Three Strikes on Ben Bernanke: AIG, Goldman Sachs & BAC/TARP
December 7, 2009
http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

The FRBNY not only used but abused the Fed’s power’s under Section 13(3) of the Federal Reserve Act. In AIG, the FRBNY under Tim Geithner invoked the “unusual and exigent” clause again and again, but there is a serious legal question whether the then-FRBNY President and the FRBNY’s board had the right to commit trillions without any due diligence process or deliberate, prior approval of the Fed Board in
Washington, as required by law. The financial commitments to GS and other dealers regarding AIG were made always on a weekend with Geithner “negotiating” alone in New York, while Chairman Bernanke, Vice Chairman Donald Kohn and the rest of the BOG were sitting in DC without any real financial understanding of the substance of the transactions or the relationships between the people involved in the
negotiations.

I read that interview, and it was quite good. That was why I cited numbers varying between 0% and -6%, with Taylor himself arguing for the 0% number. Even at the 0% number, that’s just barely where we are today – and it took the Fed several months to get there. That also presumes that Taylor’s original rule, which was backwards looking and highly empirical, is correct. Those with the negative numbers generally argue for using forecasts rather than current numbers, among other modifications.

Your point about capacity underutilization and GDP measurement is well taken. The CBO currently puts the output gap at ~6%… But, on the other hand, unemployment is very real and quite measurable; 10% is the conservative estimate.

Please note that Mr Taylor in an interview expressed his dismay about negative effective rates: his formula was abused.

One of the errors is the capacity underutilization. Typically, one extrapolates GDP from before the recession, minus GDP we have now, and calls that ´cap. underutilization´. This leads to huge errors!!

´Thanks to´ the almost ZIRP of the FED, and the ´innovation´ MBS (lenders not doing due diligence as the problem of a borrower not being able to service the mortgage had been innovated away from the lenders, with rating agencies as co-conspirators) a lot of people used their house(s) as ATM´s and spent those HELOC´s away, thereby pumping GDP. We should correct GDP in this decade. If we do, then we find that there has hardly been GDP growth. Hence, the capacity underutilzation today is less dramatic than being published in many — not corrected — graphs.

The Fed can also choose not to lower rates, and/or to lower them less than required, due to inflation fears. If you consider the magnitude of the projected capacity underutilization in summer/fall 08, monetary policy was very tight. Going into early 2009, various estimates of Taylor Rate projections called for effective rates of between 0% and -6%, depending on which model was used.

The fact that most of the pithy financial press complains that monetary policy was loose demonstrates a clear lack of understanding of the difference between Real and Nominal interest rates. The unfortunate thing is that the Fed _also_ suffered from money illusion during that time period.

The Real/Nominal rate issue was the core insight of the Friedman/Schwartz analysis of the Great Depression. Again, the financial press of that era wrung their hands over the “loose” monetary policy which would inevitably lead to inflation.

Yet, Deflation persisted for 4 years, until Roosevelt deliberately devalued the dollar and raised price levels – the rapidity of the recovery in 1933 was unbelievable. Yet, in 1937, they returned to their old ways, and the second phase of the Great Depression began.

As to the Fed minutes, one can almost forgive them in June 09 (almost). I can’t bring myself to forgive them in August 09 (by then, the evidence was getting stronger). But October 29, 2008? With T-bill rates dropping to unbelievably low historical levels, the bond market projecting deflation, and the sky falling… US consumers were hunkering down, businesses were engaging in mass layoffs, banks were hoarding reserves… Yet the Fed still considered the threat of inflation too high to engage in further easing.

Read the Hamilton piece on Econbrowser. He discusses in detail how the Fed very carefully sterilized their money injections for the first 3 months of the crisis.

~ http://www.debtdeflation.com/blogs/2009/12/01/debtwatch-no-41-december-2009-4-years-of-calling-the-gfc/

As for putting thought into posts, I don’t think referencing Fed minutes from October 2008 which raise the topic of inflation as a basis for saying the Federal Reserve is “obsessed” with inflation, shows thought. I would say it shows ZERO thought on your part. I have news for you: Inflation is a topic at EVERY Federal Reserve (FOMC) meeting.

And since you were too obtuse to figure out what I was arguing in my other post, I am arguing your statement that the Federal Reserve has been “excessively obsessed” with inflation during this recent recession which started in ’08.

http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

There are numerous references to headline inflation, dismissals of low core inflation, reliance on “survey based measures of inflation expectations” and deliberate dismissal of the implied real interest rate based on TIPS.

For example, from August: “Although downside risks
to growth remained, they appeared to have diminished
somewhat, and the upside risks to inflation and inflation expectations increased.”

This was right before the largest deflation in the post-war era. Given this, I’m not entirely sure what you are arguing.

In your comment about the discount window, you are also failing to distinguish between the real interest rate and the nominal rate (one of the things that Milton Friedman – bless his soul – got right in his analysis of the Great Depression; OK, credit to Anna Schwartz too).

With regard to the Fed’s long term easing (in combination with stable low inflation rates – the so-called Great Moderation), one has to question exactly how this represented a failure of the Fed’s narrow mandate since inflation-in-excess-of-2% did not occur during that period and employment remained high?

I have argued elsewhere that this was not so much a failure of monetary policy per se, but a failure of trade and financial regulatory policy, and policies of excess consumption. In particular, the expanding international dollar reserves allowed the Fed to print money which was absorbed by foreign countries (in some cases, into their dollarized domestic economies). The chronically overvalued dollar obliterated the trade balance; in essence, we were exporting dollars (i.e. pledges to repay in goods/services in the future).

Now that dollar flows are reversing due to accumulatd US debt and fears of partial monetization – the dollar is losing its sole reserve currency status – the Fed is doubly constrained. Necessary devaluation will cause inflation due to commodity push inflation (particularly as the world moves forward with the decoupling that was over-anticipated). US structural consumption and trade deficits will encourage this, with the US floating debt to support the overvalued dollar and consumption. Unemployment will be high, and low growth will create further debt due to tax revenue losses (which James Kwak and others have discussed in detail). It is a deadly trap, and there are two sides viciously arguing about the way out: the deflationistas, and the inflationistas.

The deflationistas want to stabilize the dollar to keep imports cheap, and try to get the world to start buying up dollars again. Consider this the Reagan approach (check the debt and fiscal deficit levels in the 80s). The goal is to keep the strong-dollar-party going a little longer. (Heh, good luck… There’s no national bank buying that line of argument.) This may work for a while, but the end result is almost certainly very high debt and low employment/growth, with a net result of heavy inflation/default later down the road.

The inflationistas are arguing for dollar depreciation, and a shift to living within our means – which means trade balance, debt reduction, lower consumption, and working harder (higher employment).

I also suggest you read Scott Sumner’s entire discussion of nominal NGDP leveltargeting, as well as Woodford’s neo-Keynesian perspective. Two completely different perspectives (Chicago vs. Keynes), yet the same conclusion.

I look forward to your thoughtful, well reasoned, and non-pithy reply.

I’d have to give more thought to all the pieces of the proposed solution, but they are a good starting place.

~ ~ ~

The goal of a Capitalistic Economy should be to create the best and most useful goods and services for the best price – i.e. to create value.

While the profit-motive often impels the business person, and pushes some to strive towards monopoly, monopoly (duopoly, triopoly, etc.) undermine the competition needed to create value.

Thus, a primary economic role of government MUST be to ENSURE COMPETITION in the marketplace (exclusive of functions, such as education, deemed essential for public policy reasons, which then become highly regulated, if not outrightly run by the government). This is just as true for banks as it is for coffee shops.

The FDIC requires transparency or else banks can lose their federal insurance backstop. There is no “off balance sheet” transactions or holdings. When larger non-bank entities use legal accounting methods to hide and distort the amount of risk they are taking on, regulation as described above is impossible.

Somehow, over the course of the year, the role of the oversight agencies (Moody’s, Fitch, and Standard and Poor’s) in facilitating the sub-prime collapse has been completely forgotten. I’ve not heard of any proposal for how to guarantee their independence yet provide an income model that attracts the best and brightest. In the world of big finance, they are still lagging indicators (downgrading after announcing bankruptcy not before).

New BIS study finds low interest rates cause an increase in risk-taking by banks.

“Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk. Using a comprehensive dataset of listed
banks, this paper finds that low interest rates over an extended period cause an increase in banks’ risk-taking.”

http://www.bis.org/publ/qtrpdf/r_qt0912f.htm

It is entertaining to see you dig your heels in deeper to this fascinating opinion though….

Long term, the justification for 2% inflation is that when the economy experiences a demand shock, the monetary authority can stimulate demand by expanding money (e.g. they are not at the zero bound).

In the short term – regardless of whether you believe the menu costs argument more than the zero bound argument – the reason for _staying_ at 2% inflation is because many contracts have been set with that explicit expectation built in (which has been the official policy of central banks for at least 2 decades). Any sudden change from that trajectory creates a massive transfer of wealth (partly due to leverage, partly due to long term debt).

A sufficiently large move off the trajectory creates such a big wealth transfer that it can cause massive disruption in the economy… banks going bankrupt, people losing houses and jobs, massive unemployment…

…dogs and cats living together, mass hysteria!