Let The Mea Culpas Begin, Part 2

By L. Randall Wray

As discussed in Part 1 (see here), some of the policymakers responsible for this calamity have started to apologize. On January 3 Chairman Bernanke admitted that rather than using rate hikes back in 2004 to deflate the housing bubble, the Fed should have used “[s]tronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management” (see here).

There appear to be at least three reasons for Bernanke’s admission that the Fed did not do its job. First, and most obviously, Bernanke is up for reappointment (his term expires January 31)—and he will not sail through. The public is mad as hell, and politicians will have to put him through the wringer or face voter’s wrath in the next election. So Bernanke will have to appear contrite, and will apologize for his misdeeds many more times while Congress makes him sweat it out.

Second, Congress is actually considering whether it should strip the Fed of all regulatory and supervisory authority, given its miserable performance over the past decade—during which the Fed has consistently demonstrated that it has neither the competence nor the will to restrain Wall Street’s bankers. Since Greenspan took over the helm, the Fed has never seen a financial instrument or practice that it did not like—no matter how predatory or dangerous it was. Adjustable rate mortgages with teaser rates that would reset to levels guaranteed to produce defaults? Greenspan praised them (see here). Liar loans? Bring them on! NINJA loans (no income, no job, no assets)? No problem! Credit default swaps that let one gamble on the death of assets, firms, and countries? Prohibit government from regulating them! So Bernanke has to grovel and beg Congress to let the Fed retain at least some of its authority.

Third, many commentators blame the Fed for the crisis, arguing that it kept interest rates too low for too long, fueling the real estate bubble. Bernanke argues “When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment”. If he can convince Congress that the problem was lack of oversight and regulation he can shift at least some of the blame to Treasury and Congress—since it was Treasury Secretary Rubin, and his protégé Summers, as well as Barney Frank, Christopher Dodd, and many others (significantly, Democrats who will now decide the Fed’s fate) who pushed through the deregulation bills in 1999 and 2000. He figures that if the Fed now supports re-regulation, he will be forgiven and the Democrats will be too embarrassed to admit their own misdeeds. (Significantly, Dodd has announced his retirement, in recognition of the role he played in creating the crisis. Another mea culpa on the way?)

While I do believe the Fed should be stripped of all such authority, I am sympathetic to his argument about monetary policy. Low interest rates do not cause bubbles. The Fed kept interest rates low after the NASDAQ crash because it feared deflation in the face of significant downward pressures on wages and prices globally (see here). The belief was that low interest rates would keep borrowing costs low for firms and households, helping to promote spending and recovery. In truth, spending is not very interest sensitive and the economy stumbled along in a “jobless recovery” in spite of the low rates. What was actually needed was a fiscal stimulus (if anything, low rates are counterproductive because they reduce government interest spending on its debt—as Japan’s experience taught us over the past couple of decades—but that is a point for another blog).

Still, the Fed was following conventional wisdom, and only began to gradually raise rates when job growth picked up in 2004. Over the following years, the Fed kept raising rates, and economic growth improved. (So much for conventional wisdom!) The worst excesses in real estate markets began only after the Fed had started raising rates, and lending standards continued their downward spiral the higher the Fed pushed its target interest rate. In other words, contrary to what many are arguing, the Fed DID raise rates but this had no impact in real estate markets.

Why not? Two main reasons. First, recall that Greenspan had promoted adjustable rate mortgages with teasers. No matter how high the Fed pushed rates, lenders could offer “option rate” deals in which borrowers would pay a rate of 1 or 2 percent for two to three years, after which there would be a huge reset. Lenders ensured the borrowers that there was no reason to worry about resets, since they would refinance into another option rate mortgage before the reset. That is the beauty of ARMs—they virtually eliminate the impact of monetary policy on real estate.

Second, and this was the key, house prices would only go up. At the time of refinance, the borrower would have far more equity in the home, thus obtain a better mortgage. Further, the borrower could flip the house and walk away with cash. While I will not go into this now, public policy actually encouraged homeowners to look at their houses as assets, rather than as homes (see here) (And now that many are walking away from underwater mortgages—treating houses as assets that became bad deals—policy makers and banksters are shocked, shocked!, that borrowers are treating their homes as nothing but bad assets.)

In truth, when speculation comes to dominate an asset class, there is no interest rate hike that can kill a bubble. If one expects asset prices to rise by 20%, 30%, or more per year, an interest rate of 10% will not dampen enthusiasm. To kill the housing boom, the Fed would have had to engage in a Volcker-like double-digit rate hike (in the early 1980s, he raised short-term interest rates above 20%). There was no political will in Washington (either at the Fed or the White House) for such drastic measures. Nor was there any reason to do this. Bernanke is quite correct: the Fed could have and should have killed the real estate boom with much less pain by directly clamping down on lenders, prohibiting the dangerous practices that were rampant.

Is there any reason to believe that Bernanke is the right Chairman, or that the Fed is the right institution, to lead the effort to re-regulate and re-supervise the financial sector? Quite simply, no.

The Bernanke-led Fed still does not understand monetary operations, as indicated by its recently announced plan to unwind its balance sheet. Over the course of the crisis, the Fed invented new procedures such as auctions through which it provided reserves. Throughout, it always was focused on quantities, rather than prices, using quantitative constraints on the size of the auctions. Further, Bernanke continually promoted “quantitative easing”, reflecting the view that quantities are what matter. Now, the Fed has begun to worry about the size of its balance sheet—and also the size of reserve holdings of the banking system (the other side of the balance sheet coin, because the Fed buys assets by issuing reserves). Still following the thoroughly discredited theory of Milton Friedman, too many bank reserves are supposed to promote too much lending which then causes too much spending and hence inflation. Thus, Bernanke and many outside the Fed fret about how the Fed can reduce outstanding reserves to prevent incipient inflation. The Fed proposes to create new bonds it will sell to reverse the “quantitative easing”.

Actually, the Fed’s tool is price, not quantity, of reserves. When the crisis hit, the Fed should have opened its discount window to lend reserves without limit, to all comers, and without collateral. That is how you stop a run. The Fed’s dallying and dillying about worsened the liquidity crisis, but it eventually provided the reserves that the financial institutions wanted to hold and its balance sheet eventually grew to $2 trillion. Banks are still worried about counterparty risk and possible runs, so they remain willing to hold massive amounts of reserves. When they decide risks have declined, they will begin to reduce reserve holdings. This will not require any special practices by the Fed. Banks will repay their loans from the Fed, using reserves. This automatically reduces reserves and the size of the Fed’s balance sheet. They will offer undesired reserves in the overnight, fed funds market. Since many banks will be trying to unload reserves at the same time, this will put downward pressure on the fed funds rate. The Fed will then offer to sell assets it is holding to mop up the excess reserves (banks will use reserves to buy assets the Fed offers). This will also reduce reserves and the size of the Fed’s balance sheet. All of this will happen automatically, following the same procedures the Fed has always followed. All it needs to do is to watch the fed funds rate, and when it falls below target the Fed will drain reserves to relieve the downward pressure on overnight rates.

Quantitative easing was a misguided notion, and reversal of quantitative easing is similarly misguided. It simply indicates that Bernanke still does not understand how the Fed operates. In truth, formulating and implementing monetary policy is extremely simple and can be reduced to the following:

1. Offer to lend reserves at the discount window at 50 basis points to all qualifying institutions;

2. Pay 25 basis points on reserve holdings;

3. Perform par clearing of checks between banks, and for the Treasury.

Surely President Obama can find a chair who can do that.

The Fed’s relationship with banks is too cozy to make it a good regulator. It is, after all, owned by private banks. The Fed’s district banks are often run by bankers, and district Fed presidents take turns sitting on the policy-making FOMC. There is a particularly incestuous relationship between the NYFed and Wall Street banks—with Timmy Geithner as a prime example of the dangers posed (“I’ve never been a regulator” proclaimed the former head of the NYFed). It does not have the proper culture to closely supervise financial institutions. Its top body, the Board of Governors, are political appointees often with no experience in regulation (many are academic economists, typically mainstream and with a free market orientation). While the FDIC was also mostly asleep at the wheel over the past decade, it does have the proper culture and experience to take over responsibility for regulating and supervising the financial sector. With some management changes, and hiring of a team of criminologists tasked to pursue fraud, the FDIC is the right institution for this job.

10 responses to “Let The Mea Culpas Begin, Part 2

  1. Hi Randy,Happy new year! It was great meeting you in 2009. I liked this line a lot "That is the beauty of ARMs—they virtually eliminate the impact of monetary policy on real estate"Plus … amazing how he continues to not get the reserve accounting! Truly amazing. Have you seen John Taylor's blog ? http://johnbtaylorsblog.blogspot.com/ The man is so obsessed with his rule, that he never misses any opportunity to use the words "Taylor Rule". There is a mini debate in the blogosphere of what the "correct" Taylor rule is which rule could have prevented the bubble and adds comedy to the situation.

  2. Excellent post. Very clear.While I agree that the Fed is too compromised to be a good regulator of the financial system, I have a couple of questions about making the FDIC the regulator. The FDIC is rather specialized, looking that all the FDIC insured banks. Its performance hasn't been exemplary. For example, recent closures have uncovered banks 30-40% underwater. Seems that the FDIC should have caught these sooner. What about Citi? Most people think that that Citi was and is still insolvent. More seriously, the big problems arose from 1) fraud and predatory practices involving mortgages, and 2) big institutions overleveraging themselves through derivatives and swaps — the investment banks, AIG, etc. Seems like this is a system that is too big for the FDIC to handle without becoming a much larger systemic regulator having a lot more purview, a much bigger budget and a comprehensive mandate, effectively necessitating a new entity. Seems like the FDIC and the proposed Consumer Protection Agency would be included under this agency, and perhaps also related financial regulators like the SEC.

  3. Bernanke has never used the terminology “quantitative easing” as his preferred or even acceptable description for what the Fed has done. Rather he has been consistent in stating that excess reserves for the most part have been the by-product of asset initiatives rather than the purpose of them. It was the case in the early stages of the crisis that reserve provision was a distinct objective as well, but that mode was ultimately eclipsed by the asset by-product dynamic as the reserve system slowly began to function better. The fact that the Fed pays interest on reserves while at the zero bound tends to support the notion that reserves are properly today as the facilitating by-product of asset policy rather than a primary liability or quantitative easing policy per se.That said, I don’t understand why he continues to pepper his speeches with phrases about banks “lending reserves”. That is completely incorrect as a description of monetary operations as it relates to the relationship between banks and their non-bank borrowing customers, a point on which I think we’d agree. Perhaps he doesn’t know he’s making such an error. But taken together, his “by-product” description of excess reserves as policy, which is correct, and his concern about banks beginning to “lend reserves” more aggressively, which is incorrect, are inconsistent at the level of understanding of how the reserve system works.I’m being charitable to Bernanke here of course. But it’s not clear to me how he could be so right (my view) on the explicit characterization of the creation of excess reserves as a by-product of asset initiatives, and yet at the same time so wrong in completely misunderstanding the true role of reserves in the monetary system, separate from the role of capital. Something doesn’t add up.

  4. Comments on two minor technical aspects:First, the amount of reserves that banks will be able to reduce as a result of repaying loans is really quite small in comparison to the total level of excess reserves. This is evident in examining the current asset mix of the Fed balance sheet. As things stand now, bank initiation would only account for roughly $ 100 billion out of an ultimate requirement for excess reserve withdrawal of $ 1.1 trillion. The vast bulk will have to come from the Fed itself through gradual wind down of its special asset programs apart from its lending to banks. This will occur primarily through asset maturities, along with some sales.Second, because of the first point, the propensity for banks to want to lend their excess reserves in the interbank market already exists to a considerable degree. That propensity has been on the upswing as the system has repaired itself and as bank borrowing from the Fed has declined. It may continue to increase with further improvements in financial health. But in any event, the payment of interest on reserves is intended to neutralize any serious interest rate effect that might come about as a result. The floor established by interest on reserves is not perfect, due to the lingering GSE zero interest problem and imperfect arbitrage, but the floor is solid enough to allow the Fed to manage the general level of short rates, including the case where it wants to increase the funds rate target even with a substantial position in residual excess reserves still outstanding.

  5. Regarding the inconsistency noted in my first comment, one way I’ve thought about this is that he may be hedging against the possibility that certain bank CEO’s have been readers of the textbooks of Mankiw and others. Well, maybe not literally, but perhaps this makes the point. The fact is that well run banks should be making risky loans on the basis of capital allocation, completely independently from their day to day reserve position. The only reason for them working their reserves into the lending equation would be in a cautionary mode of some deeper concern about their own capital position and their ability to attract deposits. That was a general issue earlier on, but I don’t think the majority of banks at this stage are concerned about their reserves. I do think that their capital positions are still binding in the sense of a general caution about the robustness of the economic outlook, combined with a dearth of credit worthy borrowers in such an environment. But reserves should not be an urgent issue for most banks on the basis of any capital adequacy knock-on effect, at least not in the more urgent way they were in the early days of the crisis.So the “Mankiw hedge” comes into play in the following sense. The recovery plods along and at some point certain bank CEOs press their underlings about “these damn excess reserves”. That might occur notwithstanding the fact that most of these banks would have sufficiently skilled managers in place who understand the nature of capital allocation for risk as opposed to the misguided idea that risk might be a substitute for excess reserves in the absence of capital considerations. In this context, Bernanke’s language about reserves might be interpreted as a moral and technical suasion device against certain banks leveraging an excess reserve “nuisance” into an overly enthusiastic interpretation of capital resources at some point.Conversely, a rationale bank CEO might look at his excess reserve position and compare it to a “benchmark” position that represents a pro rata share of system excess reserves. “Pro rata” might be defined on the basis of some balance sheet metric such as share of capital or share of nominal asset liability balance sheet size. If that excess reserve share is disproportionate, he might then ask a question about what his bank is doing in terms of other asset liability strategies that would account for such a disproportionate share and the associated opportunity cost (if any) of holding such a position. In other words, market share of “exposure” is the rational starting point for the assessment of an asset position that is essentially foisted on the banking system in aggregate.I’m being charitable to Bernanke here of course. The “Mankiw hedge” is my conjecture on this. That said, I realize there are many who are more certain that Bernanke himself doesn’t have the capacity to conceptualize a hedge to guard against a misunderstanding to which he himself has fallen prey. Those who are far more familiar with his academic training than me may well hold that view very strongly. Still, something here doesn’t make sense in considering the coherence of the full story. And I have a suspicion that Bernanke knows that reserves and capital play distinct roles.

  6. Thanks for comments.Let me just say that I realize FDIC is far from blameless. It will need more funding; it will need to hire a team of forensic criminologists. Exactly right that the big institutions are too complex, and powerful, to effectively regulate. They must be broken up or shut down.Today's news demonstrates just how hopelessly incestuous the relation between the NYFed and Wall Street has become: Geithner ordered AIG to hide the truth!JKH: too much there to respond in detail, but I agree Bernanke is confused. It is always hard to know what he and others mean by "banks lend capital" or "banks lend reserves"–is it true ignorance or pandering to the ignorant? Yes, paying interest on reserves sets the floor rate, and yes in current environment banks will happily hold reserves and earn that return. This strengthens my argument that the Fed does not need to create any new mechanisms. LRWray

  7. Randy, JKH, thanks for the clarifications. I have a question about the disposition of excess reserves. It seem that banks voluntarily continue to choose holding excess reserves, presumably as a liquidity provision owing to persistent extraordinary financial circumstances. As conditions change, wouldn't banks naturally desire to exchange low interest reserves for higher interest, e.g., tsy's, thereby automatically reducing excess reserves? So why is there so much concern about the excess reserves, when the logical reason for their persistence (at an opportunity cost to banks) is that they are still playing a valuable role as liquidity in a continuing financial crisis? Seems that this would resolve itself as conditions improve.

  8. Tom H.,My two cents worth on a tricky subject: Yes, excess reserves have liquidity value, since they represent actual settlement balances in real time. They are as good as if not better than treasury bills as liquidity in that sense – i.e. access to settlement balances. The Fed has forced a minimum level of this dense liquidity on the system by creating these reserves as a by-product of its asset initiatives. But the system is not necessarily voluntarily demanding this level as liquidity. Individual banks can voluntarily influence their reserve share through asset liability initiatives. But they can only change the system distribution of reserves, not the aggregate level, so long as they deal with counterparties other than the central bank. And for their actions to be rationale, other assets must offer superior risk adjusted returns. That availability is limited in an environment of such massive liquidity, due to pricing arbitrage already achieved. E.g. 90 day treasury bills may offer not much more or sometimes even less than reserve interest due to institutional demand. Assets further out the risk spectrum must offer yield compensation – e.g. yield for more interest rate risk on a 10 year treasury; for more credit risk on a corporate loan. And capital is required to support any kind of risk addition. When dealing with non-Fed counterparties, choices by an individual bank will only bump the distribution of reserves around the system, not change the total level in the system. It’s zero sum in that sense. With the exception of about $ 100 billion in system borrowing, only the Fed itself can act to drain the $ 1.1 trillion in total excess reserves.

  9. Tom H.,In looking again at your final paragraph 10:37, combined with my other comments, I don't think there should be so much concern. It will resolve itself through gradual Fed elimination of the excess.

  10. Tom: exactly right. Even the term "excess reserves" makes no sense. It is based on the old money multiplier view–banks "lend excess reserves". They never did, never could. Now it merely means that banks have more than legally req'd, but they only hold what they desire. Hence, if holdings are desired they cannot be excessive! They will reduce holdings when they want to. Nothing to fret about. LRWray