Topic: Finance, Banking & Monetary Policy

How the Fed Ended Up Fueling a Subprime Boom

Plenty of writers have claimed that the Federal Reserve fueled last decade’s subprime boom by holding interest rates too low for too long after the dot-com crash. But hardly anyone has tried to explain why the Fed did so.

Yours truly has taken a stab at it, together with my former student (and now eminent Market Monetarist) David Beckworth and my former University of Georgia colleague (and current Özyeğin University faculty member) Berrak Bahadir. Here is our just-published article in the Journal of Policy Modeling.

Our argument, in brief, is that the Fed blew it by not treating the exceptionally high post-2001 productivity growth rate as warranting an upward revision of the Fed’s interest-rate target (as neoclassical theory would suggest). Instead, Fed officials believed they could maintain a below-natural interest rate target without risking a corresponding increase in inflation.

We supply lots of evidence supporting our interpretation and, thereby, supporting the view that excessively easy Fed policy did indeed contribute substantially to the subprime boom. We also show how nominal gross domestic product targeting would have prevented this outcome, and that it would have done so to an even greater extent than strict adherence to a Taylor Rule.

Readers familiar with my arguments favoring a “productivity norm,” as presented in Less Than Zero and elsewhere, will understand the claims made in our paper as a specific application of those more general arguments.

The publishers have kindly allowed us to make the article available here without a pay wall for a brief period only, so consider saving it if you might want to have it for longer.

[Cross posted from]

Monetary Standards: An Introduction

A monetary standard is a set of institutions and rules governing the supply of money in an economy. These rules and institutions collectively constrain the production of money. Through its constraints on money creation, the standard indirectly acts on prices. A monetary standard may also affect the rate of growth of real economic output, but that depends on expectations. Monetary institutions may also affect other economic institutions, which themselves influence economic growth.

Some authors talk about a monetary regime, and still others a monetary constitution. For purposes of this discussion, the same underlying issues are being discussed.

The banking and financial system interacts with the monetary standard and differences in the one may affect how the other operates. Though very important, the banking and financial system is not my main focus.

Familiar Yet Forgotten Tax Lessons from Ancient Greece and Rome

In Ancient Greece, “The politicians strained their ingenuity to discover new sources of public revenue… . The results of these imposts was a wholesale hiding of wealth and income, Evasion became universal, goods were seized, men were thrown into jail. But the wealth still hid itself, or melted away.”

–Will Durant The Life of Greece, Simon and Schuster, 1939. P. 66.

 In ancient Rome; “taxation rose to such heights that men lost incentive to work or earn, and an erosive contest began between lawyers finding devices to evade taxes and lawyers formulating laws to prevent evasion. The government issued decrees binding the peasant to his field and the worker to his shop until all his debts and taxes had been paid. In this and other ways medieval serfdom began.”

–Will, and Durant, Ariel. The Lessons ofHistory, Simon and Schuster, 1968.

The Fed and the Recovery, or, QE not D

Lately more and more people seem inclined to congratulate the Fed for the great job it has done saving us from another Great Depression and getting the U.S. economy back on its feet. Frankly, I’m getting tired of it.

It’s not that I’m cock-sure that the Fed’s post-2008 actions haven’t achieved anything. It’s just that I’m pretty darn sure that all the people who claim that the Fed has done a bang-up job haven’t any solid reasons for doing so. They remind me of the characters in an episode of The Beverly Hillbillies who were certain that Granny had a concoction that could cure the common cold–certain, that is, until Granny told them that it took about ten days for the stuff to work.

Some point to Europe’s relatively feeble economy, and the ECB’s belated attempt to revive it by means of Bernanke-style Quantitative Easing, as proof of the Fed’s enlightened conduct. But that comparison may only prove that Europe’s central bank has bungled things even more than ours has. In fact, the comparison doesn’t even prove that much, since U.S. money market conditions appeared to offer better prospects for the success of quantitative easing than those that prevailed in Europe.

Apart from being better than Europe’s, our recovery offers precious little for Fed boosters to brag about. It has been remarkably slow—slower, according to some experts, than the severity of the crisis can itself account for. It has been remarkably incomplete. And it has landed us in a low low-interest-rate mire from which there’s no easy escape.

Ukraine: The World’s Second-Highest Inflation

Venezuela has the dubious honor of registering the world’s highest inflation rate. According to my estimate, the annual implied inflation rate in Venezuela is 252%.

The only other country in which this rate is in triple digits is Ukraine, where the inflation rate is 111%. The only encouraging thing to say about Ukraine’s shocking figure is that it’s an improvement over my February 24th estimate of 272%—an estimate that attracted considerable attention because Matt O’Brien of the Washington Post understood my calculations and reported on them in the Post’s “Wonk blog.”

As a bailout has started to take shape in Ukraine, the dreadful inflation picture has “improved.” Since February 24th, the hryvnia has strengthened on the black market from 33.78 per U.S. dollar to 26.1 per U.S. dollar. That’s almost a 30% appreciation (see the accompanying chart). 

On the Great Inflation Canard

Charles W. Calomiris and Peter Ireland, two distinguished economists and friends, wrote an edifying piece in The Wall Street Journal on 19 February 2015. That said, their article contains a great inflation canard.

They write that “Fed officials should remind markets that monetary policy takes time to work its way through the economy—what Milton Friedman famously referred to as “long and variable lags”—and on inflation.” That’s now a canard.

For recent evidence, we have to look no further than the price changes that followed the bursting of multiple asset bubbles in 2008. The price changes that occurred in the second half of 2008 were truly breathtaking. The most important price in the world — the U.S. dollar-euro exchange rate — moved from 1.60 to 1.25. Yes, the greenback soared by 28% against the euro in three short months. During that period, gold plunged from $975/oz to $735/oz and crude oil fell from $139/bbl to $67/bbl.

What was most remarkable was the fantastic change in the inflation picture. In the U.S., for example, the year-over-year consumer price index (CPI) was increasing at an alarming 5.6% rate in July 2008. By February 2009, that rate had dropped into negative territory, and by July 2009, the CPI was contracting at a -2.1% rate. This blew a hole in a well-learned dogma: that changes in inflation follow changes in policy, with long and variable lags.

Milton Friedman was certainly correct about the period covered in the classic, which he co-authored with Anna J. Schwartz: A Monetary History of the United States, 1867-1960. Recall that the world of that era was one in which the fixed exchange rates ruled the roost. That’s not today’s world. Indeed, many important currencies now float. Since the world adopted a flexible exchange-rate “non-system”, changes in inflation can strike like a lightning bolt.

Reg A+: Only a Partial Win for Small Business Capital Access

Tuesday, the SEC approved final rules for so-called Reg A+, a new and revitalized version of the Regulation A exemption, created by the JOBS Act of 2012.  While the new rules remove barriers for issuers seeking a raise near the top of the $50 million cap, they fail to remove the greatest barrier – state registration – for the smaller issuers, effectively leaving them out in the cold. 

Reg A has been essentially unusable for years.  The exemption allows a company to sell securities to the public without full registration, provided the issuer raises no more than $5 million and provided the offering complies with all applicable state securities (“blue sky”) laws.  Because of the low $5 million cap and, more importantly, the heavy burden of complying with at least two regulatory regimes – federal and one or more states – this exemption has become almost entirely obsolete.  Hoping to make a new, workable version, Title IV of the JOBS Act directs the SEC to create an additional class of securities under the exemption.  In addition to raising the cap to at least $50 million, Title IV left the door open for state preemption.

Surprising no one, the state regulators objected.  Although Reg A had languished for years even as small business clamored for better capital access, the North American Securities Administrators Association (NASAA), a group representing state regulators, only very recently announced it had “solved” the Reg A problem.  NASAA’s solution is a program of coordinated review whereby participating states agree to use uniform review standards and a streamlined filing process.  While this process may be a little less cumbersome, it still requires that the issuer complete two separate filings, under two separate regulatory regimes.  For the small companies likely to use Reg A, that is an expensive undertaking.  Moreover, NASAA has insisted that state-level review is important for investor protection, but it’s unclear what additional protection the state regulators provide.  NASAA President William Beatty has argued that small, local offerings require local regulators.  But, as Mr. Beatty himself has said, Reg A offerings that involve local issuers typically involve local investors who are familiar with the issuer.  Also, to the extent there is a benefit from review by a local regulator, that benefit would seem to be lost under coordinated review.  It’s also unclear how any one state regulator is “local” to a company doing a multi-state offering.

In the end, the SEC split the baby.  Reg A+, the Commission announced, will have a two-tier structure.  Offerings under Tier 1 may raise up to $20 million and will be subject to blue sky laws.  Offerings under Tier 2 may raise up to $50 million and will not be subject to blue sky laws.  Tier 2 offerings will have additional requirements not applicable to Tier 1 offerings, however, such as a cap on the amount a non-accredited investor may invest (10% of income or assets), periodic filing requirements (annual, semi-annual, and current event), and the obligation to file audited financials.  Given the expense and demands of blue sky compliance, it’s unlikely many issuers will use Tier 1.  That means that companies seeking less than $20 million will either choose a Tier 2 raise or, more likely, find that the new Reg A+ is as unusuable as the old one.