “contract with America” reduced the deficit and the ratio dropped back below 40% around 1999 and the economy was back in recession shortly thereafter. The Bush2 tax cuts got the ratio moving up but never reached the 40% mark with the ratio falling recently. And how has the economy been to most Americans the last several years? On the flip side, monetary policy control of the economy has been marked with asset bubbles and credit problems. Maybe the best solution is to set interest rates at a steady level and use automatic fiscal stabilizers to counter the business cycle.

  12. KipEsquire

    “You could in principle solve the problem of overvalued house prices by printing so much money that you bring the price of everything else up to that of housing, generating the necessary adjustment in the relative price of housing without going through the painful cycle of bankruptcies and foreclosures.”

    Or you could simply forcibly redistribute income from those who do not participate (i.e., borrow or lend) in the home mortgage market to those who do — which, last time I checked, was exactly what every pandering politician in Washington was desperately trying to do.

    This is no different than the Finance 101 principle that inflation helps debtors and hurts lenders (and the Poly Sci 101 principle that, since government is the biggest debtor, there is a perpetual policy bias toward inflation rather than defaltion).

  13. Robert Bell

    If I understand the implications, this VoxEU article complements your post nicely.
    http://www.voxeu.org/index.php?q=node/983
    This describes the differential effect (timing and magnitude) of monetary policy on various asset classes. In your example of inflating the way out of the housing problem (from Brad deLong?) the overall effect of the adjustment, when equilibrium is reached, could be an intolerable level of inflation. However, the VoxEU article suggests that because of the differential timing of adjustments, the path to equilibrium could pose additional challenges along the way. Those in turn could provoke inappropriate intermediate policy responses of the type you describe in the first paragraph.

  14. BobDylanHasSoul

    Hi Prof., I was waiting for you to begin this discussion! Thanks for starting in. I have a couple of questions for you, if you have the time answer them:
    1) Given the enormous level of public and private debts, would inflation be possible if an attempt to inflate caused even more extreme deterioration among credit spreads?
    2) From your perspective, is the recent TAF activity a way to administer a local solution to a credit problem, rather than the more general rate-cuts, which, the Fed may fear, might stoke more inflation than the novel TAF? Or is selecting the TAF a means of preserving rate cut “bullets”? Or perhaps both reasons are driving the TAF?
    3) How constrained is the Fed’s balance sheet, and if the Fed needs to expand its balance sheet, where does the money come from?

  15. MichaelM

    Debasement is not an unprecedented strategy for averting financial disaster. Hamilton conceived a bimetallic currency system in the U.S. to (1) eliminate the possibility of debasement and (2) give the government flexibility in the event that there was an attack on one base metal (e.g. Charles De Gaulle) we’d have the flexibility to switch to an alternative.
    One might argue (as many brilliant people have) that the independent fed and fiat money solves this problem. After the Bretton Woods failed and America let our currency float, monetary policy had a rocky ride; lately, we’ve done pretty well.
    Here is my concern: as financial pressures (such as the national debt and the housing/credit problems) leech into our economy, the temptation to pursue a policy of debasement–either explicitly or implicitly–is increased. If the fed were truly independent (meaning its mandates were enforced by judges and not politicians), we would theoretically be impervious to these temptations; however, recent policy trends suggest to me that this is not the case.
    The Great Moderation is a glittering endorsement of the promise of fiat currency and an independent fed. But the proving ground for democratic institutions isn’t when everything goes well, its when the going gets rough. Time will tell us whether or not we followed a prosperous path when we walked away from Hamilton’s currency system. I’ve always endorsed the fed and our currency system; however, recent policy (which wreaks of politicization) has me wavering.

  16. JDH

    BobDylanHasSoul, I intend to discuss the TSLF and Fed balance sheet in my next post. On your first question, we should distinguish between the debt (the money the government currently owes) and the deficit (the new money the government will have to borrow this year). In terms of the debt alone, a surprise inflation is a capital gain for the government, because the government then repays its creditors with dollars that are worth substantially less. In terms of the deficit (both public deficit and the trade deficit), it would be a disaster, as we would see a profoundly unfavorable change in the terms at which we could borrow new funds, which change might itself precipitate a crisis, albeit one with some different aspects from the one we are currently discussing.

    So let me be clear: I do not advocate deliberate inflation as the appropriate policy response. I believe it would be overall destabilizing, and am arguing that the primary mission of monetary policy should be to avoid becoming an additional destabilizing force itself.

  17. BobDylanHasSoul

    And one more question. Why is there an absence of discussion in the media, and even among economists (not of the quasi-nutty, semi-pro, gold bug types), about the ethicalness of intervention in the first place? All the discussion centers around whether or not the Fed can rescue the banks from this credit debacle. But again, is this ethical?
    There is a very strong sentiment among young people, such as I, of disgust with this situation. We actually want this crisis to get worse. We want foreclosures. We want affordable houses and are tired people abusing credit to bid up the prices of things we need yet are unwilling to put ourselves in a position of financial vulnerability to possess. We want banks to fail. And we want this outcome because we feel that the government to some extent turned a blind eye to, and to another extent sponsored, behavior that robbed us of a fair price for shelter. We believe that we played by the rules and are indignant about the government protecting riskloves and gamblers. We are the savers.

  18. BobDylanHasSoul

    Thanks for answering the first set of question, professor. The second was (obviously) more rhetorical.

  19. E. Poole

    The yield curve is upward sloping. There is plenty of liquidity in the overnight markets. Do we need more short-term socialism like fixes for the rich?

    One Salient Oversight: If you believe in sticky, sluggish prices, then expansionary monetary policy will help blunt the shock of high real oil prices.

    On the other hand, if you believe that monetary tinkering helps to obscure price signals, then further rate cuts may hinder more than help.

    If there were ever a time when the US could use a whopping increase in green excise taxes on gasoline and other fuels, it is now. Such a movment would signal a commitment to fuel conservation that unfortunately is still very much lacking. However, is driving the US dollar into the dumpster an acceptable alternative measure?

  20. HCash

    Nobody has ever explained to me why deflation is bad if it’s due to money supply being held stable. I usually like when things I use and need fall in price, especially if my income if falling more slowly.

  21. Karl Smith

    ^
    First, deflation can be harmful because it provides a real return on cash, which encourages people to hold cash rather than invest it.
    Second, it means that the real interest rate is higher than the nominal rate. This is a problem because it can lock the economy in a recession.
    Indeed, if the economy is ever in the position that the real interest rate would have to be zero or negative to restart growth then that is impossible in a deflationary environment.
    To the main article,
    First, I am not sure that Fed policy is limited to determining the supply of money. You yourself have noted that much of the innovation that we have seen from the Fed involves changing the set of assets that the Fed holds. This should allow the Fed to target some of the risk premium.
    Second, the Fed doesn’t have to end the housing crisis to be responsive. It simply must and should do what it can to limit contagion. For example, in theory housing prices could fall without decreases in other Capital Investment. To the extent that we can hold back declines in investment in other sectors that is a good thing.

  22. chas

    ‘Inflation’ (or deflation) is an increase (or decrease) in the supply of money. And an increase in the price level, the consequence of such an increase (or decrease).
    You and your Chinese co-blogger [the (k)eynesian one] should go back to school. Is this what you teach, nowadays?

  23. Nacho Bizness

    There is already a real return on currency. It’s negative.

    Back even before I was a wee lad, Milton Friedman wrote a paper about the Optimum Quantity of Money. Since currency is both costless to produce and riskless, the optimum quantity of it equates its return to the return to capital. Currency is riskless and pays zero nominal interest, so the riskless nominal rate must also be zero, which implies deflation equal to the real interest rate.

    There was a period in American history when this was approximately true; from the end of the Civil War up to the beginning of the first World War. Deflation was common back then, and yet it was during this time that the U.S. became the richest and most powerful nation in the world. There was tremendous innovation and economic growth, as well as rapid population growth.

    Our own history shows that deflation is not inconsistent with a growing economy, and there are no convincing historical examples of a liquidity trap. So there’s really not much basis for saying that deflation locks us into a recession.

    Of course, there was the Great Depression. But what happened then was not just deflation, it was unexpected deflation. Debtors were crushed by real rates much higher than they had bargained for. And at the same time, the Fed delivered negative demand shocks every time the economy started to recover.

  24. hcash

    Thanks for the response Karl. I have hear that argument before and it still doesn’t register with me. Say I own an Orange plantation and oranges sell 100 tons of oranges for $100/ton with cost of $50/ton and net profits of $50/ton or $5000. If oranges are expected to fall $2 next year to $98/ton, and costs are declining to $49 then profits will decine to $49/ton or $4900. Sounds bad but presumably the cost to live is also declining by the same rate so net/net I am OK. Now if I see an opportunity to buy land to expand my production by 20%- say for 2 tons at $50/ton why wouldn’t I do it? Yes, in a 2% inflation environment my investment returns me exactly 2% or break-even on a Real basis. Still, in a deflationary environment, even if I invest $100 to lose make $98, thus losing 2% I would still be even on a real basis with prices declining 2% as well. You may say that it would have been wiser to keep cash in a deflationary environment because then your $100 would have actually risen by 2% in real terms. But that ignores the $96 profit you’d gain in 2 years which would be the equivalent of about $100 in present dollars or exactly the same as your $104 would have been worth in an inflationary environment.
    Seems to me that the main reason deflation is considered bad is because we aren’t used to it. The only other arguments I can think of for inflation relate to menu costs and psychology.

  25. RebelEconomist

    Well said BobDylanHasSoul! I sympathise because I faced the same problem in the 1980s, arguably the first asset price boom that Greenspan bailed out with inappropriately loose monetary policy (and unlike some, I do not say “I got through it, so you can”). Rather than the idea that central bank committees should include representatives from industry, labour, women etc, a better suggestion might be to involve some young people in what is essentially a decision about inter-temporal preferences.

  26. Hal

    The question I have is about this threatened “economic meltdown”. Is this meltdown fully rational, or does it contain an element of irrational panic? Prof Hamilton imagines something of a dialog between a “reasonable economist” and someone who apparently has the misfortune to live in the real world. The economist’s questions are answered until we get to this point: “The problem then is many hundreds of billions of dollars in loans that are not going to be repaid, the prospect of whose default could completely freeze the market for credit.”
    What does the economist have to say to this? Would he ask why such defaults would completely freeze the market for credit? Can’t these defaults be seen as sunk costs now, and isn’t there still capital available for lending? Shouldn’t rational lenders still be willing to loan freely and widely, having learned from their mistakes and now avoiding the riskiest classes of loans?
    To what extent is this meltdown a matter of paying the unavoidable price for earlier irrationality, versus it being due to new bouts of irrationality working in the opposite direction? If the latter, can’t we hope that simple interventions to “restore confidence” will get things going again?

  27. BobDylanHasSoul

    “To what extent is this meltdown a matter of paying the unavoidable price for earlier irrationality, versus it being due to new bouts of irrationality working in the opposite direction?”
    bingo

  28. Joy

    “Seems to me that the main reason deflation is considered bad is because we aren’t used to it. The only other arguments I can think of for inflation relate to menu costs and psychology.”
    Deflation is very, very bad if you’ve borrowed money. You’ve spent $300 (plus interest) on equipment that today only costs $200. And your *income* is deflated as well.

  29. HCG

    KDP said:
    “. . . and when it does, the maniacal architect, Benjamin Bernanke, should not be permitted to slip out the back door and return to the “academy” without the equivalent of a scarlet “I” being affixed permanently to his reputation, so that his victims, one and all, shall know him as the cretin responsible for their woes.”
    This problem has older roots. I was at conference last fall where David Altig, now at the Atlanta Fed, spoke in general terms about the housing market. The start of the current problem was already apparent, and so I asked where the feds (Fed and other agencies) had been. Altig’s reply (his words): “The Fed doesn’t go around looking for bubbles to pop”. I thought: why the heck not?
    This undoubtedly came from Greenspan, and from other experiences, I know that he was putting libertarian ideologues in the Fed. For some apposite history of Greenspan’s ideological roots, see: http://www.bloombergtv.com/apps/news?pid=20601039&sid=az1pRuJzktlk&refer=columnist_weil
    I suspect this experiment of diminished governmental regulation since Reagan will be changing, but I fear we are going to pay a heck of a price.

  30. George Barwood

    “I am worried that everyone now seems to be looking to the Federal Reserve for a solution, and the Fed seems to be signaling that it is going to provide one.”
    Seems to me the Fed is risking it’s money to make sure that liquidity problems caused by fear do not cause the whole financial system to crash.
    The general tone of gloom here seems a trifle overdone to me though – where are the large insolvent institutions? Capital may have been eroded, and in some cases replaced, but the banks are surviving ok. Yes thre is a recession, and a risk of a deflationary spiral, but to jump from large widely spread losses to financial mayhen seems unproven to me. Please explain!

  31. Kevin A

    “and a risk of a deflationary spiral”
    Why do you say deflationary spiral? Clearly the risks now are to increased inflation.

  32. esb

    HCG:
    Actually, BB was the intellectual enabler of the Greenspan designs that produced the residential RE blowoff.
    Now, sitting in the “big chair,” he if free (if that is the proper term) to construct a blowoff in commodities, especially those of an “essential” nature. (The dolt probably thinks that when the complex goes “lock limit down” for a few days the blowoff will just mop itself up.)
    It is the willingness to inflate (or enable the inflation of) items essential to life itself that is, frankly, evil and so earns him the scarlet “I.”
    It will be the social classes most at risk even in stable conditions who shall suffer most (probably even to the extent of malnutrition or even death) from the rampant inflation of essentials which is the “core” of the Bernanke plan (or perhaps “plot” is the more-appropriate term).
    The man seems to have the support of Bush (George W.), and for the next ten months that is the only vote that matters.
    He probably also has the support of Barbara Bush, most famous for her response to the Katrina debacle in which she opined that the disaster was probably the best thing that had ever happened to some of the victims.
    To Bush and Bush (and probably to more Bushes that those two) the death of a number of invisible citizens is a small price to pay for the continuation of Bear Stearns and, of course, the Carlyle Group, both of whom are presently insolvent if marked to market as of 10March2008.
    Bear Stearns and the Carlyle Group should disappear from our financial lives, and the Bush family (including George Prescott Bush, yes there is another of the miscreants coming along) should disappear from our political lives.
    Never to return.

  33. PrefBlog

    March 12, 2008

    Econbrowser’s James Hamilton has an interesting philosophical piece on the limits to the Fed’s ability to influence the economy, Asking too much of monetary policy:
    I am certainly a believer in the potential real effects, sometimes for good…

  34. Stuart Staniford

    John Lipsky, #2 at the IMF, on the crisis:

    But in today’s world of contingent risks, macroeconomic policies may not be sufficient to cushion the blow if extreme events occur. We must keep all options on the table, including the potential use of public funds to safeguard the financial system. While I am not advocating the use of taxpayer funds to aid individual institutions, I fully recognize an appropriate role for public sector intervention after market solutions have been exhausted. At the IMF, we are giving serious thought to what can be done if contingent risks materialize, and we are using our expertise and many years of experience in helping our member countries weather crises to think about what policies might prove most effective. It is also important to ensure that considerations of moral hazard and are balanced against the need to safeguard the financial system.

  35. don

    I think trying to inflate our way out of this mess will work only to the extent that the inflation is unanticipated. The Fed continues to cite core inflation, conveniently excluding energy and food, as if the higher inflation in those items is a transitory source of noise in the overall inflation statistics. Does anyone believe the Fed’s forecast of $80 oil?
    If people start to believe the Fed will foster inflation as a solution to this mess, they should immediately demand higher long term interest rates to compensate, which will drive up mortgage rates. Those holding existing loans at fixed rates will be helped, but lenders on the other side of those loans will be hurt, and wary. Those with variable rate mortgages, as well as new borrowers, will see higher rates.
    So, unless Ben can fool the people, I’m not at all sure that a strategy to inflate in order to bring the relative price of housing in line with other prices will help much, if at all. On the other hand, I wonder why long term interest rates stayed below the rate of inflation for so long prior to 1980. Can we count on the same phenomenon today? Do long-tailed inflationary expectations depend on the Fed’s credibility? I think currency markets may have strong doubts about our inflation fighting credentials.
    Finally, Ben has proven to be a policy innovator. This may give hope to markets, but it may also make people nervous if they begin to suspect policies have become unmoored.

  36. Mark E Hoffer

    BobDylanHasSoul
    query: “And one more question. Why is there an absence of discussion in the media, and even among economists (not of the quasi-nutty, semi-pro, gold bug types), about the ethicalness of intervention in the first place? All the discussion centers around whether or not the Fed can rescue the banks from this credit debacle. But again, is this ethical?”
    The question of the ‘Ethicalness’ of the FedRes’ moves can never be broached in the MSM. It would lead, during an rational examination, to too many questions that, once started, would, dramatically, expose ‘Central Banking’ for what it is–a Confidence Game.
    The folly of attempting to build a productive Economy on a totally elastic, fictional, unit of account is a hubristic conceit, worthy of comparison to any of the great Greek Tradgedies.

  37. E. Poole

    HCash: There is no reason to fear deflation except our hysterical fear of repeating the Great Depression.

    don: Yes, the rate cuts work best in the immediate-term if unanticipated. That would explain the panic nature of fed rate cuts since August. Frankly, I’m surprised that more pundits have not complained about Bernanke supplying his academic pals with new, career-building data points.

  38. flow5

    “The choice for the time path of money creation ultimately determines the time path of short-term nominal interest rates, and indeed the modern Federal Reserve quite appropriately conceives of its primary operating decision as basically choosing the current value for the overnight interbank interest rate, known as the fed funds rate” — James Hamilton —–
    There is only one interest rate that the Fed can directly control: the discount rate charged to bank borrowers. The effect of Fed operations on all other interest rates is INDIRECT, and varies widely over TIME, and in MAGNITUDE.
    Discussions of interest, especially short-term rates, are usually couched in terms of the money market. As long as this is just a street-wise expression confined to the business community, no harm is done. Unfortunately, under the influence of the Keynesian dogma, academicians have been trying for too long to analyze interest rates in terms of the supply of and demand for money. A liquidity preference curve is presumed to exist which represents the supply of money. In this system interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity. All of this has little or nothing to do with the real world, a world in which interest is paid on checking accounts.
    Interest, as our common sense tells us, is the price of obtaining loan funds, not the price of money. The price of money is the inverse of the price level. If the price of goods and services rises, the price of money falls. Interest rates in any given market at any given time are the result of the interaction of all the forces operating through the supply of and the demand for, loan funds.
    Loan funds, of course, are in the form of money, but there the similarity ends. Loan funds at any given time are only a fraction of the money supply — that small part of the money supply which has been saved, and is offered in the loan credit markets. Unfortunately, Keynesian economists have dominated the research staffs of the Fed as well as the halls of academia. While monetary policy is formulated by the Federal Open Market Committee (FOMC), monetary procedures are determined by the academic research staffs. In their world, high interest rates are evidence of tight money, low rates of easy money; and, a proper rate of growth of the money supply is obtainable by manipulating the federal funds rate. Consequently, to bring interest rates down the money supply should be expanded and vice versa.
    The only instance in which an expansion of the money supply is synonymous with an increase in the volume of loan able funds involves an expansion of commercial bank credit. When the depository institutions make loans to, or buy securities from, the non-bank public an equal volume of new money (transaction deposits) is created. This expansion is made legally possible by a growth of legal reserves (and excess reserves) in the banking system, which in tern is the consequence of net open-market purchases by the Reserve banks. To increase the volume of legal reserves in the member banks, the Fed buys governments, (usually T-Bills) in the open market in sufficient quantity to more than offset all legal reserve consuming factors (e.g., the withdrawals of currency from the banks by the non-bank public). These purchases tend to increase the price of bills, thus reducing their discounts (interest rates). The incremental reserves also add to excess reserves thus enlarging the supply of federal funds. Federal funds rates are thus held down, or are prevented from rising.
    The long-term effects of these operations on short-term rates are just the opposite. The banks are able to (and do) expand credit on a multiple basis relative to the additional excess reserves. This multiplier effect on the money supply, and money flows, puts additional upward pressure on prices. The long term effect, therefore, is higher inflation rates, and a higher inflation premium in both short and long-term interest rates.
    Higher interest rates consequently are not evidence of tight money; rather they are the consequence, over time, of an excessively easy (irresponsible) money policy money expansion so great that monetary flows (MVt) substantially exceed the rate of expansion in real output.
    While interest rates are not determined by the supply of and the demand for money, changes in thee volume of money and monetary flows (MVt), as noted above, can alter rates of inflation and, therefore, the supply of and the demand for loan-funds.
    The significant effects of these monetary developments are long-term and involve an alteration in inflation expectations. Inflation expectations operate principally through the supply side for loan-funds. Specifically, an expectation of higher rates of inflation will cause the supply schedules of loan funds to decrease. That is to say, lenders will be willing to lend the same amount only at higher rates.

  39. m thomas

    What we are witnessing is also the complete distruction of the price system where humans are able to judge the value and price of any good or service. The home prices are 2x to 3x any sane level in California but they will never fall that far because of a flood of illegals who buy and rent. This flood of money that fed has been printing is the prime reason that 40 million illegals have flooded the usa and made us well on the way to a 3rd world nation. If one visits brazil one can see the already insane fall of the dollar where food in dollar terms has gone up 500% in 7 years. But gasoline is the same price in local currency but in US dollars is 2x as much or more. A new car in 2001 in brazil was $5k US, now the same car is $35k. This is a tiny horrible car that could not sell in usa. Many people will put off buying when the inflation spiral starts.

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