Topic: Finance, Banking & Monetary Policy

The Courage to Refuse

Last week I attended a talk and panel discussion at Brookings, in which Roger Lowenstein discussed his new book on the Fed’s origins. I have much to say about that book, and I eventually plan to say some of it here. But for the moment my concern is with another book, this one concerning, not the Fed’s origins, but its recent conduct. I mean Ben Bernanke’s The Courage to Act.

So why bring up the Brookings event? Because, in the course of that Federal Reserve love-fest, someone made a passing reference to those crazy people who actually want to limit the Fed’s emergency lending powers. Having seen the Fed save the economy from oblivion, such people, one of the panelists observed (I believe it was former Fed Vice Chairman Donald Kohn), are determined to make sure it can never save it again! At this, the audience chuckled approvingly.

Well, mostly it did. My own reaction was more like a bad attack of acid reflux. Is it really possible, I asked myself (as I struggled to keep my gorge from rising), that nobody here takes the moral hazard problem seriously? Do they really suppose that Senators Warren and Vitter and others seeking to limit the Fed’s bailout capacity are doing so because they like financial meltdowns and couldn’t care less if the U.S. economy went to hell in a hand-basket?

A Green Light for Investment Crowdfunding?

There’s big news in the crowdfunding world. The Securities and Exchange Commission (SEC) announced that they are (finally) voting on final rules Friday that would make investment crowdfunding legal.

Other types of crowdfunding — funding a venture with small amounts of money solicited from a large group of people — have been around for a while. The biggest crowdfunding site has even seen its name become a verb – as in “we’re Kickstarting our indie film.” And while one typically thinks of crowdfunding as a creature of the Internet, the concept has a long history. The Statue of Liberty stands in New York Harbor because of a successful crowdfunding effort, although in those days they called it taking subscriptions for donations, and the campaign was done door-to-door and not, of course, online.

But crowdfunding has been limited legally. Organizations raising money through crowdfunding, including for-profit corporations, have been restricted in what they can give in exchange for funds provided through online solicitations. Things like t-shirts have been popular thank-you gifts, while creators of innovative products, like the Pebble Watch, have offered pre-sales of their coveted inventions.

But offering any kind of return on investment, including the opportunity to buy a piece of the company, has been off limits. That’s because securities offered for sale in the U.S. must be registered with the relevant regulators, including the SEC and any state regulator in the states in which the securities will be offered. Any offering that deviates from this rule must fall under one of the laws’ exemptions. For example, there is an exemption that can apply when an issuer sells only to accredited investors (broadly speaking, institutional investors and wealthy individuals). Until now, there hasn’t been an exemption for crowdfunding.

Technology Takes On the Big Problems

Take a look at how markets and technology are taking on some of society’s biggest problems and revolutionizing the way we live. 

Nanotech and clean drinking water 

The World Economic Forum recently reflected on nanotechnology’s potential to improve people’s lives by providing smaller yet more powerful batteries, and by speeding up the purification process for air and water, among other things. Nanotechnology could deliver clean drinking water to millions of people who currently lack it, furthering the current positive trend. Around 10 percent of the global population lacks clean drinking water, down from around 20 percent in 1990.

A Million Homes Taken Since Kelo

It has been just over a decade since the Supreme Court decided in Kelo v. New London that local governments can take private property by eminent domain under a very broad reading of “public use”.  Cato held an event earlier this year to examine the legal impact of Kelo, featuring remarks from George Mason Law Professor Ilya Somin based upon his recent book, The Grasping Hand.  Not only has Kelo spawned widespread public backlash, but its also given birth to renewed interest by legal scholars.  As an economist, I am a little more interested in the direct impact on families.

Unfortunately, I have had no luck finding a database of all U.S. takings.  The American Housing Survey (AHS), conducted by the Census Bureau every two years, does, however, offer some estimates.  For survey respondents who moved within the previous year, the AHS asks respondents the “main reason” for leaving their previous unit.  One option offered is “government displacement”. For the survey years since Kelo, the average has been 109,000 households who state that government action displaced them from their previous home.  If that average holds for non-survey years, then a good estimate is that just over a million households have been displaced by government action since Kelo

A Fed Divided

Markets once again are waiting breathlessly for a decision on short-term interest rates by the FOMC, the Federal Reserve’s monetary policy making arm. All signs point to no change in interest rates. More interesting is a possible change in how members of the FOMC are thinking about the economy.

For years, most members of the FOMC have used the Phillips Curve framework in setting monetary policy. This is done against the backdrop of the Fed’s so-called dual mandate to promote maximum employment and low inflation. The Phillips Curve postulates a negative relationship between unemployment and inflation. Thus, a falling unemployment rate foretells higher inflation in the future.

Now two Fed Governors (members of the FOMC) have questioned the relevance of the Phillips Curve in separate speeches recently. The one-two punch was delivered by Lael Brainard and Daniel Tarullo. In Brainard’s words, “I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation.”

At the Kansas City Fed’s annual Jackson Hole conference last August, two former Fed economists questioned the Phillips Curve. They argued the relationship between inflation and unemployment has never been tight.

The Fed Chair, Janet Yellen, who has been largely absent from public view, remains wedded to the Phillips Curve. It is unusual for two Governors to so publicly deviate not only from the Chair’s policy guidance but also from the policymaking framework. Is Janet Yellen losing control of the FOMC?

In reality, labor markets are not so tight and there is just no sign of higher inflation in the near-term. I made those points in an August 24th op-ed in the Wall Street Journal.

Adding to the dilemma facing the FOMC is that markets are signaling that short-term interest rates should be lower not higher. New issues of short-term Treasury bills have been issued with a zero interest rate (though the most recent auction produced mildly positive interest rates). In secondary markets, bills have traded at mildly negative interest rates. Moreover, short-term interest rates are negative in around 20 countries mostly in the European Union (HT: Walker Todd).

In sum, we have a Fed divided and markets signaling a move down not up in interest rates. That makes for enhanced uncertainty in financial markets.

[Cross-posted from Alt-M.org]

The Nitty-Gritty of Fed Rate Hikes

For the past two or more years the question of whether or not (and when) the Fed might “raise interest rates” has been a constant feature in the news. With the FOMC, the Fed’s rate setting body, meeting next week, this is especially true at the moment. But no one seems to understand the nitty-gritty of just how interest rates are raised (or lowered), and very few non-economists have any knowledge of how it happens.

At times, the news reports seem to suggest that somewhere within the bowels of the New York Fed there is an interest-rate-machine, and that the monetary authorities have only to push a button, and, Voila!, interest rates will be raised. No one asks just how much they might be increased, or what happens then, although some accounts suggest that such an action would signal an end to the stagnant economy and better times ahead.

The Fed has no interest rate machine. To “hike rates” the Fed Open Market Committee (FOMC) must use its power to diminish the economy’s quantity of spending money through its control over the Monetary Base (MB), which is the accounted sum of the monetary obligations of the 12 Fed Banks. This Base includes two liabilities of the Fed Banks—the stock of hand-to-hand currency and the reserve-deposits of almost all of the commercial banks. To hike rates, the FOMC must decide to SELL government securities in the financial markets from its huge stockpile of security holdings—think ‘national debt.’ Fed Banks have accumulated these securities by previous purchases that lowered rates and increased the economy’s stock of money. Now, however, the call is for a ‘rate hike’ so the FOMC would have to sell off some of the Fed’s securities. It would make the sale through the offices of the Fed Bank of NY, by offering them on the financial market at attractive (low) prices relative to the annual dollar payments the securities promise their holders.

A large fraction of the sales would be to commercial banks thereby reducing their reserves, which would ordinarily force them , in turn, to reduce their lending to business firms. However, the banks at the moment have a huge volume of excess reserves on which they get one-fourth of one percent (0.25%) interest from the Fed Banks. These reserves are “excess” because they are not being utilized to “back” checkbook deposits that all households and businesses count (properly) as money. If the reserves had been used to finance the investments of private business , industry and households, the economy’s accounted stock of money would be perhaps double what it is now. But a large fraction of the Reserves has been “sterilized” by the device of this trivial interest rate paid on them.

With the FOMC buying, however, market rates might rise enough so that commercial banks would use up these sequestered reserves, and the depressing effect of a ‘rate hike’ might be avoided. But no one knows for sure. That’s why the officers in the Fed system are procrastinating.

Another important factor is also in the picture: the huge annual government deficit of more than a trillion dollars that must be funded every year. A ‘rate hike’ would make these annual borrowings much more difficult for the U.S. Treasury to finance. And if the fiscal problem becomes unstable—more deficit to finance than security markets will allow, the Fed will obey its political masters and finance the deficit by a hyper-inflation, or hyper-tax, as a burgeoning inflation simply taxes all fixed dollar wealth—bonds, dollars, life insurance values, etc.—by the rate of price level increase.

Finally, we might ask: ‘Why are rates so pervasively low. And why haven’t previous Fed and Treasury spending policies provided a path back to a healthy economy?’

The answer is that the Fed controls the monetary system, but it does not control the real system — the production of goods, services, and capital. The real system also has an interest rate — the real interest rate. At the moment, the real rate is effectively zero, because its determinants — the real rate of gross private domestic investment, and the real savings to finance those investments — are near zero. Taxes, regulations — the “Ten Thousand Commandments,” litigation, and harassment of venture capital has alienated real investment severely. Consequently, no matter what the Fed does or does not do, real values, including real incomes, are going to remain depressed into the foreseeable future. No amount of money and no monetary policy is going to change the government-imposed real depression.

[Cross-posted from Alt-M.org]

The History of U.S. Recessions and Banking Crises

I have never been entirely satisfied with how either economists or historians identify and date past U.S. recessions and banking crises. Economists, as their studies go further back in time, have a tendency to rely on highly unreliable data series that exaggerate the number of recessions and panics, something most strikingly but not exclusively documented in the notable work of Christina Romer (1986b, 1989, 2009). Historians, on the other hand, relying on more anecdotal and less quantitative evidence, tend to exaggerate the duration and severity of recessions. So I have created a revised chronology in the table below. From the nineteenth century to the present, it distinguishes between three types of events: major recessions, bank panics, and periods of bank failures. I have tried to integrate the best of the approaches of both economists and historians, using them to cross check each other. My chronology therefore differs in important ways from prior lists.

Recessions, Banking Crises, Federal Reserve, Economic History

One of the table’s benefits is that it gives a visual presentation of which recessions were accompanied by bank panics and which were not. Equally important, it distinguishes between bank panics and periods of significant numbers of bank failures. These two categories are often confused or conflated, and yet this distinction is critical. Not all bank panics (periods of contagious runs and sometimes bank suspensions) were accompanied by numerous bank failures, nor were all periods of numerous failures accompanied by panics.

Among other advantages, the table helps highlight how sui generis the Great Depression was. Not only does it have the longest downturn (43 months), but it also is one of the few depressions accompanied by both bank panics and numerous bank failures. Once the Great Depression is thrown out as a statistical outlier, we observe no significant change in the frequency, duration, or magnitude of recessions between the period before and the period after that unique downturn. Given that the Great Depression witnessed the initiation of extensive government policies to alleviate depressions and that the Federal Reserve had been created fifteen years earlier explicitly to prevent such crises, this overall historical continuity with a single exception indicates that government intervention and central banking has done little, if anything, to dampen the business cycle.

There has been a dramatic elimination of bank panics, at least until the financial crisis of 2007-2008, but the timing suggests that deposit insurance more than the Federal Reserve deserves the credit. Furthermore, note that more outbreaks of numerous bank failures occurred in the hundred years after the Federal Reserve was created than the hundred years before, with the Federal Reserve presiding over the most serious case of all: the Great Depression.

Because my table departs from previous lists and dating, in what follows, I explain the most important differences for each of the three categories. At the end of the post is a list of the most useful references I consulted.