Was Fed Policy to Blame?

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This week’s blog has two parts.  The first part reviews a recent paper by John Taylor.  The second part has some random thoughts (but these are dominated by some comments about the big political issue – the Bush tax cuts).

Part I: Getting Back on Track

This week, I read a short paper by Stanford Professor John Taylor.  The paper is called, “Getting Back on Track: Macroeconomic Policy Lessons from the Financial Crisis”.  Here’s the link.

As always, please understand that I am often lifting complete sentences (and charts) from this paper.  This is John Taylor’s work, not mine.  I am trying to make ideas more accessible.

This paper is significant.  It should really make us think about the role of the Fed, whether the Fed has lost its independence and whether today’s low rates will cause future problems.

A. Primer Before Reading the Paper

John Taylor is best known for “the Taylor Rule”.   This rule is an equation that quantifies the appropriate level for the Fed funds rate based on inflation and GDP growth (relative to potential growth).  The Taylor rule says that the federal funds rate should equal 1.5 times the inflation rate plus .5 times the GDP gap plus 1.   According to his blog, the Fed funds rate should currently be .75%.

If you want to read a Fed paper about the Taylor Rule, here’s a link.

B. Key Points from Introduction

1. While government intervention in the crisis was well-intentioned, much of it did a great deal of harm.  We need to get back to the policies that worked well for a long period of time.

2. From the early 1980’s until the crisis, business cycles had lengthened and recessions had become less severe.  He describes this as the “Great Moderation.”  He suggests that the Great Moderation ended because of a “Great Deviation” from what had worked so well in the past.

3. The Great Deviation was a period in which policy became more interventionist, less rules-based and less predictable.

C. Monetary Excesses

1. In the first part of this decade, the Fed kept interest rates too low (according to the Taylor rule).  Rates went too low and were kept too low for too long a period of time.  See Figure 1 below.

Federal Funds Rate

2. Even without the Taylor rule, you just have to know that the real interest rate was negative for too long a period of time.

3. Low interest rates added fuel to the housing boom which led to risk taking in housing finance.  This lead to balance sheet deterioration at many financial institutions.  Much of this boom and many of the problems could have been avoided by better Fed policy.

4. This Fed policy was a discretionary intervention – it was an intentional departure from the policies that were followed for decades.

5. While other factors were important (Fannie and Freddie also encouraged the boom and capital inflows from abroad may have added to the problem), it is clear that monetary policy had deviated and would likely lead to poor policy performance.

D. More Interventions

1.  When it started to become apparent that we had problems (August 2007), the crisis was misdiagnosed as a liquidity problem, rather than a counterparty risk problem.

2. Because of the misdiagnosis, the medicine was inappropriate.

3. The evidence that the remedy was inappropriate can be seen by the fact that the LIBOR-OIS spread did not contract as the result of government action.  See exhibit 2 below.  This spread measures the difference between the interest rate on three month unsecured loans between banks (LIBOR) and an estimate of what the Fed funds rate will be (on average) over those three months (OIS).  The spread is a good measure of the tension in the interbank market.

term auction Facility and the libor ois spread

4. Of course, we now know that the banks held many toxic assets (we didn’t know that with such clarity in real time).  But, this spread was our clue.

5. Remedies such as the term auction facility had no long-term impact on the spread.

6. Most importantly, this policy intervention prolonged the crisis because it did not address the balance sheet problem at the banks and other financial institutions.

E. Interventions to Rescue the Creditors of Individual Financial Firms

1. The most unusual and significant actions were the government interventions to rescue financial firms and their creditors.  This culminated with the rollout of the Troubled Asset Relief Program (TARP) during the week of September 21, 2008.

2. The LIBOR-OIS spread jumped during this period of panic.  See exhibit 3 below.

Worsening Crisis

3. It is particularly interesting that the spread jumped with the announcement of TARP, not with the Lehman bankruptcy.  Investors were skeptical of the plan.

4. As TARP was rolled out, we were warned of “systemic risk” and the possibility of a “Great Depression.”

5.  The chaotic pattern of these interventions could have been avoided if the markets and the general public had been guided by the Fed and the Treasury regarding the reasons behind the Bear Stearns intervention and the direction and intentions of policy going forward.

6. The turning point in the panic (measured by the LIBOR-OIS spread) occurred when the uncertainty about TARP was removed.  Originally, the TARP’s purpose was to buy toxic assets (and no one understood how it would work).  On late Sunday (October 12) and early Monday (October 13), the plan was changed so that TARP would involve injecting equity.

7. While focusing on the TARP clarification, Taylor also states that the Fed’s action in restoring confidence in the money market mutual funds and commercial paper market also helped.

F. Interventions After the Panic

1. After the panic, two other programs were enacted: the program to buy MBS and the Term Asset-Backed Securities Loan Facility (TALF).  (TALF has been very small.)

2. Taylor believes that the purchase of $1.25 trillion of MBS had a small impact on mortgage rates once we control for prepayment risk and default risk.

3. The fiscal stimulus in 2009 was larger than 2008, but the checks were smaller and more drawn out.  But, there is no noticeable effect on consumptionSee chart 4 below.

Personal Disposable income

4. Cash for Clunkers did impact consumption, but it did not last and can not be considered an effective method to stimulate the economy.

5. Taylor’s analysis of government spending is that it had too little positive impact.

G. The Legacy of the Interventions

1. The crisis has distracted us from our debt problems.  He showed our historical debt-to-GDP ratio.  See chart 5 below.

Federal debt as a percentage of GDP

2. Obviously, many of our problems are legacy problems.  But, then you have to add stimulus, recession and more importantly, the inability to rein in spending for our entitlement programs.

3. If debt progresses as the CBO projects (see exhibit 6 below), the United States will not be the United States.  Something has to give – the question is what.

Federal debt as a percentage of GDP

H. Long-Term Effects of Monetary Policy Actions

1. There are now questions about Fed independence.  The programs implemented were not pure monetary policy.

2. Unwinding the programs creates uncertainty.  The reserve balances (of financial institutions) is huge, as is the Fed’s portfolio.  We don’t know what the impact will be on mortgage rates when the Fed reduces its balance sheet.  We also don’t know what is the long-term amount of reserves that banks will want to hold.

3. There is the risk of inflation.  The two biggest risks are the possibility that the Fed is not able to reduce its balance sheet as the economy recovers and the increase of public debt.

I. Policy Implications

1.  The government interventions did more harm than good.

2. Fiscal policy needs to avoid debt-increasing and wasteful discretionary stimulus packages, which do little to stimulate GDP.  Fiscal policy needs to focus on reducing the deficit and the growth of the debt-to-GDP ratio.  It is essential to reform the entitlement programs.

3. Monetary policy must return to using the Fed funds rate (and the monetary supply) to control inflation or stimulate growth (in other words, follow the Taylor rule) and the Fed must maintain its independence and focus on its main objectives of controlling inflation and promoting macroeconomic stability.  The Fed must not allocate credit or engage in fiscal policy by adjusting the composition of its portfolio toward or away from certain firms or sectors.  The Fed needs to downsize its portfolio as soon as possible.

A Few Comments (from Leeds)

1. I had always been skeptical of the argument that monetary policy was to blame for the crisis.  But, this article leads me to respect its impact in a greater way.

2. The timing argument (the LIBOR-OIS spread didn’t blow out right after Lehman declared bankruptcy) is a tough argument.  It may have been a few days until we realized the significance.

3. Not everything can be solved with monetary policy.  You can’t solve weak balance sheets with cheap money.

4. Professor Taylor emphasized the clarification of the plan.  I’m not sure how much of this was a “clarification issue” or more of a plan that we just didn’t believe it.  Maybe if you can’t clarify something, it’s not a good plan.

Part II: A Few Random Thoughts

1. At least seven mayors in various Mexican states have been assassinated in 2010.

2. Reggie Bush is no longer a Heisman winner.  OJ Simpson still is.

3. The FT reports that global bond issuance by companies rated BBB and below is $177 billion YTD, up 96%.

4. You MUST look at this link. This has a ton of poll results about the Bush tax cuts and opinions as to who is to blame for the economy, etc.  I have to tell you that these polls SHOCKED me.  I’ve often felt like I’m the only person I know who thinks that the Bush tax cuts should all be allowed to lapse or that we should let them lapse for the top brackets.  Yet, in the last poll, Americans are basically split equally between keeping all tax cuts in place and letting them lapse for the top brackets and letting them all lapse.  It may be that I simply hear more from the people who strongly believe that all of the Bush tax cuts should be maintained.

5. The Tax Policy Center (the Urban Institute and the Brookings Institution) say that Obama’s plan would retain approximately 82% of the dollar value of the Bush tax cuts and would keep taxes the same for approximately 98% of taxpayers.

6. Moody did some research and argued that tax cuts led to higher savings rates for the wealthy and tax increases (under President Clinton) resulted in a lower savings rate.  Moody’s found that spending by the top 5% of households is much more closely tied to the stock market rather than tax cuts.  This gets to the heart of the argument (and reasonable people can disagree)…the issue is whether tax cuts for the top bracket are stimulative or not.  (While I agree with what Moody’s said, I also recognize that Moody’s told me some securities were AAA rated and that didn’t turn out that well for me…)

7. Greg Sargent blogged on washingtonpost.com that letting the tax cuts lapse for the highest income bracket is supported by the majority of voters.  Yet, the Republicans seem very willing (even eager) to fight for the tax cuts.  His theory is that the Republicans love talking about this issue because talking about taxes makes voters think about Democrats and their reputation for higher taxes and greater spending.  The fact that most Americans agree with letting the tax cuts lapse for the highest income bracket gets lost.  I thought that this was interesting.  As I described above, it does seem to me (after seeing the polls) that most people agree with letting the tax cuts lapse but that the Democrats are losing the political battle.

8. For a really interesting survey showing that 36% of Americans either think that it’s okay to walk away from a house if you’re underwater or think that it’s okay under certain circumstances, see this link. .  This survey also gives some estimates regarding the demographics of those people who are underwater.