Escape from Punchbowlism

This post was written by StatsGuy, a regular commenter here and very occasional guest contributor. We asked him to expand on the ideas he put forward in this comment on the relationships between monetary policy, international capital flows, and bank capital requirements.

Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.

Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)

Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines).  How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)

Here is a less semantic answer: When the Fed pumps money into the system to prevent deflation, the disincentive to holding cash/reserves is supposed to get money moving and thus restore the savings/investment equilibrium. In a sense, the goal is to decrease the incentive to use money as a store of value and therefore increase its use as a medium of exchange. Unfortunately, many conventional macroeconomists (unlike their brethren in the real-world finance schools) haven’t admitted that this monetary stimulus “leaks” out of their models (which focus on closed domestic economies without moral hazard). Where does it go?

Partly, it gets sopped up by large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit. Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities).

The monetary stimulus also “leaks” due to globalization of capital flows. It flows out of the country through a variety of mechanisms that traders might describe as dollar hedging (into commodities, foreign assets, and an anti-dollar carry trade). This is one of the most dominant trading features in the current market environment.

In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). This latter point is not entirely intuitive, and I might argue that the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.

So in these regards, Team Obama seems to “get it”. I concede that they have identified the right issues. How well they execute depends on many factors. As Professor Johnson notes, focusing on currency valuations (a very sensitive issue in China) on a highly public world stage like the G20 may not be productive.  By contrast, quietly moving a bill through Congress might be a better option.

But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.* If it tries to support a weak economy by keeping the punchbowl on the table (as in 2003-2005, when we had a “jobless recovery”) then we get a really bad bubble.

That is what a central bank staffer called “Second Best Punchbowlism” on Brad DeLong’s blog, and it is a very scary prospect indeed. Remember when the Fed kept rates tight in August and early September 2008 (arguably to fight the commodity bubble/dollar run)? And when, in the post-September 2008 crisis, the Fed continued its deflationary policies, even though it was abundantly clear to the entire world that aggregate demand was (to paraphrase Warren Buffett) falling off a cliff? The Fed didn’t bring out the heavy weapons until March of 2009, until things looked pretty bleak indeed. This is what we can look forward to if the Fed’s new paradigm becomes Second Best Punchbowlism.

It’s also important to recognize that we can’t just kill the Fed right now. We NEED monetary policy to be effective in order to implement new financial regulation (especially higher capital asset ratios) without killing the US (and world) economy by reducing the total supply of money. As we phase in higher capital asset ratios and other regulations, we must compensate by injecting liquidity to offset a decrease in velocity. This must be done in a highly coordinated fashion. Otherwise, financial regulation that aims at a long term equilibrium with a more stable overall money velocity (which I would argue is a good thing) could risk deflation in the near future (which will undoubtedly cause people to blame the administration currently in charge).

*“I’m acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve’s institutional commitment to maintaining low and stable inflation will prevail.”

Dennis Lockhart, President, Atlanta Fed, August 2008

By StatsGuy

61 responses to “Escape from Punchbowlism

  1. An Excellent post by StatsGuy. He makes it easy to read for the layman but doesn’t talk down to the reader, which is a gift.

    The Chinese are not fans of rapid change of ANY kind, and I doubt the Chinese will revalue the Renminbi at a speed which would be any help for America in the short-term. Right now the Chinese want to see a strong dollar because a HUGE amount of their national reserves are dollar denominated. But what happens if the Chinese no longer see it as self-beneficial to keep the dollar strong on world markets?? That is a question we wouldn’t want answered by future reality.

    My personal opinion is for the next 2-3 years deflation or high inflation will not be a problem. Just very low inflation. Past 2-3 years I have no idea. Personally, I would feel much more mental ease with someone like Alan Blinder at the helm (a man who believes strongly in Fed transparency).

    Ron Paul has talked about an audit of the Federal Reserve. He has also talked about ABOLISHING the Fed. Now let me make it very clear, I am NOT for abolishing the Fed. But maybe an audit would be a wake-up call for the Fed to be more diligent to regulate banks. And I think the THREAT of an audit alone would be a healthy way to get Chairman Bernanke away from the Washington D.C. dinner parties (a’ la Greenspan) and keep Bernanke’s eyes on big banks’ balance sheets.

    If Bernanke looked carefully at bank balance sheets he might find it interesting what banks label as “assets” now.

  2. StatsGuy: “When the Fed pumps money into the system to prevent deflation, the disincentive to holding cash/reserves is supposed to get money moving and thus restore the savings/investment equilibrium. In a sense, the goal is to decrease the incentive to use money as a store of value and therefore increase its use as a medium of exchange. Unfortunately, many conventional macroeconomists (unlike their brethren in the real-world finance schools) haven’t admitted that this monetary stimulus “leaks” out of their models (which focus on closed domestic economies without moral hazard). Where does it go?
    Partly, it gets sopped up by large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit. Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities).”

    So, why does the FED pump money into big financial institutions? Why not pump money directly into the pockets of the middle and poor classes?

  3. I do not agree that “taking away the punchbowl too fast” has been a thing to worry about at any time since the early 1980s.

    I do agree the Fed is in for a surprise when they try to withdraw money from “credit channels” and find that the money has somehow migrated into the personal pockets of the bankers, from which it is somewhat harder to withdraw. (Hmmm, how could that possibly have happened? Perhaps we should ask anyone other than an economist and they would be able to give us a straightforward explanation)

    I do not think Ben Bernanke lacks an understanding of what is on banks’ balance sheets, because most of the worst stuff is now on the Fed’s balance sheets. The “surprise” will be when the Fed goes to put the assets back to the private sector, and the Fed “discovers” that all the money has migrated from the “credit channels” into the bankers’ pockets, and the bankers are for some unfathomable reason not particularly interested in personally buying up all those bad assets at anything like the prices the Fed paid for them. Then the leakage becomes fixed and permanent and the dollar devaluation can begin in earnest.

  4. That’s the same question I’ve had right from the beginning of all this. If the rationale for saving Wall St was that otherwise destruction would be contagious to “Main St” (and that’s exactly how the bailouts were originally sold politically, though by now the power elite wants us to forget this), then why weren’t all available resources (infinite, evidently) used to shore up Main St, build a firewall, quarantine the disease?

    If smaller Main St banks were vulnerable to the collapse of the big banks, the government (including the “Fed”) should have “bailed out” them. And the stimulus, to the extent it needed financial middlemen, should have gone through them.

    The answer to the question is that the Fed is not there to help the non-rich, but to help the big banks expropriate them. Go with that theory, and you’ll find it accounts for all phenomena.

    I say all that as someone who came to these subjects via other routes. I think if you went to school for it the capacity to even ask questions about the fundamental ideology gets rooted out of you.

    If any system ideologue even tried to answer the question, “Why should the big banks exist at all?”, he’d say something like, “We need them in order to have this kind of globalization”.

    On the other hand, the real answer as to why we “need” financialized globalization at all, and in particular the kind which treats America as nothing more than a mine and a dump for a handful of big banks, is really nothing more than that only that kind of system allows for the existence of the big banks.

    So the reality is just a self-justifying vicious ideological circle, whose only intended practical result is the existence and aggrandizement of the feudal finance racket, and from there of corporatism in general. This explains all the evidence, and no counter theory explains any of it.

    The “Main St” concept was always a flat out lie, and I suppose according to the cosmopolitan finance elites we’re uncouth louts for insisting on still bringing it up.

    But by now even those elites, in their own lying corporate media, admit that the crisis is no longer the reason we don’t demolish the TBTF banks. Even they admit there’s no “reason” not to get rid of them other than alleged political obstacles, which obstacles boil down to the greed and malevolence of politicians, starting with Obama.

    Everywhere there are zero structural obstacles, only personnel problems.

  5. Perhaps you can invite 3-4 experts on organized crime to discuss their thoughts on the extent to which criminals have captured the mechanisms of economies? We’ve all seen the movies and read the articles about their “influence” on Wall Street. Are they the real giant vampire squid? Examples of what they can do locally, with impunity — The Phenix Story. In Italy Berlusconi is reputed to have deep relationships with the bad guys. China? Run by the Triads? It seems like a pretty simple thing: Do what I tell you to do and we will reward you. Refuse, and we will kill you. They certainly have a history of doing this. Why not do this on national bases? Global?

    Why has this never been addressed by any of the econ blogs? In reality, the impulses of a few sociopaths could have far more influence on our economies than all this other claptrap, no?

    Also, anyone know if the Caruana family (nicknamed the “Rothschilds to the Mob”) from Sicily (orig. Malta?) is closely related to the Caruana (Valencia) at the Bank for International Settlements?

  6. Unfortunately, this time around we waited until people were puking in the stairwells before taking away the punchbowl. People on Wall Street had a grand time for years before the feds took action – and in my ignorance, it was Treasury Secretary Paulson who took the reins last fall (not Bernanke) at least in the public telling of the tale.

    Federal policy cannot be viewed in isolation – it is blended today with a terribly corrupt business environment.

    I do not understand a financial sector that focuses so intently on profit that it destroys the business – but the business is salvaged by a federal government that views the company as “TBTF.”

    I don’t understand how Henry Paulson, as CEO of Goldman, was there when the company started divesting itself of MBSs because they were dangerous, yet when he came to Treasury, he wanted to fix social security… (he says in the VF story.) Really?! Knowing our financial sector was perched on a volcano about to explode, he did nothing?

    I do not understand a business community so focused on defeating competition that they throw all accounting practices out the window (How is it possible that CEOs of these banks had no idea how toxic their assets were?! How was Enron heralded for so many years at the next big thing, when it was really just a big ponzi scheme? How did Arthur Anderson allow itself to be destroyed? Yes, I’m going back a few years, but there is a climate of corruption that is far-reaching in America and it is killing the country.)

    I do not understand how TBTF institutions that have grown even larger will ever be able to stand on their own and take responsibility for their terrible decisions. We’ve established a very strong precedent that no matter how damaged their business is, it must be saved at whatever cost to the public. And those responsible generally get to keep their jobs.

    And then they get to keep the profits that immediately follow.

    None of it makes sense to me. And when the feds are dealing with a financial sector that sees profit as the only motive, I doubt there is any policy they can devise that will help in the end.

  7. Excellent post as usual, StatsGuy.

    Would we need the Fed if we came up with a standard, mathematical explanation of what constitutes a bubble?

    Is monetary policy an art or a science? The Fed seems to treat it like an art; it tries to get a feel for the economy and then time the use of its tools. And the subjectivity embedded in the process leaves the Fed open to intellectual capture. By the time they realize what has happened, dramatic intervention is required.

    Many others actually treat this as a science, following the money as you have here.

    Why can’t we just quantify “triggers” for these tools and send Bernanke and friends packing? Sure, there will be some uncertainty as far as the effect of implementing new regulations (assuming that happens), but the effects will show up in the numbers. The folks at Google could probably address our monetary policy issues better than the Fed.

  8. Great post, thanks!

    Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.

    We’ve become too reliant on limited monetary tools available to the Fed. Whatever the problem might be, the Fed’s answer over the past 20(?) years has been the same – lower the Fed funds rate. That would help with immediate symptoms, but fundamental problems have kept accumulating.

    Notice that crises of the past 20 years seem to be getting more and more severe and requiring more and more dramatic responses from the Fed (both in terms of magnitude of rate cuts and in terms of magnitude Fed’s direct intervention in capital markets, which is now measured in Trillions of Dollars). In other words, the Fed has had to come back with a bigger bowl full of more spiked punch.

    Therefore, it is of fundamental importance to decide whether the Fed should be charged with the overall regulatory oversight of the financial system, or, alternatively, whether the Fed should remain focused on the monetary policy, and another body, more independent from the financial system and more suitable for engaging in a political dialog with the Congress, should be charged with the regulatory oversight of the financial system.

    I favor the latter option: just like one doesn’t want the Congress to determine interest rate, one shouldn’t want to give private banks, who directly elect 1/3 of Board members of Federal Reserve Banks and have strong overall influence at the Fed, the ability to design the regulatory system.

  9. BG – Interesting thought, going all the way back to Friedman IIRC.

    In reality, one never wants to delegate important decisions completely to a set of formalized rules. One always needs to apply proper judgment. The current crisis is yet another example of what happens if one blindly follows models without questioning them.

    That said, it could be helpful to have those rules defined, publish their output before each FOMC meeting and then have the Fed explain why they chose to act differently if they did. Charts showing Taylor rule recommendations vs. actual rate decisions are interesting in the hindsight but could be made into a powerful policy tool if the Fed were forced to explain why it kept deviating from the rule for so long and by so much.

  10. I know it is hardly an original thought. What exactly is the “judgment” that must be exercised in what the Fed does? (I mean, aside from how power and wealth is distributed in our society.)

  11. I did not mean to use the Friedman reference in a negative sense, we are all standing on the shoulders of giants :-)

    “Judgment” should apply to the trade-offs the Fed has to make:
    – How inflation is measured (rent-equivalent adjustments, hedonic adjustments, etc)
    – What is the “natural rate of unemployment”
    Whether there are other reasons to adjust the interest rate, not reflected in the rules (which by design will always be based on old historic data)

    You follow best statistical models without judgment, you blow up as spectacularly as LTCM – except that for the Fed the stakes are much higher.

  12. Monetary policy was not the biggest problem at the Fed. Although that certainly played a part. Lack of regulations for the derivatives market, and the SEC taking an 8 year hiatus from their duties were much bigger contributors to the crisis. Again Arthur Levitt and the SEC were basically bullied by then Senator Phil Gramm that if they dared to enforce the regulations, the SEC’s funding would be taken away.

  13. ” Taylor” monetary policy rules are the closest to the “triggers” you refehttp://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3234r to.

  14. I’m not sure why those are necessarily judgment calls.

    I’m not talking about blindly following models. I’m talking about taking a genuinely scientific approach to this problem. And science does involve testing. There is nothing scientific about a bunch of people sitting around talking about how the economy feels and then drafting an opaque justification for their behavior, which cannot be scrutinized in any meaningful way.

    I think it is unfortunate that the dominant narrative for this crisis is that people were blindly following models; in reality, all our quants were doing was concealing a fairly straightforward game (any child can tell you how to play hot potato). This game would not have been played as well if regulators were not so enchanted with the financial sector and confident that the derivatives markets were manageable. All the models narrative does is make this look like an accident – even the smartest people in the world could not see this coming, etc. We would have exercised proper judgment, but you have to appreciate that this is complicated, etc.

    Right now we have a political club, and that is all the Fed will ever be.

  15. I’m talking about taking a genuinely scientific approach to this problem. And science does involve testing.

    Science also involves keeping conditions of the experiment fixed – something that is not possible in economics. That is why “physics envy” among economists, as Andy Lo put it, is both so deeply rooted and so dangerous. And that is why understanding of ever-changing causal linkages and of “natural levels” in the economy and in financial markets (call it judgment) will remain critically important to economic policy

  16. Some of this did happen – when the Fed buys government debt, and the government legislates a tax cut for lower income folks (as in the stimulus bill) – this yields exactly what you are suggesting. Everything is a question of scale, however.

    Notably, the Fed can’t easily (and legally) pump money directly into the hands of the middle class. It does not own fiscal policy (only monetary policy).

    Recently, it has stretched its authority. Some of this has benefited the middle and lower classes (notably, the repurchase of massive amounts of repackaged mortgage finance debt, which has made refinancing cheaper for people with good credit who need to convert option ARMs). But arguably, the benefits to common folk were only side-effects, since much of this policy was intended to stabilize the value of mortgage-backed financial assets and prevent banks from imploding.

    Even so, there is a great deal of discussion about whether the Fed’s newly-discovered authority is really fiscal policy in disguise. The most visible case is when the Fed takes TARP funds, “borrows” money from thin air to generate massive leverage, collateralizes these borrowed funds with treasury funds to cover losses, and goes to town.

    I’m not necessarily against everything the Fed did, but one could fashion a strong argument that the Fed has impinged heavily into fiscal policy to the great advantage of banks, and that non-banks have gotten small potatoes.

  17. This is why Scott Sumners is getting so much attention for his NGDP futures targeting idea… But notably, this is reliant on futures markets (or some other predictive market mechanism).

    There’s a weird paradox, here. If we could defie bubbles mathematically, then if you believes in the efficient markets hypothesis, the markets would just arbitrage the bubble away. If we could mathematically define bubbles, and the bubbles continued to happen anyway, then that violates so many assumptions in economics that the whole house of cards is threatened. Im sure there are hundreds of very bright graduate students working on this problem right now.

  18. Only a puritan that cannot feel the joys of a party would think of “take away the punchbowl just as the party gets going.” The punchbowl should be taken away only if it seems like the party going out of hand”, or if the punchbowl seems wasted on a party that has no chance of turning into a good party.

    I must especially thank StatsGuy for referring to the need of “better capital asset ratios (to help moderate moral hazard and asymmetric risk)” and as most simplistically do to “higher capital ratios” The lending to our unrated entrepreneurs or local grocery stores have shown no evidence of requiring more than the 8 percent in capital requirement, the lending to the AAAs with their ridicule meager 1.6 percent sure have, among others because it channeled too much lending their way. (They were given access by the host to a very special and spiked punchbowl)

  19. For what this is worth. Here are some links to the Dalai Lama peace conference in Vancouver.There are six Nobel Peace laureates taking part. Peter Buffet (yes, Warren’s son) is also part of event.

    Here is a backgrounder. You can watch it live here. Starting live today at 9:30 am PST. Mixed reviews on organized religion. But I am going to check it out.

    What I take from the organizers is being smart (the proverbial best and the brightest) is a flawed equation. Something else is needed. But what is it? That is the perennial question.

    With apologies to the quants.

  20. You mean if a bubble somehow persisted after less accommodative measures were triggered? Difficult to envision, but I’d say scientific revolutions tend to be useful in the long run.

    That logic could apply to things as they are now too, even as bubbles are not mathematically defined. If we think there is a bubble and our measures cannot tame it, then something fundamental in our philosophy is misguided (assuming we are being intellectually honest and not political in deciding how to act).

  21. Regardless of whether we should “just kill the Fed right now”, here is why Congress will not kill the Fed:

    The Fed has enormous powers to print money, lower short-term interest rates,and pump liquidity into the economy. These powers are flexible, can be implemented quickly as economic conditions change, and without much Congressional oversight.

    Administration powers to spend are less flexible- more long-term, subject to congressional approval and delays of implementation. Through “Fed capture” , the “Administration of the day” uses the Fed’s powers to supplement its own policies. Fed cooperation is easily obtained – the Fed demonstrates its usefulness, enhances its political standing, and the Fed will always find some plausible justification for their actions.

    Both Democrats and Republicans have a vested interest in the status quo of the Fed, although for different reasons. Democrats like the spending power abilities of the Fed; Republicans can protect the interest of financiers through influencing Fed regulation of financial institutions, low interest rates to bolster bank capital and trading activities, and bailouts on demand.

  22. There’s a reason why they call it “the dismal science”. Is Economics not classified as a Social Science when you take it in college?? The idea that Friedman or Taylor or ANYBODY could write an equation for bubbles is laughable. There are not and there will never be reliable “triggers”. It is not true science nor will it ever be. There’s too much psychology involved and human arrogance to ever write an equation for such things. There’s always those few folks who think they’re smart enough to beat the system. Or in the case of the housing bubble an entire mass of folks who think they can beat the system.

    And I strongly disagree with “Bond Girl” about the Fed being a political club. Who here thinks Bernanke and Geithner were chosen for their political skills?? I for one don’t. I don’t think the Fed “distributes” wealth either. The Fed may be doing a little fiscal policy now, but they wouldn’t be if bank CEOs still knew how to make a proper balance sheet.

  23. So the real problems are that:

    1. The Fed is too obsessed with inflation, and

    2. The Fed doesn’t give us enough of the punchbowl, and

    3. We should reduce the ridiculous and unfair impression that we’re poised to devalue the dollar by…. devaluing the dollar

    Sorry, but this guy should go back to crunching stats.

  24. Punch bowls. Prefer trifle with sherry myself. With Madeira even better.

  25. StatsGuy , I am not sure what kind of a “straw man” you are trying to set up in your “punchbowl” comments. Taking away the punchbowl refers to the Fed using monetary policy, i.e. raising interest rates to prevent/moderate asset bubbles so that if and when they burst, they do not cause serious damage to the economy.

    The fact is, the Fed abandoned a policy of intervening in asset bubbles about 20 years ago; Fed officials have repeatedly stated – as a matter of policy – that they would not use interest rates to moderate asset prices , except to the extent that the bubble negatively impacted economic growth, or moved a broad measure of the price level, such as the consumer price index, outside of acceptable parameters.

    The current crisis has its roots in the housing bubble. We had a housing bubble because the Fed refused to take away the punchbowl.

    Regardless of whether one believes the Fed should have or should not have taken away the punchbowl, the fact remains that excessive monetary liquidity was a substantial contributor to the current crisis.

  26. “The current crisis has its roots in the housing bubble. We had a housing bubble because the Fed refused to take away the punchbowl.”

    Certainly the Fed could have stopped the bubble in 20002-2005, but the cost for popping that bubble would have been extreme – far higher than it _should_ have been.

    Imagine that the Fed faces a pareto frontier in which it trades off inflation/unemployment in the short term. The lack of regulation in combination with huge moral hazard, in combination with the overvalued dollar that creates expectations of future devaluations (and thus capital flight), have contracted that pareto frontier. At ANY given level of inflation, unemployment is higher than what it would be otherwise.

    That is the essence of “Second Best Punchbowlism”.

    If you look at the capacity utilization time trend, in 2004 we can easily see that the rate was below 80% – well below the historical rate that we would expect to see inflation becoming a problem. (In 2004, a primary theme of the presidential debates was the “jobless” recovery.)

    This 30 year downtrend in the average (and peak) utilization rates (which co-occurs with the increase in the composition of the economy dedicated to finance and with the drop in median wages – which SJ and JK have repeatedly noted) is frightening, and as many have noted – it’s highly likely that unless we fix the structural problems with finance (and other areas like healthcare), our recovery will settle into an “equillibrium” with a permanently higher unemployment rate.

  27. unless we fix the structural problems with finance (and other areas like healthcare), our recovery will settle into an “equilibrium” with a permanently higher unemployment rate.

    A permanent high unemployment rate will require a conversion to a more European-style state with rich welfare benefits and affordable universal healthcare. Short of that, we’ll have social problems.

  28. StatsGuy. “We had a housing bubble because the Fed refused to take away the punchbowl.”

    Sorry, I do not agree. Yes there was a lot of liquidity sloshing around but the reason why this bubble really went into the stratosphere was that there were AAA rating signs (2004- mid 2008) pointing it out as a risk-free investment zone… and with the AAAs they really meant no risk at all. Without this signs this liquidity would have gone elsewhere, where it could have created similar problems.

    In other words, yes there was a punchbowl, but what made so many drink so much from it was that the AAAs pointed it out as the best punchbowl ever, not to be missed.

    And by the way your Pareto frontier has contracted because of many other reasons too; including among others your oil-addiction, your litigation mentality, your inefficient health sector (which you mention) and your extreme generosity when it comes to handing out intellectual property right monopolies (without even charging for the protection)

  29. And yet the ratings agencies continue to dictate the trustworthiness of financial instruments and entire governments.

  30. And yet a loan to a corporation rated AAA still requires only 1.6 percent in equity for the bank, compared with the 8 percent that is required when lending to an unrated entrepreneur

  31. Watched the online event. The biochemist turned Buddhist monk Matthieu Ricard more or less sums up the general problem (and perhaps specifically regarding the quants.) Quoting from memory: “With ever higher and higher intelligence the end result is catastrophe.”

  32. Anne has an understanding that has to be heard esp.”there is a climate of corruption…and it is killing the country.” We have allowed the high risk debt of banks to be handed off to the taxpayer to bail them out while right wing wingnuts assail the eventual need to drastically cut social programs as unaffordable.To me it seems as if the American people have no sense of the past beyond yesterday and the arrogance to not see the contradictions that permeate the culture.

  33. Try http://thegreatrecessionconspiracy.blogspot.com. You may be pleasantly surprised.

  34. Anne, see http://thegreatrecesionconspiracy.blogspot.com. You’ll find your answer.

  35. I do not understand why nobody seems to want to acknowledge that Business Cycles have been observed in every developed economy for 500 years. Their characteristics are observable and most everybody has agreed upon what they are. Nevertheless, apparently everyone wants to ignore these facts and re-invent the wheel. The characteristics of Business Cycles are nowhere to be found in government policies so far (which the exception of extending unemployment insurance). When Ben says he “had no road map” last October, it truly beggars belief!!

  36. Interesting that the Washington Post has a very good article on the Federal Reserve recently written by Binyamin Appelbaum. This article focuses on the Federal Reserve’s regulatory function more than the monetary function. StatsGuy did an excellent job with his post, but if I had one complaint it is that it puts to much emphasis on the monetary policy failures and not enough stress on the Fed’s regulatory failures.

    Greenspan’s TOTAL blind spot to the Fed’s regulatory responsibilities were what led to the crisis, monetary policy just made a small assist. Here is the link to Appelbaum’s story.

    http://www.washingtonpost.com/wp-dyn/content/article/2009/09/26/AR2009092602706.html

  37. I should qualify my remarks by saying I don’t blame Greenspan for the crisis, but as much as the Fed had a part in the crisis, it was because Greenspan’s ideological blindness to his duties to regulate banks.

  38. StatsGuy – can you please send me to a source for information about the efficient markets hypothesis? I see absolutely nothing efficient or rational about a market for loans made to people with no hope of ever paying them back. There was nothing beneficial in such a business practice except for the broker who got the commission.

    And of course there were gains for the bankers who bundled up crap and then sold that crap for years for a healthy profit – and then profited again when the market for crap tanked and the feds then rushed in with the bailout.

    If we continue to insist on developing policy built on the foundation of this efficient market hypothesis, the policy will ALWAYS fail to keep up with the business people so focused on their bonus that they toss good business sense out the window.

    Or perhaps, now that I think about it, the hypothesis works – the piper always come ’round to collect the debt eventually – but our policymakers are too queasy to let banks with toxic debt deal with the piper on their own – TBTF means that policy needs to be written to bail out such bankers who earned so much to accumulate such crap on their books.

    So let’s just abandon EMH, once and for all. It’s a silly hypothesis because no one has the guts to let it really work as it should.

    (Consumers, of course, who rack up toxic debt are on their own – no bailout for them!)

    And can I just toss out a hypothesis of my own on bubbles – using real estate, as an example. If real estate values, which have been puttering higher at a slow and steady pace for years, suddenly take off into the stratosphere, it’s a good bet you’re in a bubble.

    Everyone knew there was a bubble. No one wanted to stop slurping at the punchbowl, however.

    (And don’t bubbles disprove the existence of an efficient market?!)

  39. A clue:

    “Some of the Maltese merchants established on Spain’s eastern littoral in fact proved very adroit at adapting themselves to the new circumstances. They were the few who stayed on in contrast to the majority who appear to have gone home. The Cachia, Seiquer, Scicluna, Cardona and Camilleri in the City of Murcia; the Butigieg in Cartagena; the Borja and Cachia in Lorca; the Cutajar in Alicante and the Attard, Mifsud, Piscopo, Busuttil, Formosa and Caruana in Valencia all played an important role in the economic development of their respective cities int he nineteenth century (Vassallo: forthcoming). Starting out as humble pedlars and shopkeepers in the eighteenth century, they branched out into a whole range of activities during the course of the nineteenth century. They are a clear vindication of Eva Morowska’s claim (1990:203-5) that first-generation migrants often accumulate economic and human capital which, once released by the relaxation of the attitudes of the host society, is used by following generations to move into the mainstream society in a spectacular display of accomplishment. The Caruana of Valencia are a prime example of this phenomenon.”

    “The eldest of the three brothers, Peregri, who had been involved in his father’s manufacturing concern, became a particularly active figure in the economy of nineteenth-century Valencia. Apart from property speculation he was also the driving force behind the project to establish Valencia’s first issuing bank and was heavily involved in railway and potable water development…

    http://tinyurl.com/caruanas

    “Prior to joining the Banco de España, Mr. Caruana served as Director of the Spanish Treasury and headed investment services and fund management companies for nearly 10 years.”

    Does anyone know which services and companies? Whose funds? The Caruanas had a Bishop in Malta, as well as some titled citizens, and a Caruana was the chief minister of Gibraltar. A strong tradition of art in the family had young Caruanas making plenty of visits and studies in Italy and tutelage by Vatican painters. Does Jamie of the BIS maintain any ties to Malta or to Rome?

    Do he and Alfonso know each other? Alfonso looks to have been (still is?) king of the Canadian drug world.

    http://en.wikipedia.org/wiki/Alfonso_Caruana

  40. The financial regulator’s exam

    1. Do you believe that the capacity of a client to repay his debt to a bank is so important to the health of the financial system and the economy so that you should not have any other concern than measuring the risk of default?

    2. Do you believe that risk of default could be defined and measured in such a consistent way so as to be used for establishing different capital requirements for banks?

    3. Do you believe there are credit rating organizations capable to resist being captured by those rated even if their ratings are used for establishing the capital requirements of banks?

    4. If you decide to use different capital requirements for banks dependent on credit ratings will this be sufficiently transparent for the markets and not distort their risk allocation mechanism?

    5. As a financial regulator do you see it your duty to stop any bank from defaulting?

    Our financial regulators answered yes to all questions above and that is why we are in a mess. What is most incredible is that we allowed our financial regulators to elaborate and correct their exam themselves. From their answers anyone should have been able to see they were not ready to be financial regulators.

  41. “First found in Sicily, which has included the island itself, Naples, and the southern portion of the peninsula. Research shows that records of the Caruana family date back to the year 1189 when a member of the Caro family was the Archbishop of Monreale, a town just outside of Palermo.”

    http://www.houseofnames.com/xq/asp.fc/qx/caruana-family-crest.htm

    (This is weirdish, considering that the base of operations for the Canadian Cuntrera-Caruanas was Montreal)

    http://en.wikipedia.org/wiki/Cuntrera-Caruana_Mafia_clan

    Per, note the fondness of the Cuntrera Brothers for Venzuela.

  42. Burton Malkiel’s “A Random Walk Down Wall Street” is a good one Anne. Just get the used paperback. It’s a very good read. Just a few jargony parts. But easy for you I think.

  43. The regulatory blindness crossed all ideological borders… ask Simon?

  44. Actually, James posted a good intro a while back…

    http://baselinescenario.com/2009/07/20/efficient-market-hypothesis-no-free-lunch/

    And Mike Rorty raised one practical problem that rarely gets any attention in formal models – the lack of unlimited liquidity.

    http://baselinescenario.com/2009/08/21/the-limits-of-arbitrage/

    As to a backgrounder, Wikipedia does it better justice than I could do on my better days anyway…

    http://en.wikipedia.org/wiki/Efficient-market_hypothesis

  45. Amazing!! Crabby old Ted K and I actually agree on something. Maybe there is hope for the country after all.

  46. StatsGuy, great article. Lucid and amazingly intuitive for your readers. Something interesting to consider, that occurred to me as I read the paragraph ending: “This latter point is not entirely intuitive, and I might argue that the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.” What occurred to me, and maybe I’m just naive is that there is a major reason why China is wanting to establish some new neutral international reserve currency to replac the dollar: Currently they continuously invest in our economy, not to make money, but to support the value of our currency. It’s their version of the hedge which operates to their benefit, so long as they can control the dollar’s value by careful manipulations. The reason why they wanted a currency to replace the dollar is multifold, first they can’t ascend to any kind of global dominence as long as they must continuously expend large amounts to prop up our dollar, and they don’t want a perminent symbiotic relationship with us which prevents them from having real independence and using resources to help create other markets for their goods, especially since they see a long term drop in exports for the foreseeable future (so long as we are mired in something resembling perpetual low level recovery — which I see as where we are headed).

    I just hope that we can help them break this cycle, because I actually feel that it will hold both of us and the world back from a better future sooner. I believe that whatever is good for the host is also good for the parasite (I don’t know who is who in this case, but maybe both are both in some ways.).

    Much of the effectiveness of any cure for this issue will come from the Fed, Treasury and Congress getting serious about regulation, and bringing big finance back into its appropriate interest in the GDP (more like 15%, and less like the current, which is absurd at best.).

    Back to Simon and James insofar as taming the oligarchs’ plutocracy. It’s probably time to get back to democracy and away from Michael Moore’s version of capitalism (right now our “capitalist” economy looks a lot like the French economy right before the revolution, and unless we can change, we will have our own version of 1775-6 in France, no doubt, and it won’t be pretty.).

  47. Just kind of in reply to a few of the comments from Bond Girl, specifically “Would we need the Fed if we came up with a standard, mathematical explanation of what constitutes a bubble?”:

    One of the issues here is that (at least as I see it) Monetary Policy should be evolving over time to better develop techniques that will allow the fed to achieve it’s goals of maintaining price stability and full employment…

    The fed is not just a tap of cash to turn on and turn off, in fact this function of the fed has been somewhat more of a science with techniques such as the Taylor Rule, which aim to make the determination of the interest rate a more mathematical and transparent procedure.

    However other functions of a central bank, including operating the discount window, conducting open market operations, and intervening in the foreign exchange market, need a lot more judgment (and secrecy, imagine if traders knew that the Central Bank would always intervene in the Forex market given a specific ‘trigger’!).

    One quite recent and important innovation is the ability for the fed to issue short term bonds, (which the Central Bank does here in New Zealand as well as in other countries). This innovation required congressional legislature to pass, but it will help the fed to put a floor on interest rates as they increase, by issuing extremely liquid short-term (overnight/30 day…) ‘bank bills’ that are for all intents and purposes, interest bearing cash.

    Sweden has experimented with negative interest rates (-0.25%) on deposits held overnight at their reserve bank.

    One potential (but unlikely in any country) policy that could be pursued by a central bank would be to limit the growth rate of the total pool of mortgage finance in the country. (This may sound easy to get around by calling loans non-mortgages, but non-mortgages require quite a lot of capital under Basel II, so ‘putting your house on your credit card’ would carry heavy interest rates) So the total pool if mortgage finance in a country would be pretty easy to regulate. You could set a growth rate each year at trend gdp. That would be pretty bubble-preventing.

    But such innovations require a Central Bank with a lot of autonomy, independence, and clever people.

    Now potentially, the gains of all these innovations (and of having a central bank at all!) are not large enough to justify the existence of the fed, or the people at the fed are just not clever enough to do any good! In either case it would be pretty reasonable for the fed to be reduced to a Taylor Rule, automatic punchbowl machine, or to go to commodity money.

    I personally believe however, that central banks can do better, but must be able to innovate.

  48. Are we now supposed not to blow balloons for ever more?

    Perhaps we would all have loved to have seen a bubble but in another sector, like that of renewable energy, as it seems that without such bubbles the world might not stand a chance.

  49. Here he is. Apparently he ran Rent4, and a few other things along with getting involved in govt.

    http://books.google.com/books?id=neKm1X6YPY0C&pg=PA283&lpg=PA283&dq=%22caruana+lacorte%22&source=bl&ots=l2U0vjlPOV&sig=U8dnRRaKLRKsVd7HuphWxbiQxd4&hl=en&ei=vLXASvzQGZGgswOp9YUp&sa=X&oi=book_result&ct=result&resnum=3#v=onepage&q=%22caruana%20lacorte%22&f=false

    His spanish wikipedia page has his full(?) name: Jaime Caruana LaCorte. There is also a Jaime ‘Felix’ Caruana LaCorte floating around out there. Same fellow?

  50. “…the cost of popping that bubble would have been extreme..”

    That essentially was Greenspan’s argument. He nor you ever explained why the cost would be extreme. Is the cost greater than the cost of the current crisis- the most severe financial crisis since the great depression?

    The current crisis has its origin in the housing bubble. You likely would not have had the bubble without the excess monetary liquidity.

    The excess monetary liquidity enabled price speculation to develop and gain traction. That speculative opportunity was seized upon by mortgage investors and levered derivative players.

    Without the initial Fed induced speculation, the mortgage speculators would not have had the opportunity which they took advantage of.

    Its a lot like baseball: the Fed put the bubble across the plate; financiers drove it home.

  51. fwm “You likely would not have had the bubble without the excess monetary liquidity.”

    Oh yes you could… the way the AAA ratings were pointing at it as one of the greenest no-risk valley in town too much liquidity, even if not excessive, would have gone there.

  52. Someone needs to explain the difference between debt and currency in terms of money.

  53. “It’s also important to recognize that we can’t just kill the Fed right now.”

    Oh yes we can!!!!! I think you are just worried about losing your overpaid job as an economist.

  54. This is precisely the point – for lack of a scalpel, the Fed’s only option was the sledgehammer, and neither outcome (bubble, or possible depression) was desirable. How does one explain why the rate-raising sledgehammer was needed in 2004 with capacity utilization at 78%?

    The answer is that the liquidity generated by the Fed was not being channeled into productive investment, but rather was leaking into bubbles and capital flight due to poor regulation and an overvalued dollar. These leaks are crippling the effectiveness of monetary policy as a tool to avoid unnecessary drops in utilization rates, (and by extension widening the fiscal deficit due to lost taxes, lower growth, and costly social support/unemployment programs).

  55. Your article was fun to read.

    I also enjoyed reading the exchange of ideas with BondGirl about bubbles and what will happen once they are defined. Personally, I think that once bubbles are defined there may be a few new tools for policy development that will help avoid imbalances between the real economy and financial sectors. I guess we’re just waiting to hear from those all from all those graduate students working on the problem!

    I always liked reading Keynes so I can sincerely appreciate your hesitancy to shift away from the use of “leaks” in the system. (I have had to work really hard on realizing the limitations of a couple of Keynes’ interesting concepts). You gave me the sense that your use of the term “leaks” was qualified; “Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities)….The monetary stimulus also “leaks” due to globalization of capital flows. It flows out of the country through a variety of mechanisms that traders might describe as dollar hedging (into commodities, foreign assets, and an anti-dollar carry trade).”
    So tongue in cheek – do you think we need some new terms – such as “flood”, “gush” or “surge” or “swoosh” ? Just wondering!

    I am looking forward to reading more!

  56. “…the Federal Reserve’s expansionary monetary policy supplied the means for unsustainable housing prices and unsustainable mortgage financing.”

    http://www.cato.org/pubs/journal/cj29n1/cj29n1-9.pdf

  57. “..Fed interest rate policy, especially from 2002 through 2005, promoted easy credit and kept interest rates very low for a protracted period……Accommodative monetary policy and a flat yield curve meant that credit was excessively available to support expansion in the housing market at abnormally low interest rates, which encouraged overpricing of houses.”

    http://www.cato.org/pubs/journal/cj29n1/cj29n1-7.pdf

  58. ” … the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.”

    Unsurprisingly since the consensus (weaker dollar/stronger yuan) is probably wrong. The peg is what it is, it serves the Chinese as well as it serves the US. At the same time, it allows the Fed to export inflation to China; it’s just another kind of carry trade.

    What occurred to me, and maybe I’m just naive is that there is a major reason why China is wanting to establish some new neutral international reserve currency to replac the dollar: Currently they continuously invest in our economy, not to make money, but to support the value of our currency.

    Another reserve currency handed to them on a plate is the only way the Chinese establishment can see their way out of the colossal jam they’ve made for themselves. The USA is too big to fail.

    Since a new replacement reserve currency is not going to happen, China remains the 51st state.

    Also, nice to read a solid article about the Fed, without the ‘Kill the Fed’ hysteria. No mention of energy, however. The economy runs on energy, credit is an outlier, it is simply another way to allocate (scarce) energy. Think about it.

    We needed the four extra Saudi Arabias ten years ago to keep crude prices @ $15 a barrel. This conversation would not be taking place with those extra Saudi Arabias.

    An asset bubble is just another way to hedge inexorably rising crude prices. This is why the establishment is working so hard to craft another one.

    steve