There is a paper by three economists at the Federal Reserve Bank of Minneapolis that is getting a lot of attention on the Internet today. (How often can you write that sentence?) V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe set out to debunk four myths about the financial crisis:
- Bank lending to nonfinancial corporations and individuals has declined sharply.
- Interbank lending is essentially nonexistent.
- Commercial paper issuance by nonfinancial corporations has declined sharply and
rates have risen to unprecedented levels.
- Banks play a large role in channeling funds from savers to borrowers.
In short, they are saying that despite all the hand-wringing about banks not lending to consumers and businesses, it just ain’t true, and even if it were, most lending isn’t done by banks anyway. The implication, to simplify somewhat, is that we are in a media storm of hype that may itself have negative effects.
While I would love to believe this, I don’t think they make the case conclusively. A few quibbles (for this to be understandable, you may have to look at the original paper):
- Total bank credit has not decreased (Figure 1): This measure includes everything on the asset side except vault cash, so any shift from, say, corporate bonds to T-bills is not reflected here.
- Lending has not decreased (Figures 2-4): First, total lending is a sticky number. When a bank has loaned you money for 30 years to buy a house, they can’t call it in. Similarly, it takes time to reduce credit limits on credit cards. Lehman failed on September 15. Assume it took a week for banks to change their underwriting guidelines in the field (and that would be extraordinarily fast). It takes time for a loan application to flow through the system. How big an impact would you expect to see by October 8, when the authors pulled the data? I would be more convinced by a chart of new lending than one of total loans outstanding. Second, the chart says nothing about duration; one very real possibility is that banks are lending money for short durations but not for long ones.
- Interbank lending is not down that much (Figure 5): Again, this conflates overnight lending with 3-month lending. There is a big gap in LIBOR between those durations right now (although it is smaller than a week ago).
- Non-financial commercial paper is not down that much (Figure 6): This one shows a drop from 9/15 to 9/29 and then no data after that, so I’m not sure. Again, a fair amount of longer-duration commercial paper would not have expired yet, so the number is inherently sticky. Also, it hides any shortening of durations.
- Commercial paper rates are not up (Figure 7): The chart hides a huge jump in commercial paper rates for lower-grade companies. The spread for A2/P2 companies versus AA companies is 4.45 percentage points, up from historical levels of 20 basis points and just 80 basis points this summer. (Thanks to Calculated Risk for this indicator.)
- Banks provide less than 20% of the lending to nonfinancial companies (the rest is in bonds held outside of banks): Yup, this is true. But it ain’t so easy to issue new bonds these days, either.
Besides, like most people, I know that I should be convinced by data, but I place an irrational weight on conversations I have with other people. I just talked to my contractor (bathroom remodel), and he said that he’s been having a tough time all year. One client recently backed out of a job because her bank wouldn’t lend her the money because the equity in her house had dropped. So there. (Yes, I know this paragraph is completely irrational.)
I certainly haven’t proven that they are wrong. It’s possible that there is different data that will prove them right. In particular, if they could show me Figures 2-4, for a few more weeks, showing just new lending activity, I might be convinced. And I want them to be right. But I think it’s too early to blame it all on the media.
Update: Mark Thoma at Economist’s View and Free exchange (The Economist) also think think the Minneapolis Fed paper isn’t all it’s cracked up to be.
12 thoughts on “Credit Crunch: Did We Make It All Up?”
I agree with what you said above. It would be nice if they were right but it sure doesn’t feel that way.
1. The paper by the Minneapolis Fed doesn’t offer conclusions, but these four myths may not be the cause but the symptoms of another financial factor. These four things may not be the causes but certainly something is going on in the financial markets.
2. Banks are slow to lend. After being pre-approved/pre-qualified for a home loan it took a total of 9 weeks to go through under writing. Of my three credit scores, the lowest was 790. I was buying a home with 10%, I can’t imagine if I was a small business owner trying to convince the bank to loan on the strength of a business plan.
3. I wouldn’t blame the media I would blame the administration for not going about this more methodically and injecting so much fear into the market and the world. I believe a lot of instability came from the Administration asking for a bailout. In the weeks leading up to it, there was some instability in the market but it didn’t seem as cataclysmic until Hank Paulson went to Congress and convinced them there was a crisis. The Administration either saved us from complete financial Armageddon or caused a serious panic in credit markets. I don’t believe we’ll ever know which.
Makes you go hmmm…
Sometimes I’m not sure what the Fed is trying to accomplish with their communications. When the fire alarm goes off in a crowded building but no one sees smoke, it’s very effective for the authorities to tell people not to panic and to make their way to the exits in an orderly fashion. On the other hand, attempt the same approach while people are surrounded by flames and, in fact, some are on fire (e.g., AIG, LEH) and you lose all confidence in their ability to manage the crisis.
I’m not sure how many innings we are into this financial crisis but there are too many stories that we all know of that tell us that the credit crunch is not simply a figment of the media’s imagination. If the credit crunch were a “myth”, how is it that my friend was laid off due to her small company’s inability to extend a line of credit through her bank? Sure, this story is irrational but I didn’t have these stories last year.
I would have loved to have been in that discussion that Simon had at MIT. I certainly feel like we all have only partial pictures of the impact of the financial crisis.
At best, I hope that the Minneapolis Fed is just trying to limit the panic of consumers and investors. At worst, I’m afraid that they just don’t “get it”. I’m shocked that in this totally deflationary environment – (TIPS spreads are projecting less than 0.2% annual inflation for the next 5 years in spite of the flood of dollars into the market) – that the ECB and the Fed have no cut interest rates further. Actually, the ECB’s lack of action is particularly shocking as they have a lot further to go.
Thanks for the vote of confidence. I think the Fed is doing a reasonable job of lowering interest rates; there is an expectation, I think, that they will lower them again later this month. I don’t think lowering interest rates is a panacea, but I do think it will help. I agree with you that the ECB is far behind the curve. As Simon has said in other contexts, they seem to be still stuck in the inflation-fighting mentality of the 1970s (or, rather, the mentality people should have had in the 1970s). Yes, they have an explicit 2% inflation target, but they should realize by now that inflation is not the problem to be worried about.
Can you fix the link on: “four myths about the financial crisis”. Thanks.
Sorry, that’s fixed.
they ignore the massive decline in financial and asset backed commercial paper. where do you suppose those folks are getting financed now. banks perhaps?
Got points about that paper. Still, I would say too much of the “bad news” has been based on conversations with people and not a hard look at the data.
Here’s my question: If, over the last 10 years we’ve adjusted our behavior to unsustainable levels of credit does a return to “normalcy” qualify as a crisis or simply a painful but recoverable recession?
Businesses borrowed to undertake risky projects/expansion, the FS industry over-leveraged, and private citizens over-borrowed, instead of saved, to buy cars and houses because credit was so cheap and easy. If wall street, and even people like your contractor benefited from our largess, why should government step in to protect them from the fall?
I’m not unsympathetic. It is unfortunate for many people. But that doesn’t make it a crisis.
“they ignore the massive decline in financial and asset backed commercial paper. where do you suppose those folks are getting financed now. banks perhaps?”
Exactly. You have hundreds of billions of dollars worth of ABCP now sitting on sponsor bank balance sheets – obviously that shows up in “total credit”, but it’s hardly an indicator that banks are actively lending, let alone that the overal financial system is. Quite the opposite.
The one that really made me question what they were doing was the insistence that the 90 day CP rate didn’t show any sign of a crunch. Based on absolute rates. Never mind the A2/AA spread, they didn’t even mention the spread over Libor or the target rate. So if the Fed slashes interest rates, that’s a sign that the market is healthy, according to the authors.
Crisis or recession? Good question. At this point I think everyone is reconciled to a recession. A large number of major banks vanishing, and a consequent freeze on lending even to strong companies with good uses for the money, would have been a crisis. I would say the goal of policy makers has been to get us out of what seemed like a crisis and into a recession, and they are partway there. But there are still ample opportunities for things to slip back into crisis mode: we may be headed for an overcorrection in the housing market; there is chatter that hedge fund failures could cause an overcorrection in securities markets; and many emerging markets are going through real crises. If you assume that asset values and leverage ratios need to return to “sustainable” levels, whatever those are, there are still two ways to get there – the gradual way and the precipitous fall well below those levels – and one is better than the other.
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