Topic: Finance, Banking & Monetary Policy

The Real Bills Doctrine: A Short Response

Juan Ramón Rallo has thoughtfully replied (in English) to my earlier Alt-M post that discussed two versions of the real-bills doctrine and what I took to be his defense of a prudent-banking version of the doctrine. Here I offer a few comments on his reply.

  1. One topic under discussion is the common banking practice of borrowing short and lending long (aka maturity transformation). The practice is remunerative to the bank when short-term interest rates are lower than long rates, but it exposes the bank to risks that I previously discussed.

    In his latest piece Rallo suggests a categorical condemnation of the practice: “The banks that transform the maturities of their assets and liabilities are causing a discoordination between savers and investors. They are promising savers to redeem their liabilities much sooner than the moment when their assets will be paid by investors, i.e., they are promising savers the availability of some future goods before they are provided by the investors’ projects they are financing.” In my view, by contrast, whether there is a “discoordination” does not depend so much on the promises or contract terms, or what we may call the de jure maturities, as on the de facto maturities.

    As Rallo recognizes, holders of short-term liabilities have the option to roll them over. This is especially obvious for demand deposits that remain in the bank for longer than one instant. A one-year certificate of deposit that is renewed at an unchanged interest rate can be considered de facto a two-year (or longer, if renewed again) deposit. This means that a profit-seeking bank faces the challenge of estimating the distribution of actual times-to-withdrawal-or-repricing of its liabilities, which are longer than the de jure maturities.

The Courage to Act in 2008

Ben Bernanke’s memoir is now out and is unapologetically pro-Fed. It is titled The Courage to Act. Here is the cover quote:

bernanke, courage to act, 2008 crisis

The main point of Bernanke’s book is that absent the Fed’s interventions over the past seven years the U.S. economy would have undergone another Great Depression. Thanks to him and his colleagues at the Fed the world is a much better place.

There has already been some push back on this Bernanke triumphalism. George Selgin, for example, notes that the recovery under Bernanke’s watch was anemic. Inflation consistently undershot the Fed’s target and the real recovery was weak. We may not have experienced another Great Depression, but we sure did get a long slump. Ryan Avent makes a similar point by observing that Bernanke had a chance in late 2011 to do something bold by endorsing a NGDP target, an action that could have jolted the economy from its doldrums. But alas, Bernanke failed to muster up the courage to have what Christina Romer called his “Volker Moment”.

Expect more push back along these lines from a book with such a bold title. One strand of criticism that many observers miss, but I hope will be considered in future reviews of Bernanke’s book is the role the Fed played in allowing the crisis to emerge in the first place. Could the Fed have done more to prevent the recession from becoming as severe as it did? Maybe a recession was inevitable, but was a Great Recession inevitable? These are the questions first raised by Scott Sumner and echoed by others including me. Our answer is no, the Great Recession was not inevitable. It was the result of the Fed failing to act aggressively enough in 2008.

This understanding draws upon the fact that the housing recession had been going on for about two years before a wider slowdown in economic activity occurred. As seen in the two figures below, sectors of the economy tied to housing began contracting in April 2006 while elsewhere employment growth and nominal income continued to grow. This all changed in the second half of 2008.

So what went wrong in the second half of 2008? Why did a seemingly ordinary recession get turned into a Great Recession? We believe the Fed became so focused on shoring up the financial system and worrying about rising inflation, that it lost sight of stabilizing aggregate demand. Based on theses concerns, especially the latter, the FOMC decided to do abstain from any policy rate changes during the August and September 2008 FOMC meetings. But by doing nothing at these meetings the FOMC was doing something: it was signaling the Fed would not respond to the weakening economic outlook. The FOMC, in other words, signaled it would allow a passive tightening of monetary policy in the second half of 2008.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in money velocity. The decline in the money supply and velocity are the result of firms and households responding to a bleaker economic outlook. The Fed could have responded to and offset such expectation-driven developments by properly adjusting the expected path of monetary policy.

The figures below document this monumental failure by the FOMC. The first one shows the 5-year ‘breakeven’ or expected inflation rate. This is the difference between the 5-year nominal treasury yield and the 5-year TIPs yield and is suppose to reflect treasury market’s forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and half months leading up to the September FOMC meeting. This forward looking measure was screaming trouble ahead, but the FOMC ignored it.

One way to interpret this figure is that the Treasury market was expecting weaker aggregate demand growth in the future and consequently lower inflation. Even if part of this decline was driven by a heightened liquidity premium the implication is the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers’ monthly nominal GDP data indicates this is the case:

The Fed could have cut its policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just the change in the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signaling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten.

Recall that Gary Gorton provides evidence that many of the CDOs and MBS were not subprime, but when the market panicked a liquidity crisis became a solvency crisis. This is especially true in late 2008. Had the Fed responded to the falling market sentiment in the second half of 2008 the financial panic in late 2008 may have been far less severe and the resulting bankruptcies fewer. Again, the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed.

So had Fed had the courage to act in 2008 the economy would be in a very different place today. Future reviewers of Bernanke’s book should keep that in mind.

P.S. For a more thorough development of this view see the book by Robert Hetzel of the Richmond Fed.

[Cross-posted from]

Court Denies Insider Trading Appeal

This week the New York Times reports that the Supreme Court has refused to review the ruling of the Second Circuit Court of Appeals in the case United States v Newman. The Second Circuit, in December, overturned the insider trading conviction of a pair of hedge fund managers because nothing of value was exchanged in return for the information and thus the managers could not have known that the information they received was improperly disclosed to them by the information source.  The Supreme Court decision would seem to block insider trading prosecutions in the absence of clear financial gains to those who leak the information.

This, in turn, has energized some members of Congress to introduce legislation to make it illegal to trade on insider information regardless of how one obtains it. This standard would define insider trading far more broadly than the standard laid out in Newman, or, for that matter, even before Newman based on the precedent in Dirks v SEC.

In his article in the current issue of Regulation, Villanova University law professor Richard Booth explores the Newman ruling.  He argues that ordinary diversified investors neither lose nor gain from insider trading because they own all stocks and don’t trade very often.  The only investors who have an interest in the prosecution of insider trading are “activist investors – hedge funds and corporate raiders – who stand to benefit from slower reaction times as they buy up as many shares as possible before anyone notices.”  “… [H]edge fund managers have a distinct interest in seeing other hedge fund managers prosecuted for insider trading.”  They rather than ordinary investors are the beneficiaries of insider-trading prosecutions.  Thus ordinary investors should applaud the Newman ruling and oppose the attempts by Congress to adopt a European-style law against all insider trading.

For more Cato work on insider trading, see these links.

Research assistant Nick Zaiac contributed to this post.


Bitcoin Air-Kisses the Euro

Volatility is a well-recognized impediment to the success of Bitcoin as a currency. An example of the argument for volatility-based caution about Bitcoin, chosen at random, appears in Professor David Yermack’s December 2013 NBER working paper, “Is Bitcoin a Real Currency? An Economic Appraisal.” Wide swings in the price of bitcoins vis á vis other things will obviously tend to suppress its utility as a store of value or unit of account. Nobody wants to deal with recalculating prices denominated in Bitcoin day over day or hour over hour.

But I’ve long felt the volatility knock on Bitcoin to be slightly unfair. My favorite response line has been to say that judging Bitcoin based on its current volatility is like declaring a 10-year-old unfit to play in the NBA because he’s too short.

As a new asset class (or very different member of the “cash or cash equivalent” asset class), Bitcoin has yet to find its place in the world. The uses to which it is put will ultimately translate into a dollar price based on a recognized, relatively steady level of demand. Right now, speculation about where demand for Bitcoin will end up takes place in thinly traded markets. Just those two ingredients — uncertain future use and thin markets — are recipe enough for plentiful volatility.

But there’s every reason to believe that the market for Bitcoin will deepen and grow in sophistication, tempering its volatility. The capacity of the Bitcoin protocol to transfer and store value in exciting new ways will produce transaction demand — supplanting speculative demand, which today dominates because of anticipated price appreciation. Transaction or “use” demand will also increase because of Bitcoin’s capacity to administer countless economic and social functions beyond value transfer, including messaging, proof of authorship, land and title registry, and identity/naming. This will drive volatility down, I believe, both because it will shift bitcoins out of speculation and because it will give the markets more concrete information about what use demand is and will be.

End the Fed’s Guessing Game

The FOMC decided last week against raising interest rates given its concerns about the global economy and financial conditions. While these concerns are reasonable, the FOMC’s decision highlights a growing problem that has increasingly plagued the Fed since the crisis erupted: its incredibly ad-hoc approach to monetary policy.

Just a few months ago the FOMC was signaling it would almost certainly raise interest rates, but now it has changed its mind. This change would not be so bad if it were predictable, but it was not so. No one expects the Fed to perfectly forecast the economy, but we should expect the Fed to make clear how it would respond to differing states of the economy. This simply has not happened. From the QE programs to forward guidance to lifting interest rates from zero, Fed policy has been made up on the fly. This unpredictable behavior has meant that no one, including Fed officials, knows for sure what will happen from one FOMC meeting to the next.

As a result, markets have become more and more obsessed with every word coming from the mouths of Fed officials. Post-FOMC press conferences like the one last Thursday became must-watch TV for anyone concerned about investments. Ironically, then, the Fed’s attempt to calm markets through these ad-hoc measures has only made them more fragile.

It would be far better for the Fed to focus on a narrow mandate in a rule-like manner that makes conditional forecasts possible. For example, if the Fed were to target a stable growth path for total dollar spending and adjust policy as needed to hit it there would be far less of the Fed’s current guessing game. The FOMC’s decision last week highlights how sorely this change is needed.

[Cross-posted from]

New Policy On White Collar Prosecution Risks Scapegoating

Last week, the Department of Justice announced a new policy regarding its approach to corporate criminal investigations.  Instead of focusing first on the company and, having resolved that portion of the investigation, turning to the task of identifying potential individual criminal suspects, prosecutors are now directed to build their cases against individual wrong doers from the start.  Media coverage of this policy statement has focused on criticism levied against the administration for being too soft on Wall Street and too cozy with corporate donors.  The New York Times trotted out the old complaint that no one went to jail in the wake of the financial crisis (even though, to my knowledge, no one has ever identified a criminal law the violation of which caused any part of the crisis).  While the administration’s rhetoric about equal justice before the law is admirable, the policy memo and its surrounding coverage have a distressing whiff of scapegoating about them. 

Reforming the Federal Reserve’s Rescue Authority: Warren and Vitter Come to Cato

For all the ink spilled on TARP — the bailout package authorizing the Treasury to purchase or insure up to $700 billion of “troubled assets” during the financial crisis — that program is dwarfed by another market intervention that occurred around the same time. In fact, the Government Accountability Office estimates that the Federal Reserve lent more than $16 trillion to financial firms between December 2007 and July 2010 — a figure that comes close to matching the entire, annual gross domestic product of the United States.

On Wednesday, Cato’s Center for Monetary and Financial Alternatives hosted a two-part discussion of the Federal Reserve’s emergency lending power, and the legislative efforts underway to reform it. The first panel saw the Washington Post’s Ylan Mui interview Phillip Swagel, a former Treasury official turned University of Maryland professor, Marcus Stanley, the policy director at Americans for Financial Reform, and Mark Calabria, Cato’s own director of financial regulation studies. United States Senators Elizabeth Warren (D-MA) and Richard Vitter (R-LA) joined us for the second panel, during which they outlined their proposed “Bailout Prevention Act of 2015,” as well as their broader, bipartisan quest to end “too big to fail.”