By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
When you compare Bernanke’s “Deflation: Making Sure It Doesn’t Happen Here” speech of 2002 with his recent Jackson Hole speech, you cannot help but notice changes in his view of the economy and the financial system as well as a significant decline in his confidence in the ability of monetary policy to insure full employment,. The changes between the speeches and the possible explanations for the changes have implication for the course of Fed policy in the near and medium terms as well as the long-run health of the US economy. They suggest that the FOMC sees less upside to further stimulative policy actions and at the same time sees possible downsides where it had not seen them before. This, in turn, suggests that the FOMC will be more tentative in adopting further nonconventional stimulative measures than past behavior would indicate.
The 2002 speech reflected a confidence in the underlying health of the US economy and the robustness of the financial system, as well as the effectiveness of both the regulatory system and economic policy:
“…we read newspaper reports about Japan, where what seems to be a relatively moderate deflation…has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors
I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself….A particularly important protective factor in the current environment is the strength of our financial system: Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.
The second bulwark against deflation in the United States… is the Federal Reserve System itself… I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.
The recent Jackson Hole speech has a decidedly different tone. In particular, the Fed appears to have doubts about the ability of further monetary stimulus to produce a stronger economic recovery:
“…… As I mentioned earlier, the recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed..
….In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting….
Beyond the general tone, the speech is telling. Past speeches and FOMC minutes frequently referenced discussions centered on differing forecasts, but I do not recall another speech or FOMC minutes in which the discussion indicated that the FOMC did a “benefit/cost” analysis of possible policy tools, i.e. “We discussed the relative merits and costs of such tools”. The speech also reflects the Fed’s recent decision to stand pat, at least temporarily, on the policy front despite painfully slow growth, continued high joblessness and continuing problems in the housing and financial sectors. This stands in contrast to the statement in the 2002 speech wherein Bernanke stated that “the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation (and presumably the attendant slow growth and high unemployment) that might occur would be both mild and brief.”
In the Jackson Hole, while Bernanke continued to be optimistic about the US economy in the long-run, he introduced a caveat that was not in prior speeches:
To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies.
This shift in tone along with the decision to refrain from pursuing additional stimulus and the litany of additional required policy changes raises questions.
1. Does the recent speech and the Fed hesitancy to pursue further non-conventional policies reflect a reappraisal of the expected net benefits of further monetary stimulus?
2. Does the FOMC weigh the factors behind the decision to “pause” so heavily that a resumption of unconventional policy is unlikely?
3. Has the FOMC come to recognize that there are limits to the effectiveness of monetary policy and that the economy’s problems reflect the failure of other policies and the need for structural reform?
FOMC members in the Bernanke inner circle among others have recently given speeches which suggest that the benefits of any stimulus that monetary policy might provide must be weighed against possible costs of resource misallocation, increased leverage/financial fragility as well as the cost of forestalling policy responses to a range of structural problems facing the US economy.
In a recent speech, “Assessing Potential Financial Imbalances in an Era of Accommodative Monetary Policy”, Fed Vice Chair Yellen outline avenues by which an environment of low and stable interest rates could contribute to financial instability and economic dislocations:
The severe economic consequences of the recent financial crisis have underscored the need for central banks to vigilantly monitor the financial system for emerging risks to financial stability. Indeed, such vigilance may be particularly important when monetary policy remains highly accommodative for an extended period. As many observers have argued, an environment of low and stable interest rates may encourage investor behavior that could potentially lead to the emergence of financial imbalances that could threaten financial stability….
But a sustained period of very low and stable yields may incent a phenomenon commonly referred to as “reaching for yield,” in which investors seek higher returns by purchasing assets with greater duration or increased credit risk….
But taken too far, this dynamic has the potential to facilitate the emergence of financial imbalances. For example, with interest rates at very low levels for a long period of time, and in an environment of low volatility, investors, banks, and other market participants may become complacent about interest rate risk. Similarly, in such an environment, investors holding assets which entail exposure to greater credit risk may not fully appreciate, or demand proper compensation for, potential losses. Finally, investors may seek to boost returns by employing additional leverage, which can amplify interest rate and credit risk as well as make exposures less transparent.
At present, we see few indications of significant imbalances, and the use of leverage appears to remain well below pre-crisis levels. That said, I’ve noted some recent developments that warrant close attention, including indications of potentially stretched valuations in certain U.S. financial markets and emerging signs that investors are reaching for yield. Should broader concerns emerge, I believe that supervisory and regulatory tools, including new macroprudential approaches, rather than monetary policy, should serve as the first line of defense.
While Yellen asserts that it would be preferable to have monetary policy specialize in macroeconomic concerns, leaving financial stability issues to be in the realm of supervisory tools, Yellen and FOMC are now aware that monetary policy and regulatory policy are intertwined.
In a recent speech, Andrew Haldane, the Director of the BOE’s Financial Stability Committee, also recognized that prudential policy (or the absence of it) has implications for the macro-economy.
…, however, these arms (fiscal and monetary policy-ed.) are at present close to fully stretched…
With fortuitous timing, there is a new tool in the box, a third arm of macro-economic policy. This is so-called macro-prudential policy. As its name implies, this policy tool is intended to meet macro ends using prudential means.
Haldane recognizes the fact that regulatory, monetary and fiscal policies are to some degree substitutes for each other. However, his statement, “With fortuitous timing, there is a new tool in the box.” is rather perplexing. The rediscovery of the fact that financial regulation has macroeconomic consequences can hardly be viewed as accidental (the first definition of fortuitous.) Policymakers and economists had been actively searching for non-conventional policy tools ever since Japan entered its lost decade.
Furthermore, this rediscovery was neither, lucky nor fortunate (the second definition of fortuitous). Changes in regulatory policy have always had the potential to have macro-economic consequences even if economists and policymakers chose to ignore them in the years prior to Lehman. If policymakers had stopped or reversed the erosion of the regulatory structure in the early 1990s, that would have been “fortuitous”’, i.e., lucky or fortunate. The post-2008 realization of the implication of the weakened regulatory regime was not lucky or fortunate. It is just a case of two decades late (literally) and more than a few Trillion Dollars short (figuratively).
Recognition that regulatory/prudential policy has a macroeconomic dimension also has implication for efforts to distribute the “blame” for the crisis and recession . Acknowledging that financial regulatory policy is to some degree a substitute for conventional monetary policy implies that the appropriateness of conventional monetary policy and regulatory policy cannot accurately be determined in isolation from each other. Hence the argument that monetary policy was exactly where it should have been and that regulatory policy is exclusively to blame for the crisis and its aftermath does not hold up to scrutiny. The changing pre-2008 regulatory regime reinforced monetary policy. Together they had the effects for better (real growth and stable prices) and worse (unsustainabilities including external deficit, depressed private savings, and fragility of the financial system) on the financial markets and real economy that have been reflected in US economic performance. If the regulatory regime had been more robust and had limited credit creation and risk taking, then growth would have been slower, etc. However, given the Taylor Rule framework, the Fed would have simply run looser monetary policy until the market innovated and avoided/evaded the regulatory constraints. In the absence of an acceleration in inflation, the looser policy would presumably have been pursued until such time as the economy reached the same state that it was in 2007.
It is not certain that the current regulatory structure will promote socially advantageous levels of leverage and risk taking. It is still possible that regulation will once again allow destabilizing leverage and risk taking. The FOMC must still fear waking up some day only to find excessive leverage and risk taking embedded in the system just across a political or regulatory border, or hidden in plain sight.
In a speech titled “U.S. Economic Policy in a Global Context,” William Dudley, President of the Federal Reserve Bank of New York, links the financial crisis and the current economic troubles to the interplay of globalization and policy choices made both here and abroad. Furthermore, Dudley’s analysis implies that successful US stimulative counter-cyclical policy (in the absence of the other policy changes mentioned by Bernanke) would at best contribute to a return to the unsustainable patterns of trade, debt accumulation, savings, and investment that characterized the period from the mid-1990s to 2008.
… even before the crisis, it was evident that the relationship between developed and emerging economies was becoming strained and needed to be adjusted; the status quo would clearly be unsustainable…
Some experts have summarized the arrangements as follows. The United States bought Chinese exports at low prices, which bolstered U.S. living standards and held down U.S. inflation. The United States did not take extreme steps to try to force China to revalue the renminbi upward against the dollar, and China, in turn, invested its trade surplus and capital inflows into U.S. Treasuries in order to keep the renminbi from appreciating too rapidly. The U.S. terms of trade improved as the cost of imported goods dropped, and U.S. interest rates stayed relatively low as China recycled its trade surpluses back into U.S. financial assets. For China, the benefits included strong economic growth, technology transfer and the creation of many manufacturing jobs. These developments, in turn, helped foster rising living standards and political stability in China….I think this is a reasonable, albeit overly simplistic, description of what happened.
For the United States, the consequence was elevated consumption facilitated by asset price inflation, easy underwriting standards for credit and structural budget deficits. Of course, this particular outcome was not preordained or caused by the EMEs. There were multiple combinations of domestic demand consistent with full employment in the United States during the pre-crisis period. For example, if the United States had adopted different policies, it might have shifted the composition of growth toward more business investment and less consumption and housing.
…While it is tempting to draw a line of causation from actions in one part of the global system to the other, this is overly simplistic. Rather, we have to think of the global economy as a single system, with outcomes based simultaneously on all the choices and preferences throughout the system. What is new is that the so-called periphery is now weighty enough to have a large impact on the pattern of economic activity in the core, as well as vice versa.
It is clear that the pre-crisis formula for global growth was not sustainable. This is obvious in the case of industrialized nations where private consumption and fiscal deficits reached unsustainable levels and needed to be cut back.
Dudley acknowledges that US macroeconomic variables, e.g. the real growth rate, the rate of unemployment and the inflation rate, are no longer exclusively domestically determined. Furthermore, in the absence of a US adjustment to the “globalized” world, the analysis implies that the US will only be able to achieve full employment by returning to something like the unsustainable pattern of consumption and debt growth relative to s that was experienced between prior to 2007.
It is likely that consideration such as those cited by Yellen and Dudley led to the FOMC’s discussion of the relative benefits and costs of the remaining tools of policy as well as to Bernanke’s addition of the caveat to his optimistic view of the US long-term economic prospects. But are these considerations, weighty enough to dissuade the FOMC from taking further steps to stimulate demand in the absence of a good reason to believe that inflation is about to accelerate?
The simple answer is no. Neither Yellen nor Dudley have dissented or voiced disapproval of pursuing further stimulative measures. Furthermore, while Bernanke has expressed reservation about monetary policy alone being able to return the economy to potential output, he does not appear to have linked 1)low interest rates to financial fragilities as Yellen has done nor 2) the external imbalances to domestic policy and the financial crisis as Dudley has done. In fact, in his recent speech Bernanke attributes the current recession and its costs to the financial crisis itself:
I have already noted the central role of the financial crisis of 2008 and 2009 in sparking the recession. As I also noted, a great deal has been done and is being done to address the causes and effects of the crisis, including a substantial program of financial reform, and conditions in the U.S. banking system and financial markets have improved significantly overall.
Conspicuous in their absence is any mention of the external imbalances, the low interest policy and the other unsustainabilities which were reflected in massive misallocations of real resources in the years before the crisis hit.
However, the most telling comment in Bernanke’s Jackson Hole speech is:
…the recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed..
It suggests that stimulative fiscal and monetary policies post-2008 have resulted in a shorter-lived and less vigorous recovery than had been expected by the FOMC. Some FOMC members may draw the conclusion that the possible benefits of additional monetary stimulus are smaller than they thought prior to past efforts at stimulating the economy.
Conclusion
Does the recognition that monetary policy has potential costs as well as benefits or the fact that there are non-cyclical (structural) impediments to a return to potential output preclude a role for stimulative monetary policy? No. Does the existence of structural impediments rule out stimulative fiscal policy? No. However, the market and institutional failures and the structural impediments do imply that 1) stimulative counter-cyclical policies entail risks and 2) counter-cyclical stimulative policies alone will not return the US economy to sustainable trend growth with full employment.
Bernanke and the current FOMC are not the Bernanke and FOMC of 2002, of QE1 or QE2. Nonetheless, the FOMC will almost certainly take additional stimulative steps. However, given:
1. 1) possible downside risks attached to continued low and stable interest rates,
2. 2) the failure to address the external imbalance and other structural problems, and
3. 3) the erosion of the effectiveness of monetary policy,
FOMC policy actions are likely to be tentative relative to earlier responses taken to the crisis.
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“FOMC policy actions are likely to be tentative relative to earlier responses taken to the crisis.”
So, when the next Fed pole gets shoved in, it will do what? Leave hesitation marks?
+1913 Well said.
Boy, just think how many tens of trillions the Fed and the Treasury have thrown at Wall St and the zombie banks. How much farther ahead would our economy be if we protected our financial system, let the zombie banks fail, let good banks grow (without fraud or excessive leverage) and spent that money on real things like our electrical system, dams, roads, schools, bridges, education, health care, and so on? Real things to improve our country.
Instead, we’re going to get Bernanke giving us lip service when we slide into another Great Depression, “Sorry folks, we shot our wad bailing out the people that caused this crisis. Sucks to be you.”
Makes the Chinese spending big bucks on infrastructure projects to keep their economy moving look like geniuses.
Yep. At this point, the only productive thing the Fed can do is to spend money directly on actual things, actual construction. But they haven’t admitted that they can do it. (They can, you know.)
Yellen and FOMC are now aware that monetary policy and regulatory policy are intertwined.
Please tell me that our central bankers are not just now figuring this out.
I’ve noted some recent developments that warrant close attention, including …. emerging signs that investors are reaching for yield.
Yep. If safe vehicles are paying 2% yields or even less, how else will retirees fund their basic living expenses?
There are some allusions in Alford’s post about this recession having other fundamental causes besides the financial crisis. It has been a source of amazement to me that so few analysts, economists, pundits, whatever, have seemed to grasp that the country’s economic structure had a number of factors which portended a recession and increased unemployment even without any financial crisis. The case that this hasn’t been considered means that all attention was focused on the financial meltdown and pumping untold amounts of ‘money’ into the system to ameliorate that – and that in the process the underlying fundamental recession factors were still being completely ignored – and are still being almost completely ignored.
Automation, feared in the 50s and 60s and then forgotten, has finally made its full impact felt. The disastrous trade imbalance in and of itself means that there is a net deficit in jobs. And exacerbating that is the structural reality that our exports take less labor hours per dollar than our imports per dollar. And anyone who looks at the curve of the percentage of the working age population that needs jobs sees an ever increasing linear rise from 42% in 1950 to 62% in 1999 (jobs data from BLS employer survey (CES) versus working age population) and sees the severe exacerbation of decreasing jobs versus increased percentage need for jobs.
I still don’t see any economists or pundits who realize that we have entered a state where the subset of the population that currently has jobs is now a closed system with no need for any additional job production from the currently unemployed. The currently unemployed have become an isolated subgroup OUTSIDE of the main economic structure. Certainly exacerbating this tremendously is the almost 100% retailing of commodity goods from foreign imports. Although seemingly almost never discussed by formal economic treatises, capitalism is a really relatively poor and indirect mechanism for engaging the full working age populace in productive activity (although certainly better than any other sociological structure). I have to wonder how many years of desperation of the massive (one-sixth) number of unemployed, whom the system is now incapable of reintegrating, it will take before economists and even pundits realize what the paradigm really is.
It is drolly amusing also how the economists and pundits have been totally lacking in awareness and understanding that in terms of unemployed, the UNEMPLOYMENT recession that began in June of 2001 HAS NEVER RECOVERED. Taking into account the number of additional jobs NEEDED for population expansion, the percentage of jobs vs working age population peaked at 62.14% in May of 2001 and NEVER RECOVERED to more than 59.54% in April of 2006 – and then leveled off at that depressed level until the 2007 economic effects. The graphs of job loss published by Calculated Risk and duplicated by the New York Times FAIL TO INCORPORATE ANY POPULATION GROWTH. If you do the jobs loss graph taking into account population growth, there has been NO REAL RECOVERY of jobs – AT ALL for the last 20 months since the job loss hit its nadir and now stands at 54.67% (remember, 1999 was 62.14% and at the start of ‘this’ recession it was at 59.54%).
So when everyone ponders a double dip recession, you can smile in your awareness that it would be a triple dip recession where the ‘double dip’ never recovered any net jobs AT ALL. Smile.
By the way, the corollary to what I outlined above is quite starkly simple – no matter what the FED does, it CANNOT ‘fix’ this recession. That observation seems little different than the substance of Alford’s post and indeed what he infers is the dawning realization of Mssr. Bernanke and company. The acute danger is that every appearance that the FED is ‘doing something substantially helpful’ takes away all incentive for any actual measures to try to restructure our economy. Morbidly distressing.
Actually, the Fed *could* print money and spend it as wages, on direct employment, employing large numbers of people to build things.
Beyond unorthodox. However, nothing is actually *preventing* the Fed from doing this — except mere conventional interpretations of laws, and as we know from Dick Cheney, those can be violated at will by powerful people.
The Fed has the power to print the money and credit people’s bank accounts. It could do this.
Powerful commentary Economics. I was thinking the exact same thing last night in regards to a class of permanently unemployed and the civil effects on American society. Where it seems we’ll land is like Russia of the 1990’s. So many similarities and of course same management that assisted the Oligarchs of draining the wealth. We’re landing as a two-tiered mafia society. Since I didn’t make the 1% wealth grade I’ll consider the vast appeals of being a local warlord (sarc off).
If WW3 is avoided (doubtful) then the trajectory will be a 15-20 year recovery to a good place.
One last bit: Bankers make loans, they hate fiscal policy. Too much detail and work…
We may avoid WWIII. But I’m not sure we’ll avoid some sort of civil war. (Even Russia had some civil war while it collapsed.)
You got it!
Jobs will be offshored by global corporations until our wages are the economic equivalent of India’s or China’s.
Global Corporations don’t give a crap whether we can buy their products if they can make more outside the US. they have th choice, we don’t.
Global Corporations will play all governments agaisnt each other to negotiate the best deal fro their bottom line. GE, Exxon, and the rest are not on our side, they are on their side.
They don’t need us, they need the US (taxpayers) to support and backstop their overseas investments.
I think you get the picture. Macro Economics has gone Global – jobs in the US are a very small and unimportant of the picture for the Globale Economy…
Grrrr…..
Looking at this post from the triple perspectives of kleptocracy, wealth inequality, and class war, it appears decidedly theological in nature. And by that I mean not terribly grounded in reality.
First, when has the Fed ever paid anything but lip service to its mission of full employment?
Second, none of the Fed’s crisis policies have stimulated demand, if by demand we are talking about the real economy. So the whole discussion of monetary stimulus seems wrong. In this regard the concept of velocity is useful. Velocity is a combination of a scalar quantity “speed” and a vector “direction”. You can argue whether Fed policy represents only the scalar portion of velocity or whether it’s a vector just the wrong one, but Fed monetary policies have been spectacularly ineffective directing money to where it is needed in the economy. If you look at this in terms of kleptocracy, as I do, then this was not accidental but a feature to facilitate looting.
Third, the Fed is still using unconventional tools. We have been talking about the ramp up again of its dollar swaps program.
Fourth, I noted this howler back when Bernanke made his Jackson Hole speech:
The recession began in December 2007 so could hardly have been sparked by financial crises that came after it.
If you look at how Bernanke and the Fed reacted during the period from the housing bubble burst in August 2007 to the meltdown in September 2008, he was mostly hands off, expecting markets and the economy to self-correct and come back on their own, what interventions he made were ad hoc and specific, like for Bear Stearns, nothing sustained. When the sh*t hit the fan, you know when Bernanke, Paulson, and Geithner decided not to resolve Lehman, he then intervened massively, desperately, and not very smartly. I should point out in this same September timeframe when he let Lehman go bust he had no problem vastly exceeding the Fed’s legal powers with AIG. So again massive but no overall vision, mostly opening up the floodgates to the banksters. His current dinking around policies look like he has returned to his pre-meltdown pattern.
Let’s see if I’ve got this straight –
You’re expecting the obnoxious, pompous asshole leader of the fractional reserve banking system that took trillions of OPM & lost it gambling on inflated housing loans which they broke up & sold to investors for a fee, to fix the real economy? When the intended purpose of the fractional reserve banking system is to mediate loans between savers & producers to grow the real economy.
This same asshole who printed out of thin air & loaned trillions to these fractional reserve banks at 0% & paid them interest to keep the loans at the fed to repair their balance sheets & keep the trillions from the real economy.
You’re expecting this stupid asshole to fix the real economy? Give me a break.
He has moved from denial to resentment, he still has to go through bargaining, depression and acceptance. Millions will pay the price for his education.
Alford writes about a 2002 Bernanke speech about how the US/Fed is going to avoid deflation. This subject was clearly on the radar screen by 2002. 5 years before the crash which they smugly thought they could avoid. (Bernanke and Greenspin et al.) Then Bernanke wrote a paper (blurb yesterday on zero hedge) in 2003 about the synergy between the Fed and the Stock Market which sounded like Bernanke was outlining the logic of maintaining relative wealth levels as the Fed slowly devalued the dollar. No doubt to become competitive with China and the rest of the world. So maybe this would have worked in a market that had not already been ruined by offshoring every job that could not be nailed down, which had been happening at breakneck speed since the late 90s. Bernanke was clearly speaking directly to international corporations and assuring them their stock values would remain high in the US. Bernanke, however, completely ignored the reality. That being the meaninglessness of maintaining relative stock values in a nation of jobless, no-growth, poverty. Now he makes the excuse that monetary policies can’t solve all problems. But he will still maintain his low interest rate, even though he admits it creates no jobs, because it will keep stock prices from crashing. So, thinking back on how this morphed from somehow intending to devalue the dollar for the sake of competitiveness, to having no competitiveness at all is curious. It is beyond “structural” because growth is the old paradigm. Sustainability is the new.
“the decision to refrain from pursuing additional stimulus”
That would appear to be a misdirection based on the following article.
Bernanke Joins King Tolerating Inflation to Revive Economy http://www.bloomberg.com/news/2011-09-18/bernanke-joins-king-tolerating-more-inflation-as-economies-fail-to-revive.html
I read “tolerating inflation” as ‘more stimulus on the way.’ The history of the Fed indicates an ongoing pattern of deception and misdirection when dealing with the public. An analysis of the Fed’s ritual-speak would be more useful, IMO, if it did not cater to conventional economic evaluation but intead addressed the underlying power and money games.
We would have found ourselves in a bad but relatively normal recession had it not been for the “financial crisis” aka. massive bank fraud, and the housing crisis. These two things I hold against Bernanke. He denies the fraud, allows it to go unaddressed, and stops the entire nation in its tracks. Then he does some photo op where he tries to look as languid as the Cheshire Cat. There will be no jobs or any significant revival, until Bernanke himself addresses the root of the problem.
OK, this is an article by a former Federal Reserve banker, who quotes other Federal Reserve bankers, and as in any profession, the professionals have their jargon. But the nice sounding words they use puts a distance between what they say and what their decisions mean to real people’s lives — their jobs, homes, health and happiness, their futures. To understand what is being said we have to interpret their jargon. Here are a few conclusions not at all obvious from the uninterpreted text.
Yellen: “The severe economic consequences of the recent financial crisis have underscored the need for central banks to vigilantly monitor the financial system for emerging risks to financial stability. Indeed, such vigilance may be particularly important when monetary policy remains highly accommodative for an extended period. As many observers have argued, an environment of low and stable interest rates may encourage investor behavior that could potentially lead to the emergence of financial imbalances that could threaten financial stability….”
Ah, yes, “financial imbalances”. What does this mean? Bubbles, crashes, crises, depressions, more jobs lost, hunger, homelessness.
Yellen: “But a sustained period of very low and stable yields may incent a phenomenon commonly referred to as “reaching for yield,” in which investors seek higher returns by purchasing assets with greater duration or increased credit risk….”
I thought investors were supposed to be smart — analyzing interest rates, yields, in terms of credit risk, interest rate risk, and a bit of profit. You mean they are not all that smart, that they mix up credit risk with interest rate risk, that maybe they just guess at what’s a good yield.
Yellen: “But taken too far, this dynamic has the potential to facilitate the emergence of financial imbalances. For example, with interest rates at very low levels for a long period of time, and in an environment of low volatility, investors, banks, and other market participants may become complacent about interest rate risk.”
Complacent? Banks, investors? Aren’t they supposed to be rational? Or is this an example of apparent stability generating instability?
Yellen: “Similarly, in such an environment, investors holding assets which entail exposure to greater credit risk may not fully appreciate, or demand proper compensation for, potential losses. Finally, investors may seek to boost returns by employing additional leverage, which can amplify interest rate and credit risk as well as make exposures less transparent.”
OK, so they can’t properly estimate credit risk, so they will add a big fudge factor so as to “demand proper compensation”. Demand it! Yes! But some of them — poor babies — might become complacent and fall asleep at their desks after big lunches. Credit risk cannot be known in any particular case, and even if it could be known at a particular time, it will change as macro and local situations change. So there will always be a tendency to add a big fudge factor to any credit risk interest rate.
Alford: “Yellen and FOMC are now aware that monetary policy and regulatory policy are intertwined.”
It’s good they are learning something. See below where Dudley says the whole world is one big economic system where everything affects everything else.
Alford: “Andrew Haldane, the Director of the BOE’s Financial Stability Committee, also recognized that prudential policy (or the absence of it) has implications for the macro-economy.“
Prudence is a virtue. What does “prudential policy” mean? It seems to mean rules. Can rules make people prudent? I doubt it. A good system means rules — laws, regulations, that are enforced so that the system as a whole behaves in a way we want, such as for example no bubbles, no crashes. Prudence has nothing to do with it.
Alford: “Changes in regulatory policy have always had the potential to have macro-economic consequences even if economists and policymakers chose to ignore them in the years prior to Lehman….”
Why would regulatory policy be changed without expecting macro effects unless it were a change benefiting some special interest.
Alford: “If the regulatory regime had been more robust and had limited credit creation and risk taking, then growth would have been slower, etc. However, given the Taylor Rule framework, the Fed would have simply run looser monetary policy until the market innovated and avoided/evaded the regulatory constraints. In the absence of an acceleration in inflation, the looser policy would presumably have been pursued until such time as the economy reached the same state that it was in 2007.”
So, to translate, if there had been no fraud, no corruption, no laws broken there would still have been an economic crisis, only later than 2007. This is the nature of bubbles. They can’t go on forever. They must burst. So fraud, corruption, breaking of laws contributed to the crisis in that they speeded it up and may have made it worse, they were not necessary contributors. So if we only fix the system so that there is no more fraud, corruption, or lawbreaking, we can still have crises because we can still get bubbles with our present banking and money system. Notice how this critical conclusion is obscured by the way Alford says it.
Dudley: “…While it is tempting to draw a line of causation from actions in one part of the global system to the other, this is overly simplistic. Rather, we have to think of the global economy as a single system, with outcomes based simultaneously on all the choices and preferences throughout the system. What is new is that the so-called periphery is now weighty enough to have a large impact on the pattern of economic activity in the core, as well as vice versa.”
“… we have to think of the global economy as a single system.” Way too much so called economic thinking assumes a single mostly isolated nation state. And when we hear an economic argument we often do not know if it is based on a single nation state or not.
Alford: “Dudley acknowledges that US macroeconomic variables, e.g. the real growth rate, the rate of unemployment and the inflation rate, are no longer exclusively domestically determined.
Furthermore, in the absence of a US adjustment to the “globalized” world, the analysis implies that the US will only be able to achieve full employment by returning to something like the unsustainable pattern of consumption and debt growth relative to s that was experienced between prior to 2007.”
It will take more than “a US adjustment to the ‘globalized’ world”. (Why does he use scare quotes around “globalized”? Is Alford saying he does not believe Dudley’s statement that the whole world is a single economic system?) It will take more than a US adjustment. The whole world needs to be changed. The banking system of the world needs to be changed. There is a fundamental problem with the charging of interest hinted at above. The interest rate to be charged for a loan can be only a guess. The future cannot be predicted in detail so there will always be risks that loans cannot be repaid. And the lenders will always tend to up the interest rate to counter this, and the borrowers generally are in no position to predict their future ability to repay the loan either. The lenders have significant informational advantages over the borrowers.
Here is another way to look at this. At present the interest rate for a bond or mortgage or any loan is said to be necessary to account for several possibilities. The first is to account for possible default by the borrower — the borrower for whatever reason does not pay back the total amount of the loan — credit risk. So this part of the interest charged by the lender is there to compensate him for money he lends that is never paid back to him. The second is interest rate risk — the possibility that the interest rate being paid by borrowers in the near future goes up and the lender thus does not have the opportunity to charge this higher rate. It would seem that this risk is somewhat countered by the possibility that in the near future the interest rates borrowers are accepting goes down and thus the lender gets an unexpected bonus. Or if the lender borrows the money he lends at a lower short term interest rate than he lends at, he runs the risk that his short term loans will have a higher rate in the future. The third is the risk of inflation. The interest rate the lender charges must be enough to counteract expected inflation so that the money he gets back in the future has the same value as that which he originally lent. The fourth component of the interest rate the lender requires is something for his profit — to pay him for his work. In actuality this component is probably added as a little fudge factor in each of the three previous components. But if not, if the first three are just right to balance their respective risks, then without the fourth component, the lender’s expected profit is zero, and he makes no money (real, inflation adjusted) in the long run. But this fourth component should not be tied to the size of a loan. A $1,000,000 loan has essentially the same amount of work as a $2,000,000 loan. So the lender’s pay for his work should be proportional to the work he does, not proportional and compounded to the amount of the loan. If the lender has to do extra work — work beyond what would be required for a borrower who always repaid on time, then he should be compensated for the actual amount of extra work he has to do to collect his payments. Of course we are already seeing some of this in origination fees for home loans and servicing fees, and whatever fees they can and will tack on in the future. You might ask what if the lender is just relending money he borrowed from someone else and this someone else charged only interest in place of fees for his work. Then our middleman would have to do the same. So to correct the system, fees for work performed would have to everywhere replace compounded interest for the profit or pay component for work performed.
Compound interest instead of fees for work performed by lenders — is why, through many periods throughout the last 5000 years, the rich have been lending to the poor, and the poor have been unable to pay back the original loan plus interest, until such a large number of the poor had all their property seized, including sometimes their families and themselves as slaves, that the “economy”, the social system, could no longer function, and the king would have to declare all debts zeroed out and all seized property to be returned to the previous owners, including release of those enslaved for debt. See David Graeber’s book “Debt: The First 5000 Years”. Our present system still has some of the same problems people had 5000 years ago. We handle them piecemeal via personal and corporate bankruptcies, central bank bailouts, and sovereign defaults.
The problem for borrowers is the trick of compound interest that lenders use to pay themselves for whatever useful work it is that they do.
This idea will take a while to be broadly accepted. Don’t hold your breath. After all bankers and lenders are paid in compound interest and it’s a good deal for them, while most everyone else is paid by the hour, the week, or the month worked. Most people do not appreciate the difference between a fixed fee and a small additional amount of compound interest. So most borrowers are in no position to negotiate the interest payments on what they borrow. The system doesn’t allow it in the first place. And the borrowers don’t have the knowledge. It’s pretty much take it or leave it. This is why debt crises have been happening since 5000 years ago up until and including right now.
Some possible conclusions: 1) Lending should be eliminated; 2) Lending with interest should be eliminated (like Islam did successfully and prosperously — See Graeber’s book); 3) Banking and lending should be a regulated utility; 4) The governments, since they create money, should make loans strictly on an actual administrative cost basis.
Just like to point out that Bernanke has never been “re-educated.”
Great educational commentary, especially the conclusions. Thank you for the time.
Face it. The Financial sector has proved itself incapable of doing the job it’s supposed to do – and wants to keep doing what it has been doing.
Paul Volker has it right.
1.) “The question that really jumps out for me is, given all that data, whether the enormous gains in the financial sector — in compensation and profits — reflect the relative contributions that sector has made to the growth of human welfare” (from NYT story)
2. Too big to fail banks are alive and well – and this poses a major problem to our future prosperity.
“There is an expectation that very large and complicated financial institutions will not be allowed to fail,” he said. “Unless that conviction is shaken, the natural result is that risk-taking will be encouraged and in fact subsidized beyond reasonable limits.”
In short, I think we are all screwed unless someone starts shouting the truth. The question seems to be join them or jail them.
I don’t think Bernanke has changed his thinking one little bit, rather, that both he and the Fed have adapted their public utterances to the fact that there is a great deal of opposition, both domestically and internationally, to further money bombs into a lawless global market structure.
The “full employment” mandate ought to be withdrawn from the Fed and placed back in the hands of fiscal policy managers. The “price stability” mandate ought to countenance low, no or even negative inflation. There is no reason whatever for productivity gains not to be fully reflected in prices.
QE1 “saved” a bunch of institutions that should have been shuttered. It did virtually nothing for real economic activity. QE2 did even less for the real economy, but did manage to blow up several weaker countries (food and fuel riots, governments falling, civil war)as well as cause policy nightmares for Brazil, China, India, and many other emerging markets.
But Bernanke has repeatedly written and stated that the stock market is the mechanism which transmits Fed policy into the real economy – probably the least effective tool imaginable, unLESS you’re in the top 20% or so and have your portfolios essentially guaranteed, and could care less about job creation. Anyone watching the last couple months knows he’s already intervening regularly under the table. I fully expect this to continue.
I suspect he’d like to wait to see what the Super Congress farce produces before unloading the big guns. I expect a modest announcement this week in terms of immediate action, but a very clear signal that more is coming by year end – we’re going to get a $trillion package twixt the Admin stim and the Fed. And quite possible more.
Nothing can fix the problem but really fixing the problems – the Fed just isn’t in to that. I don’t relish the prospects for 2013. Not one bit.
Bernanke is tolerating dissent but pushing past it http://www.boston.com/business/articles/2011/09/19/bernanke_is_tolerating_dissent_but_pushing_past_it/?page=full
What a guy! We are soooooo lucky to have someone as tolerant and understanding on the job! After all ‘soft power’ is the meme of the day [warning, snark alert!].
Honestly, who dreams up PR bullshit articles like this anyway? Someone looking for a job reference or just access?