Tag: monetary policy

Congress Begins Conference on Financial Regulation

Today begins the televised political theatre that Barney Frank has been waiting months for:  the first public meeting of the House and Senate conferees on the two financial regulation bills.  While there are a handful of important differences between the House and Senate bills, these differences are overshadowed by what the bills have in common.  The most important, and tragic, commonality is that both bills ignore the real causes of the financial crisis and focus on convenient political targets.

As our financial system was brought to its knees by an exploding housing bubble, fueled by government mandates and distortions, one would think, just maybe, that Congress would roll back these distortions.  Despite their role in contributing to the crisis and the size of their bailout, however, neither bill barely mentions Fannie Mae and Freddie Mac.   Except, of course, to continue their favored and privileged status, such as their exemption from a proposed new “consumer protection” agency.  What we really need is a new “taxpayer protection” agency.

Nor will either bill change the government’s meddling in what is probably the most important price in the economy:  the interest rate.  Given the overwhelming evidence that loose monetary policy was a direct cause of the housing bubble, one might expect Congress to spend time and effort preventing the Fed from creating another bubble.  Not only does Congress ignore the issue, the Senate won’t even allow GAO to look at the Fed’s conduct of monetary policy.

Instead of spending the next few weeks gazing into the camera, Congress should stop and gaze into the mirror.  This was a crisis conceived and born in Washington DC.  The Rayburn building serving as the proverbial back-seat of the housing bubble.

Prof. Krugman Is Wrong, Again

Prof. Paul Krugman asserts in his New York Times column of May 31st that “Both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea – not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts.”

While Prof. Krugman and most other fiscalists believe this to be self-evident, it is not.  Indeed, this fiscalist dogma fails to withstand the indignity of empirical verification.  Prof. Paul Krugman’s formulation fails to mention the state of confidence.  This is an important oversight.  As Keynes himself put it: “The state of confidence, as they term it, is a matter to which practical men pay the closest and most anxious attention.”

By ignoring the confidence factor, economic theory can lead to wildly incorrect conclusions and misguided policies.  Just consider naive Keynesian fiscal theory – the type presented (as Prof. Krugman notes) in textbooks and embraced by most policymakers and the general public.  According to Keynesian theory, an expansionary fiscal policy (an increase in government spending and/or a decrease in taxes) stimulates the economy, at least for a year or two after the fiscal stimulus.  To put the brakes on the economy, Keynesians counsel a fiscal contraction.

A positive fiscal multiplier is the keystone for Keynesian fiscal theory because it is through the multiplier that changes in the budget balance are transmitted to the economy.  With a positive multiplier, there is a positive relationship between changes in the fiscal deficit and economic growth: larger deficits stimulate growth and smaller ones slow things down.

So much for theory.  What about the real world?  Suppose a country has a very large budget deficit.  As a result, market participants might be worried that a further loosening of fiscal conditions would result in more inflation, higher risk premiums and much higher interest rates.  In such a situation, the fiscal multipliers may be negative.  Fiscal expansion would then dampen economic activity and a fiscal contraction would increase economic activity.  These results would be just the opposite of those predicted by naive Keynesian fiscal theory.

The possibility of a negative fiscal multiplier rests on the central role played by confidence and expectations about the course of future policy.  If, for example, a country with a very large budget deficit and high level of debt (estimated U.S. deficit and debt levels as a percentage of GDP for 2010 are 10.3% and 63.2%, respectively) makes a credible commitment to significantly reduce the deficit, a confidence shock will ensue and the economy will boom, as inflation expectations, risk premiums and long-term interest rates decline.

There have been many cases in which negative fiscal multipliers have been observed.  The Danish fiscal squeeze of 1983-86 and the Irish stabilization of 1987-89 are notable.  The fiscal deficits that preceded the Danish and Irish fiscal squeezes were clearly unsustainable, and risk premiums and interest rates were extremely high.  Confidence shocks accompanied the fiscal squeezes, and with negative multipliers in play, the Danish and Irish economies took off.  (Evidence from the U.S. is presented in an article by Professors Jason E. Taylor and Richard K. Vedder which appears in the current May/June 2010 issue of the Cato Policy Report.)

Margaret Thatcher also made a dash for confidence and growth via a fiscal squeeze.  To restart the economy in 1981, Thatcher instituted a fierce attack on the British deficit, coupled with an expansionary monetary policy.  Her moves were immediately condemned by 364 distinguished economists.  In a letter to the Times of London, they wrote a knee-jerk Keynesian (Prof. Krugman-type) response: “Present policies will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.”  Thatcher was quickly vindicated.  No sooner had the 364 affixed their signatures than the economy boomed.  People had confidence in Britain again, and Thatcher was able to introduce a long series of deep free-market reforms.

While Prof. Krugman’s authority is weighty, his arguments and evidence are slender.

Public Wants Fed Audit

A new Rasmussen poll has 80% of the American public supporting an audit of the Federal Reserve.  Only 9% of the public oppose, with the rest unsure.

Unfortunately the poll did not ask specific questions over whether such an audit should cover monetary policy or just the Fed’s 2008 bailout activities.  So while the poll is likely to keep pressure on Congress, during its conference negotiations over financial regulation, to retain some audit of the Fed, the likely result is that Congress will leave out any real, on-going audit of monetary policy. 

After Sen. Bernie Sanders essentially gutted his own amendment, Senator Dodd and the Obama administration agreed to a minor audit of the Fed’s emergency lending programs.  Ron Paul, sponsor of the House version of the audit, quickly labeled this as a “sell-out”.  Fortunately Congressman Paul looks to be a House conferee on the bill, so some hope remains of a full audit being included.

Opponents of a Fed audit claim this would undermine the Fed’s political independence.  Sadly what opponents, including many economists, are missing is that the Fed is currently far from independent of politics.  This is again an area where the public gets what the experts miss, as just 20% of poll respondents thought the Fed has acted independently.  A full 60% felt the Fed was too much influenced by the President, getting at a crucial point concerning Fed independence:  it is independence from the Executive branch that is critical.

Wednesday Links

Bernanke Still Doesn’t Get It

Yesterday, at the annual meetings of the American Economic Association, Fed Chairman Ben Bernanke offered a continued defense of the Fed’s monetary policies earlier this decade. Essentially he believes that monetary policy did not contribute to the housing bubble.  He also makes clear that he believes that the excessively loose policy stance of the Fed after the dot-com bubble burst was appropriate given the level of unemployment at that time.   Given that today’s unemployment level is even worse, Bernanke has offered us a clear indication that monetary policy will remain excessively loose for the foreseeable future, regardless of the Fed’s inability to actually create jobs.

Bernanke’s remarks also illustrate the contradictions in his own thinking.  At one point he comments that it would have been inappropriate for the Fed to response to increases in energy prices, because such prices were viewed as temporary; yet elsewhere he indicates that most market participants viewed house price increases as permanent, yet the Fed felt it was appropriate to ignore those, for what reason we do not know.  No where in his remarks does he address the impact of ignoring the single largest item behind consumer spending:  housing.

Perhaps the weakest link in Bernanke’s arguments is presenting the false choice of either monetary policy or mortgage underwriting standards.  How about accepting that both played a role.  Sadly when discussing underwriting standards, Bernanke continues to miss the most essential element: downpayment requirements.  Nowhere in his discussion of mortgage defaults does he seem to recognize the role of equity.

Great Moments in Bureaucracy

The picture below, taken from a story in The Economist, shows that France, Germany, and Italy are among the nations with the most central bank employees (as a share of the population). In some sense, this is a dog-bites-man factoid. After all, is anyone surprised that Europe’s major welfare states have bloated public payrolls? But there’s more to this story. All three of these central banks ceased to have a monetary policy, starting back in 2002, when their nations adopted the euro. The mission is gone, but the bureaucracy lives on.

Central bank bureaucrats

To be fair, the bureaucrats in these nations presumably are not sitting in quiet rooms playing minesweeper. Perhaps these central banks are responsible for other functions, such as financial regulation. Of course, given how governments around the world pursued policies that led to a financial crisis, perhaps all of us would be better off if bureaucrats did play computer games all day.

Congress Grows Fed Up

The Wall Street Journal reported that Congress likes Fed Chairman Bernanke, but not the institution that he heads. There is growing consensus that the Fed needs to be reformed and restructured.  Most notably, there are calls to strip the Fed of its supervisory authority.  In practice, the new sentiment reflects the failure of the Fed to rein in risk taking by the largest banks.

The Fed is pushing back.  One reserve bank president said that removing the Fed’s supervisory authority “would affect our ability to conduct monetary authority effectively.” He went on to say that without the supervisory authority, the Fed wouldn’t know enough about risks brewing in the economy.  This argument is shop worn. The Fed had the authority. It fueled the housing boom with its monetary policy and failed to head off the banking crisis with its supervisory powers. And let us not forget the regional banking crises of the 1990s; the fallout of the Latin American debt crisis for Citibank; and others (e.g., the failure of Continental Illinois National Bank).  All on the Fed’s watch.

Around the world, some central banks have supervisory authority over banks and some do not.  There is no clear pattern for either monetary policy or bank regulation with respect to how the powers are structured and distributed.  Other factors seem to matter much more. It would be useful to identify what they are.

Congress is moving a few deck chairs around as the ship sinks. No fundamental rethinking of bank regulation is occurring. The Fed is probably being made a scapegoat for Congress’s own failings.  But that is how Washington works.