Fed Chest-Thumping for Beginners

I generally avoid writing about monetary policy, since every economics course I’ve taken since college has been a micro course, and besides Simon is a macroeconomist, among other things. But since just about everyone in my RSS feed has been linking to Tim Duy’s recent article on the Fed, I thought I would try to put in context for all of us who don’t understand Fed-speak.

Duy takes as his starting point a series of statements by Fed governors and bank presidents indicating “hawkishness,” which in central banker jargon means caring primarily about inflation, not economic growth. (“Doves” are those who care more about economic growth and jobs, although, just like in the national security context, no one likes to be known as a dove. This itself is a disturbing use of language, since it implicitly justifies beating up on poor people, but let’s leave that for another day.)

Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do. But I digress again.

This is what Duy sees:

  • Kevin Warsh of the board of governors: “If ‘whatever it takes’ was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed’s institutional credibility.”
  • Richmond Fed president Jeffrey Lacker, from Bloomberg: “The Federal Reserve will need to raise interest rates when the economic recovery is ‘firmly’ in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.”
  • Philadelphia Fed president Charles Plosser: “[J]ust as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. …  The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.”

Can you feel the testosterone?

Duy argues that all this manliness is misplaced. The Fed hawks’ basic argument seems to be that, because it acted so aggressively to stimulate the economy last year, it will have to act equally aggressively to dampen growth at some point — just to send a message. And to send that message, they need to be willing to raise interest rates while unemployment is still 10% (Lacker) or “well before unemployment rates and other measures of resource utilization have returned to acceptable levels” (Plosser).

Now, there may be something to this. Duy points out that the hawks seem to be worried about recreating the debt bubble of the last decade through too much cheap money. If cheap money is going to flow straight into overvalued houses, then that’s a problem. But Duy says that that is a failure of regulation. Low rates are supposed to stimulate capital investment by businesses, which is what long-term economic growth depends on. But earlier this decade, despite low rates, capital investment never returned to 1990s levels, because all the cheap money was flowing into housing instead — for reasons we know.

“Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade’s debt bubble? …

“With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.”

The solution, then, is better regulation to protect against misallocation of credit to the next asset bubble. Simply raising rates will choke off an asset bubble, but it will also choke off real investment by businesses.

This goes back to what StatsGuy said in a post here:

“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). …

“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.”

In other words, if you’re going to throw in the towel on regulation, then there is no place for cheap money to go except the next asset bubble. You might as well try to prevent that, but then you are consigning the real economy to a long, slow decline since you have no way of getting monetary stimulus where you need it (factories, not new condo towers).

So there seem to be two possible futures. If we repeat the Greenspan policy of low rates during a boom, we’ll just create a bubble all over again, since none of the underlying factors (weak consumer protection, weak bank regulation, etc.) have changed. Or if the hawks win (both in the Fed and in Congress, which controls fiscal stimulus), we’ll have high unemployment for a long, long time, since no one will have the guts to risk higher inflation. Being a “hawk” has become the safe, comfortable choice — even in a week when monthly job losses were up and weekly new unemployment claims were up.

By James Kwak

42 responses to “Fed Chest-Thumping for Beginners

  1. Tim Duy does as many others do and base their assumptions on the belief that the Fed operates in a vacuum. Those days are gone. Bernanke and the Fed will be forced to react due to external, global developments instead of acting to influence, control global monetary policies. A defensive posture, not an offensive one.

  2. So the unspoken argument is that if we fail to regulate, the Fed should abandon its hawkish stance and allow high inflation and risk the next asset bubble all to keep unemployment a bit lower temporarily? I can see why you wouldn’t want to expound on that.

    Perhaps hawkishness has finally become the safe, comfortable choice because we have finally learnt that high inflation is bad for everyone in the long-run, rich and poor. I guess that common-sense view doesn’t allow bad faith to be ascribed to the Fed tho.

  3. As Churchill said, “better to jaw-jaw than to war-war.” The point of all this “hawkish” talk is to keep inflationary expectations in check, precisely so that the Fed isn’t forced to take hawkish action. Whether management of inflationary expectations is really enough remains to be seen.

    StatsGuy’s thesis that the Fed will err on the side of taking the punch bowl away too soon and giving it back too late is abundantly contradicted by real world experience, where in fact the Fed takes the punch bowl away too late and brings it back as soon as things have clearly turned down.

    Bernanke was unprecedentedly rapid (even radical) in his interest rate cuts. Please let’s not pretend that things would be any different today if Bernanke had been even more aggressive than he was.

  4. “So the unspoken argument is that if we fail to regulate, the Fed should abandon its hawkish stance and allow high inflation and risk the next asset bubble all to keep unemployment a bit lower temporarily? I can see why you wouldn’t want to expound on that.”

    Uh, no. Nobody is making that argument, spoken or unspoken. That’s merely a third possibility that nobody will find palatable

    “Perhaps hawkishness has finally become the safe, comfortable choice because we have finally learnt that high inflation is bad for everyone in the long-run, rich and poor. I guess that common-sense view doesn’t allow bad faith to be ascribed to the Fed tho.”

    Again, no. If hawkishness has become the safe, comfortable choice, it is only because we have accepted that we will not use all the tools we have available to us to prevent the creation of a new bubble. “Easy money” does not arise solely as a result of monetary policy. In fact, the dominant driver of easy money over the last decade was the unregulated and underregulated extension of credit. While it is true that what passes for common sense these days tells us that all regulation is bad and that it is all the Fed’s fault, the facts prove that, while such views are common, this doesn’t make much sense.

    The argument is that we cannot fail to regulate.

  5. I have always wondered why the Fed doesn’t use all the tools in it’s quiver. It does seem that the “sledgehammer” to use Statsguy’s phrase, of interest rate setting is the only tool they employ. I realize during this crisis, they have rolled out a whole host of new tools that go beyond interest rates, all to effectively do the same thing as low interest rates would do since they can’t go lower than 0%.

    However, the mandate for economic stability gave the Fed the power to set margin rates on investment accounts, the idea being that during booming stock markets the Fed can raise the margin requirements and not only slow the market advance but make sure people, institutions etc. aren’t caught with their pants down during a crash. This tool hasn’t been employed for decades, keeping the margin limits at 50% on stocks and higher on more “stable” investements. Just think of how much less liquidation would have been required last Fall if the Fed had raised the Margin requirement during the 2003-2006 market upswing to 60% or so vs. what happened? Or again in the late 90′s? Rising it slowly like it does with interest rates. This would be a great tool for economic stability, that’s why it was given to the Fed after The Great Depression.

    The complete lack of use of this tool also shows that the post-Volker Fed has basically abandoned the mandate of economic stability and focuse exclusively on fighting inflation. Why? Because the last great financial crisis in this country was the stagflation of the late 70′s and early 80′s. Maybe this recent crisis will shift that priority, but it seems the Pentagon isn’t the only organization in America that is constantly fighting the last war.

  6. Yeah, like the Fed wants actual reform. That would require them to admit that the crisis was the logical consequence of bad decision-making, not a loss of confidence in the system. Then the Fed’s heroic intervention would look a little more like accessory to theft.

  7. What kind of regulation would accomplish this: “avoid new liquidity being channeled into bubbles instead of real investment”? Doesn’t it sound somewhat like central planning?

  8. “…then there is no place for cheap money to go except the next asset bubble.:

    Otherwise known as the stock market.

  9. James said: “because all the cheap money was flowing into housing instead ­ for reasons we know.”

    Wouldn’t it be helpful for James to rephrase his comment to what really happened, as an example: “because all that bogus money inflated the price of housing – for reasons we know.”

    The local culture — where housing gets constructed — has not seen cheap money in decades. We did get quite a ride out of the bogus money that fake bonds put into circulation. However, like all investments that are not supported by real value, we are now paying the price for a mess we did not create.

    Today, the large banks are borrowing money from the FED at near zero interest, credit cards, again, are offering 17 – 31% interest for the FEDs bogus money. The banks get cheap money, and the local culture pays the price. Clearly, this mess is going to be a slow fix, since neither the FED, Treasury, nor the Banks have a clue as to how to build a value supported economic culture.

    When the national banking system, 30 years ago, was small banks loaning only within their county, how easy it was to put that cheap FED money in the hands of small, innovative businesses. One can name any number of large corporations today that were placed on the road to being big businesses well before the local banks began to merge into the weird collection of financial services we have today. And, I might add, have brought one mess after another.

  10. Paul Volcker recently on the Charlie Rose show.

  11. Dan P,

    Insisting that people say things with the spin you prefer is bad manners. What our host has said if factually accurate, and though you’d prefer more emotion and finger pointing, factually accurate ain’t wrong. The comments section gives you plenty of room to speak in your own voice, without implying that what our host has said is wrong, simply because it doesn’t spin as hard as you’d like.

  12. Daniel Habtemariam

    The primary argument is indeed that we cannot fail to regulate.

    But I’d say the secondary argument is that it’d be nice if we could altogether incentivize businesses and individuals to direct their excess capital into ventures that utilize the excess productive capacity in the U.S. at the moment.

    Failing to regulate would mean a financial crash occurring again in the future. Short of that, failing to encourage traditional fixed investments (the kind that ultimately makes use of blue-collar Americans) means long-term unemployment and the continued emergence of the two-track economy in the U.s.

  13. What Wally Said. But there’s a legitimate question how much new money is actually going into the stock market.

    Those cheering the Fed’s “let’s get tough on inflation” stance are reminded that this was precisely the Greenspan argument of 2002 et seq. What it led to–because people aren’t as stupid as some Fed governors hope–was a flattening of the yield curve when rates rose, precisely because of the lack of real inflationary pressure. (The disingenuous argument offered above that inflation-fighting is required by “global forces” is precisely backwards.)

    So you’re inviting the next bubble. Probably not housing–though, as Rush Limbaugh pointed out recently, lending to an additional 1-2% of the population didn’t cause the crisis, leveraging those loans by a factor of 40 or 50 did–but probably in the ABS or lend/lease markets.

    But, of course, then the complaints will again come from the same sources who argue “WIN” now about how Evil the Bubble was.

  14. Amen, kharris. I wish you could make that point to everyone on the Internet!

  15. I am unable to grasp this whole recovery business.

    Unemployment is still rising and the only thing that’s good right now is that the financial system is not collapsing.

    Is that the new recovery normal?

  16. GDP is no longer contracting. That’s all. Recession refers to the first derivative, not the absolute level. It’s like falling off a cliff and cheering because you splattered your guts on the ground.

  17. With a “W” just around the corner, the last thing we need is a Fed that is either trying for political correctness and acceptance by seeming to act responsibly, but in fact pressing down any real recovery by raising rates. I understand about the possibility of inflation in the future, some time, some day, but for the next year or two, at least, that is the last thing to be worried about. I can’t even imagine a bubble coming within the next 5 to 7 years, let alone soon, and inflation, wow, how is that possible in this (negative, struggling) environment. The fact is that much of the money has flowed toward the (propped up) finacial sector, either directly from the Fed and TARP, or indirectly from markedly higher saving rates.

    This recession stands a good chance of becoming the new normal, and here we are talking (already) about fears of inflation. If anything we need more, and more directed, stimulus, although Congress won’t add more to the national debt (reasonably) but may change the distributional percentages in the current recovery bill (also reasonably), since it really isn’t infrastructure that is likely to go far to stem the slippage in economic activity and (long term) unemployment.

    The Fed needs to find ways to assist in growing a new economy and repairing the (out of kilter) financial sector. That is all they need to do, before we have a real armageddon and fall off the much sought after cliff into the dreaded abyss of permanent third world status.

  18. One key bit of information about Fed policy that I didn’t really become aware of until recently was the extent of Fed efforts to support the credit system back in Fall of 08 _without_ letting that money get into the hands of the general public.

    In other words, the widely observed increased in base money was offset by a huge plummet in velocity. You can see this at the St. Louis Fed charts…

    http://research.stlouisfed.org/fred2/series/AMBNS

    http://research.stlouisfed.org/fred2/series/MULT

    There’s a huge debate about what caused this, and MANY people chest-thumped about immediate hyperinflation. Yet we got near deflation. Much of this can be attributed to a decrease in demand for credit (let’s call this “demand side” deleveraging).

    At first I thought the Fed just didn’t seem to get the demand side story… but lately, after reading various posts by Madison (such as the one linked above) and S Sumner, I’ve come to wonder…

    Even while flooding various credit channels with liquidity to support the financial system, the Fed did two things to STRONGLY encourage banks to hold onto that excess liquidity – they started paying them interest on reserves (equal to the overnight rate, which means the Fed is creating money and then paying banks interest to sit on it) AND it _sold_ t-bills to the public (to suck money out of the system).

    This action is entirely consistent with the Fed’s stated belief that the root cause of the decline was credit channel blockage, which Dallas Fed President Fisher STILL expresses here:

    http://research.stlouisfed.org/fred2/series/MULT

    and which Sumner takes apart here:

    http://blogsandwikis.bentley.edu/themoneyillusion/?p=2419

    Fisher calls it the “Evil Credit Channel Blob”, and says that this blob made a severe recession unavoidable. Fisher, btw, is an inflation hawk.

    In other words, the Fed explanation for the economic disaster was “the banks aren’t healthy”.

    (I have to say, hearing Obama champion that position – free flow of credit is the lifeblood of the economy – was exruciatingly painful, and remains so whenever I think about it.)

    So, they channelled huge amounts of money into the banks to keep them healthy (making everyone scared of inflation) but (as James Hamilton noted) they “sterilized” these efforts by sucking money out of non-banks and simultaneously paying the banks to sit on the new money (even what publicly claiming the banks would “put that money to work”, which of course they didn’t – not that anyone expected them to).

    If this doesn’t clearly spell out the Fed’s priorities, I don’t know what does:

    1) Protect the banking system at all costs.

    2) Assuming the banking system is steady, do whatever is necessary to keep inflation low – which of course means that bank assets will lose value, but that’s OK because you can deploy all sorts of mechanisms to suck money out of the rest of the economy and funnel it into banks

    3) Cross your fingers and hope unemployment goes away, or else the politicians might get uppity and try to interfere with the central bank autonomy (which is critical to achieving #1 and #2).

    It seems the Fed finally caved and committed to a meager 300 billion in QE around March (which marked the beginning of the recovery) only because it became clear that unless assets reflated, no amount of infusions from Treasury were going to keep the banks afloat.

    Can anyone point to any evidence that the Fed’s priorities deviate from this description?

  19. I bet you couldn’t see a bubble coming 5-7 after the dotcom bubble Fed policy.

    It is also interesting, that you are worried about the unemployment in the long term, but with economy you choose the short term. Purpose of infrastructure investment is not only to spur jobs on the short term, but create the backbone of production based economy for the next few decades.

  20. You had Bank of America that paid $5.8 billion in bonuses, which they didn’t tell shareholders about. Then after the SEC exposes their lies, they agree to only charge them a $33 million fine. Let’s see, $33 million divided by $5.8 billion= what percentage???? I mean wow……..

    Maybe the Federal Reserve won’t have to give unlimited credit to large banks, if the large bank executives stop spending it on exorbitant salaries for themselves and large bank CEOs learn how to value assets on their balance sheets.

  21. Quite the contrary, it means:

    1) Removing the artifial anti-market support for the US dollar, which is harming US competitiveness and encouraging traders to bet against the dollar long term (since they know that at _some_ point in the future, the US will no longer be able to provide that support, and that the longer the artificial anti-market support continues, the worse the future adjustment will be).

    2) Either removing the federal government deposit guarantees and implicit TBTF guarantees (which I do not favor, since the resulting bank run would likely destroy the world economy) OR employing standard second-best regulation to ensure that beneficiaries of these guarantees do not abuse them by making excessively risky bets on short-term securities (with the Fed or Treasury owning the downside). The government-sourced incentives to invest in highly volatile short term securities effectively crowd out productive long term investment. Thus, a new bubble emerges long before capacity utilization has recovered, forcing the fed to tighten.

  22. On this note…

    This whole mantra that “Employment is a Lagging Indicator” is a lark (sadly repeated by President Obama) – it supports a belief that employment recovery is not required for the first year or two of recovery. It’s an excuse for the Fed to avoid facing reality until 2 years from now, and to deflect demands that it use monetary policy to support capacity utilization.

    The Fed and OMB and CBO all project that employment “won’t” return to normal (~5%) until 2012… Because, you know, that’s what the old historical business cycles looked like. This sounds pessimistic, but actually that’s the _optimistic_ case.

    Does anyone seriously believe we’ll get back to 5% by 2012? We’re almost certainly breaking 10% by Jan 2010. We would have to see AMAZING job growth to achieve 5% in just 2.5 more years – and the 10% unemployment rate understates matters. There are underemployed, discouraged workers, and elderly folks who are delaying retirement/re-entering the workforce.

    Let’s put it this way, the CEOs of America’s top companies don’t seem to believe it…

    http://www.msnbc.msn.com/id/33070643/ns/business-stocks_and_economy/

  23. I agree with a lot of what you say, and you state it logically. One part that I disagree with is #3—a “Fed priority” that politicians would interfere with central bank autonomy—the Federal Reserve IS the central bank. They certainly don’t want to have their own power taken or even threatened. We can see this with Bernanke’s little verbal spats with Ron Paul.

  24. Loose money will continue to create bubbles, primarily, under any conditions unless and until we move from a financial economy (effectively gambling) back to a real economy (production and consumption of real goods and services).

  25. We currently have am “asset bubble” (albeit short term) in the stock market because the loose monetary policy for the banksters has them playing in the market and sucking out what money is left held by the suckers who still think thee stock market is a fair game.

  26. We’re arguing that raising interest rates is too blunt an instrument, because it raises the hurdle for desirable investment in productive enterprise, as well as for less desirable investment in housing and asset price bubbles in general. Then we’re claiming that regulation is needed to steer investment away from excess housing and asset price bubbles, and towards more productive investments.

    All this assumes that regulators and their political overseers agree that measures should be taken to reduce the amount of money put into housing and other asset price bubbles, and put instead into more productive investments. What is the evidence on this? Well, Larry Summers, Geithner, Bernanke, Frank, Dodd etc have all made keeping air in the housing bubble a core goal of their economic strategy. Of the trillions of govt money pumped into the economy in the last 12-14 months, most has gone into house price supports.

    The evidence is that regulators will continue to favor investments in housing over productive enterprises. Only by changing this bias will it be possible to get more money into the hands of entrepreneurs who want to expand production, at a cost they can afford.

  27. Clearly some form of regulation is needed. But the question is what kind of regulation?

    In reading the posts and links this week, I can understand Bond Girl and Per Kurowski’s critical view of regulation. Basel, the FED under Greenspan and other agencies — aided, abetted and institutionalized — the AAA-rating that allowed junk bonds to be sold as 100% risk free.

    The philosopher Francis Fukuyama famously opined “the end of history” had arrived. Meaning that society had evolved into its final stage: A golden era of liberal democracy and free market triumphalism.

    Then in September 2008 the whole thing collapsed. If not for socializing the losses the world would be in a Depression. The investment banker Chris Whalen says here taxpayers will be paying for the bailout for the next 100 years.

    So much for regulators and theorists who claim they know what they are doing.

    But back to my point. Regulation is needed. But what kind of regulation? And where is the political will to serve the public interest?

  28. Bond Girl and Min,

    The investment banker Chris Whalen, testifying before a congressional sub committee, says he is not a big fan of regulation.

    Whalen does not share Taleb’s view new financial products should be reviewed like new drugs by the FDA. Whalen says the government does not have the competence to analyze complex securities. He says the Fed is populated by monetary economists who could not even work on Wall Street.

    Rather, he says, take a minimalist approach.

    (1) Let the markets discipline the behaviour. Increase liability to the issuers by forcing disclosure and SEC registration. The trial lawyers for the large buy-side investors will make sure the financial instruments are credible. Otherwise the trial lawyers will “come over the hill like barbarians and they will feast”.

    (2) Make dealer own some of the risk. They cannot just abandon their client after making a complex deal.

    His minimalist approach makes sense. What do you think?
    ____

    Hat tip to SJ and JK for link to congressional hearing. — Fascinating talking heads. — Greg Berman, James Rickards, Chris Whalen and David Colander in final 30 minutes.

    http://science.house.gov/publications/hearings_markups_details.aspx?NewsID=2586

  29. Just to add a little propellant to your fire:

    “In the U.S., small businesses employ 50% of the country’s workforce and contribute 38% of GDP. Without access to credit, small businesses can’t grow, can’t hire, and too often end up going out of business. What’s more, small businesses are often the primary source of this country’s innovation. Apple, Dell, McDonald’s, Starbucks were all started as small businesses.” Meredith Whitney

    http://online.wsj.com/article/SB10001424052748704471504574445470989162030.html

  30. Roger K. Brown

    ummm, no…. We have been working under a minimalist approach for the last 20 years. We have volumes of meaningless reguleations. I’d prefer a maximalist approach but the good news for Whalen is that Bernanke and Obama agree with him and you.

  31. Thanks Roger, I am pro regulation but open to hearing other views. By forcing disclosure and SEC registration, Whalens says, if the financial instruments are flawed the trial lawyers will “come over the hill like barbarians and they will feast”.

    Perhaps this is a lighter regulatory touch that could serve a similar aim.

  32. Fed-speak: The Long “Con”

    All of the “hawkish” comments are an attempt by the Fed to manage expectations and convince the public that they are “really” serious” about controlling inflation. They need to keep inflation expectations down. If the market believes that the Fed will keep interest rates too low for too long, bond yields will rise and undermine the recovery. On main street we call this a long “con”.

    Its a con because the Fed is trying to trick the market into believing something that the weight of evidence suggests will not occur. History teaches us that when government/Fed debt becomes as large as it is projected to be, when push comes to shove ,the easiest path to reducing the burden of debt is to create inflation by printing money. The view that inflation is the most likely exit strategy, is supported by the markets belief that the dollar will need to be devalued, and the way to do that is to create inflation. Its called a long con because we won’t know for a number of years how all of this will play out. In the meantime, the Fed hopes to keep the market on a short expectations leash.

    Fed Policy,Bubbles, and Leverage:

    Much of the current discussion centers around how to control excesses that develop during the business cycle, and how to mitigate the damage to the economy and taxpayers, when bubbles burst. Leverage is often cited ass a major component of the problem.
    While leverage is undeniably an key issue, it is important to keep in mind that leverage does not work unless the return on investment exceeds the cost of financing that investment. You lose money and there is no incentive to invest when the return is less than the cost of financing.
    So the key elements here are the return on investment and the cost of financing. The return on investment consists of two components – income and price appreciation. The income part, like profits or rent, is based on fundamentals; the price appreciation component is more speculative in nature. Pure speculation kicks in when the income part becomes minor and the asset is purchased primarily for its expected price appreciation; the asset is bought and sold like “pork bellies” -a commodity.
    Speculation is propelled forward by leveraged players who magnify their returns by arbitraging the spread between the price appreciation return and the cost of financing the investment.
    The big investment banks- GS, Bear Stearns,Lehman, and others played a key role in the current financial crisis. At the height of the crisis they were highly levered and perhaps half of their financing was short-term debt. The cost of that short-term debt was ,at the margin, set by the Federal Reserve. The Fed controls short-term interest rates through the Federal Funds rate. Loose monetary policy kept the real Fed funds rate unusually low during the period 2001-2005.
    The low interest rate environment initiated the speculative buying in housing. The housing bubble gained traction as the speculative price increases continued to outpace the marginal cost of funds set by the Fed.
    But for the loose monetary policy, leverage would not have been as effective, and the current financial crisis more benign.

  33. Stiglitz attributes the easing of credit to widening income inequality. Has anyone seen an article/data substantiating this claim?

    In the US the compression of low incomes was compensated by the reduction of
    household savings and by mounting indebtedness that allowed spending patterns to
    be kept virtually unchanged. At the same time, the limited safety nets forced the
    government to pursue active macroeconomic policies to fight unemployment,
    increasing government debt as well. Thus, growth was maintained at the price of
    increasing public and private indebtedness.

    Most European countries tread a different path. The redistribution to higher
    incomes resulted in an increase in national savings and depressed growth. In the
    past fifteen years the institutional setting, notably the deficit constraints embedded
    in the Maastricht criteria and in the Stability and Growth Pact, resulted in low
    reactivity of fiscal policies and restrictive monetary policy. Together with a
    financial sector less prone to innovation, this limited consumer borrowing. The shift
    in distribution resulted in soft growth.

    Fitoussi/Stiglitz, OFCE 07/2009

  34. It seems to me that even now, the Fed and Treasury’s actions still reveal a bias toward helping out the banking sector at the expense of both long-term economic growth and stability, and inflation. The fact is that US banks still have huge holdings of mortgage and CDO assets on their balance sheets. Changes in accounting rules, fiscal stimulus and the low interest rate environment have allowed financial institutions to exhibit stability in the past 2 quarters – but these toxic assets would threaten to create zombie banks if further deterioration is realized on the balance sheets. If the Fed continues to believe that defending banks’ balance sheets is the best way to save the economy and avoid zombie banks (at least in the short run), its low-interest rate, inflation-be-damned approach makes complete sense. But will the Fed know when to take away the punch bowl? I wouldn’t count on it.

  35. To say that the Fed is worried about wage inflation or commodity inflation is overstating their concern. I think what the Fed is far more worried about is asset price inflation. And if they keep rates too low, they will be stoking that fire..

    The statguy says:
    “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).

    The problem in this episode is that if asset prices are ahead of the real economy — in other words we are creating the next bubble — it is being cretaed by the household sector and not banks. So capital requirements will not do much to control that.

    That is, if savings are rising and policy is very accomodative, you will cretae new bubbles. And if the Fed does not do anything, it is deeply worried that it will be blamed for again.

  36. StatsGuy,
    Stop writing such pithy and thoughtful posts and comments – you are making us all look intellectually lazy.

    Ok, now that’s done. You are looking at an artifact of how the economy now runs – inflation control is king, and unemployment is no longer a consideration. We will have a jobless “recovery” because we have both a regulatory scheme, a financial policy, and an economic intelligensia who prize profit over sustainability, efficiency over employment, and private ownership (and thus reward) over all else.

    And we did it to ourselves thorugh who we elected to national office for the last 30 years.

  37. Stiglitz may be referring to loose monetary polict/credit creating asset bubbles with implications for income reditribution effect. This link looks at some evidence:

    http://curiouscapitalist.blogs.time.com/2009/04/15/the-asset-bubble-theory-of-income-http://utip.gov.utexas.edu/papers/utip_27.pdfinequality

  38. cityislander

    Thanks, while related, the article doesn’t exactly support Stiglitz’ claim that the arrow of causation from is from distribution inequality to asset bubbles:

    inequality —> (greater) need for the fed to ease credit —> bubble.

    Any thoughts? Supporting article?

  39. Can you provide the source for the statement that “Stiglitz attributes the easing of credit conditions to widening income inequality”?

    I did a “quick read” of the voluminous -Report By The
    Commision On The Measurement of Economic Performance and Social Progress- but I did not see any definitive statement on this issue.

    http://www.ofce.sciences-po.fr/pdf/documents/rapport.pdf

  40. I read the article:

    I found it vague, at best; It wasn’t clear to me exactly what they were saying about the relationship between income inequality, loose monetary policy, and bubbles.