Tag: monetary policy

Show Me the Money

A number of economists have been warning about the Federal Reserve’s easy-money policy, but defenders of the central bank often ask, “if there’s an easy money policy, why isn’t that showing up in the form of higher prices?” Thomas Sowell has an answer to this question, explaining that people and businesses are sitting on cash because anti-business policies have dampened economic activity.

Not only has all the runaway spending and rapid escalation of the deficit to record levels failed to make any real headway in reducing unemployment, all this money pumped into the economy has also failed to produce inflation. The latter is a good thing in itself but its implications are sobering. How can you pour trillions of dollars into the economy and not even see the price level go up significantly? Economists have long known that it is not just the amount of money, but also the speed with which it circulates, that affects the price level. Last year the Wall Street Journal reported that the velocity of circulation of money in the American economy has plummeted to its lowest level in half a century. Money that people don’t spend does not cause inflation. It also does not stimulate the economy. …Banks have cut back on lending, despite all the billions of dollars that were dumped into them in the name of “stimulus.” Consumers have also cut back on spending. For the first time, more gold is being bought as an investment to be held as a hedge against a currently non-existent inflation than is being bought by the makers of jewelry. There may not be any inflation now, but eventually that money is going to start moving, and so will the price level.

I do my best to avoid monetary policy issues and certainly am not an expert on the subject, so I asked a few people for their thoughts and was told that perhaps the strongest evidence for Sowell’s hypothesis comes from the Federal Reserve’s data on “Aggregate Reserves of Depository Institutions” - specifically the figures on excess reserves. This is the money that banks keep at the Federal Reserve voluntarily because they don’t have any better options. As you can see from the chart, excess reserves shot up during the financial crisis. But what’s important is that they did not come back down afterwards. Some people refer to this as “money on the sidelines” and Sowell clearly is worried that it will have an impact on the price level if banks start circulating it. That doesn’t sound like good news. On the other hand, it’s not exactly good news that banks are holding money at the Fed because there are not enough profitable opportunities.

What this really tells us is that the combination of easy money and big government isn’t working any better today than it did in the 1970s.

Why Limits On Banker Bonuses Are Meaningless

The European parliament has just approved a measure that would limit bonus payments and other aspects of compensation for bankers. National finance ministers are expected to approve the measure next week, and it will take effect Jan. 1. The goal of the legislation is to limit banker incentives to take risk, since this was allegedly a major cause of the recent financial crisis.

The key question about compensation limits is why shareholders and creditors have not imposed these on bank executives already. If the possibility of large bonuses indeed generates excessive risk-taking, then bank stakeholders have ample incentive to adopt such limits without government coercion.

The answer is that bank risk-taking was not necessarily excessive from the perspective of the bank stakeholders, since banks were living in a world with private gains but public losses.  Stakeholders stood to earn large returns when times were good, and they knew taxpayers would cushion the losses – via deposit insurance or accomodative monetary policy – when times went bad.

Since events of the past two years have done nothing but reinforce the view that major banks are too big to fail, the incentive to pile on risk is stronger than ever.

So limits on bank compensation are fighting an uphill battle, and bankers will find ways around them via creative accounting and clever compensation packages. The limits are therefore just political pandering to populist outrage over banker excesses. That outrage is understandable, but limiting compensation will not prevent the next blow up.

C/P at Forbes.com

Congress to Expand Deposit Insurance

While I never had much hope that this Congress would actually fix the real causes of the financial crisis - loose monetary policy, Fannie/Freddie - I had hoped that they wouldn’t do a lot to make an already bad situation worse.  Boy, was that hope naive.

Take the area of federally provided deposit insurance.  There is a massive amount of scholarly work, much of it empirical, that demonstrates that expanding the level and scope of deposit insurance results in more frequent and severe financial crises.  So what is Congress considering?  Yes, you guessed it:  expanded deposit insurance.

Recall during the financial crisis Congress raised the coverage limit to $250,000 - forget that there were never any premiums charged ahead of time for this coverage.  The FDIC also, without any basis in law, offered unlimited coverage to non-interest bearing accounts, targeted mostly at business customers.  While these expansions may have brought the system some short term stability, they come at the cost of considerable long term instability.

Congress is also making the misguided change of basing  insurance premiums on total assets rather than total deposits.  This will punish banks for relying on sources of funding other than deposits, giving banks an incentive to shift their funding toward deposits, putting the taxpayer ultimately at even greater risk.

So why all these expanded bank guarantees? Smaller banks view these as changes that would give them a competitive advantage relative to larger banks.  After all community and regional banks are far more dependent on deposits as a source of funds.  And while big banks are damaged politically, the smaller banks, despite their higher failure rates, have managed to maintain their political ability to shift the costs of their risk-taking onto the backs of the taxpayer.

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.

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