Via Mark Thoma and Arnold Kling, the Federal Reserve Bank of Minneapolis published an interview with Stanford Professor Robert Hall. The interview is terrific not just because Bob is a very smart guy, but also because interviewer Douglas Clement did a great job choosing the right questions. The whole thing’s worth reading, but I wanted to focus today on Bob’s comments on the role of financial frictions in the crisis and policy options to address them.
Here’s what Bob said on the topic in the interview:
I would distinguish between conventional monetary policy which sets the interest rate and this kind of financial intervention of buying what appear to be undervalued private securities. Issuing what appear to be overvalued public securities and trading them for undervalued private securities, at least under some conditions and some models, is the right thing to do….
There’s a picture that would help tell the story. It’s completely compelling. This graph shows what’s happened during the crisis to the interest rates faced by private decision makers: households and businesses. There’s been no systematic decline in those interest rates, especially those that control home building, purchases of cars and other consumer durables, and business investment. So although government interest rates for claims like Treasury notes fell quite a bit during the crisis, the same is not true for private interest rates.
Source: Federal Reserve Bank of Minneapolis.
Between those rates is some kind of friction, and what this means is that even though the Fed has driven the interest rate that it controls to zero, it hasn’t had that much effect on reducing borrowing costs to individuals and businesses. The result is it hasn’t transmitted the stimulus to where stimulus is needed, namely, private spending….
So to get spending stimulated you need to provide incentive for private decision makers to reverse the adverse effects that the crisis has had by delivering lower interest rates. So far, that’s just not happened. The only interest rate that has declined by a meaningful amount is the conventional mortgage rate. But if you look at BAA bonds or auto loans or just across the board– there are half a dozen rates in this picture– they just haven’t declined. So there hasn’t been a stimulus to spending.
The mechanism we describe in our textbooks about how expansionary policy can take over by lowering interest rates and cure the recession is just not operating, and that seems to be very central to the reason that the crisis has resulted in an extended period of slack.
The graph Bob presented above shows the spread between an average credit-card interest rate and 10-year Treasury debt increasing by about 200 basis points during the crisis. Is that more than it should have been? Banks’ annualized credit-card charge-off rates were up about 400 basis points at their peak.
If by “financial frictions” Bob means that creditors were less willing to lend because their fears of not being repaid had gone up, then yes, financial frictions played a fundamental role in the crisis. But the reference to undervalued assets suggests that Bob may instead be thinking of financial frictions as something that prevented private lenders from extending loans that they really should have been making.
I’m currently working on a research project with a student to try to measure changes in the pricing of risk during the crisis as one way to sort out which of these two interpretations may be the correct one. As we ponder how to do that, let me ask for assistance from our readers. Can any of you tell me why Bob Hall, or anyone else, should be persuaded that risky assets such as credit-card debt, Baa-rated bonds, and asset-backed commercial paper were significantly undervalued as of February 2009?