60 Minutes on the Shadow Banking System

The Fed's Contribution to the Financial Crisis

Mark Thoma points us to an interesting take by Nick Rowe on the origins of the financial crisis. Among other things, Rowes' account speaks to the role the Federal Reserve played in creating the financial crisis. Here is a key excerpt:

So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high.

So Rowe has drank the "saving-glut" Kool Aid and sees no culpability for the Fed. His justification for this conclusion is that since inflation was not accelerating in the early 2000s it must be that the Fed did not push interest rates below the natural interest rate level. A stable inflation rate, however, is not a sufficient condition for macroeconomic stability. This is evident when one considers that the inflationary effects of an overly accommodative monetary policy--a positive aggregate demand shock--can be temporarily masked by gains to aggregate supply. A close look at the data seems to indicate this was case in 2003-2005: productivity growth accelerated just as the fed pushed interest rates to floor. The figure below illustrates this point. It shows the year-on-year growth rate of productivity versus the real (ex-post) federal funds rate (click on figure to enlarge):

It is worth noting that higher productivity growth rates are typically associated with higher real interest rates, not lower ones. When productivity growth--which provides a proxy for profitability--diverges so far from the real federal funds rate--the cost of borrowing to invest in this profitability--as it did during this time a credit boom is inevitable. Given the Fed's monetary hegemon status, this credit boom went global and created a global liquidity glut.

Clearly, there was more than just loose monetary policy behind this financial crisis (see Barry Ritholtz for a nice summary). But as I have argued here on this blog and elsewhere, inordinately loose monetary policy between 2003-2005 played a key part in stoking the coals of the housing boom during that time.

The Financial Crisis on SNL

Here is Saturday Night Live's take on the financial crisis:



Update: the video clip seems to have vanished from the SNL website, but for now you can find it on You Tube:



Update II: Apparently this skit was too politically sensitive for NBC and thus was pulled. See here for the details and the transcript of the clip.

Update III: Greg Mankiw directs us to this site where the video clip is still up.

How Bad Could it Get?

Dr. Doom (i.e. Nouriel Roubini) says we may soon see the mother of all bank runs.

The next step of this panic could be the mother of all bank runs, i.e. a run on the trillion dollar-plus of the cross-border short-term interbank liabilities of the U.S. banking and financial system, as foreign banks start to worry about the safety of their liquid exposures to U.S. financial institutions. A silent cross-border bank run has already started, as foreign banks are worried about the solvency of U.S. banks and are starting to reduce their exposure. And if this run accelerates--as it may now--a total meltdown of the U.S. financial system could occur.

What Presidential Candidate Do Economists Prefer?

Paul Krugman had a recent column in the NY Times titled The 3 A.M. Call. Here is the lead paragraph:

It’s 3 a.m., a few months into 2009, and the phone in the White House rings. Several big hedge funds are about to fail, says the voice on the line, and there’s likely to be chaos when the market opens. Whom do you trust to take that call?

Krugman makes clear his preference, but what about other prominent economists? Who would they want to take the call? The Economist magazine now has a tentative answer. The magazine polled the economists associated with the National Bureau of Economic Research (NBER), an association of leading research economists. The poll was not favorable to McCain. Here is the summary figure from the article (click to enlarge):


I found this paragraph from the article to be interesting:

A candidate’s economic expertise may matter rather less if he surrounds himself with clever advisers. Unfortunately for Mr McCain, 81% of all respondents reckon Mr Obama is more likely to do that; among unaffiliated respondents, 71% say so. That is despite praise across party lines for the excellent Doug Holtz-Eakin, Mr McCain’s most prominent economic adviser and a former head of the Congressional Budget Office. “Although I have tended to vote Republican,” one reply says, “the Democrats have a deep pool of talented, moderate economists.”

McCain, however, did edge Obama on free trade and globalization issues. McCain also did better in a survey given to industry economists back in May. I wonder if industry economists still favor McCain today.

Read the rest of the article.

Credit Crisis Hits Higher Education

From the New York Times:

In a move suggesting how the credit crisis could disrupt American higher education, Wachovia Bank has limited the access of nearly 1,000 colleges to $9.3 billion the bank has held for them in a short-term investment fund, raising worries on some campuses about meeting payrolls and other obligations.

[...]

Wachovia’s action was perhaps the most tangible signal yet that the credit crisis could have a powerful impact on higher education. Another sign came on Tuesday as Boston University, saying it needed to respond to the financial crisis with cautionary steps, announced an immediate hiring freeze and a moratorium on new construction projects.

[...]

Colleges have used the fund, formally called the Commonfund Short Term Fund, almost like a checking account, depositing revenues including tuition payments and withdrawing funds daily to finance payrolls, maintenance expenses, small construction projects and other short-term needs, college officials said.

Gulp. Did I mention I, a tenure-track assistant professor, am the lowest on the food chain in academia?

Redefining the "Bailout": A Hedge Fund for the Masses

Does the bailout have you down? If so, Daniel Gross of Slate and John Berry of Bloomberg have the perfect cheer-me-up tonic in their clever redefining of the bailout. First, Daniel Gross tells us that the bailout is like a hedge fund for the masses:

The Wall Street bailout is alive again...What's most interesting about the Emergency Economic Stabilization Act of 2008 is just how much it reads like a prospectus for a hedge fund. In the past, hedge funds—secretive pools of capital—were open only to qualified (read: rich) investors. But with the stroke of a pen, President Bush will soon make all American citizens investors in the world's biggest fund—and a democratic one at that. Taxpayers won't just be the investors. We'll own the management company, too. Best of all? For at least a few months, we'll have the former CEO of Goldman Sachs run our investment for a very small fee. Call it the "Universal Hedge Fund."

Hedge funds use leverage: That is, they borrow money to amplify their returns. The Universal Hedge Fund will use massive leverage, borrowing up to $750 billion, which it will use to buy up distressed assets. The Universal Fund might best be described as a multi-multistrategy fund. Its stated goals are to maximize returns to its investors while promoting general market stability and bolstering the crippled housing market.

Universal hedge fund coverage for people like me. I love it! But wait, it gets better. Not only is this endeavor a hedge fund for the masses, it may just be one of the more successful ones in history. John Berry tells us how this is possible:

There might be a gem in the Treasury's plan to buy $700 billion of dubious mortgage-related assets.

Call it the biggest carry trade in history. It might just put as much as $60 billion a year in the government's coffers.

[...]

The government will get the $700 billion by selling a range of Treasury securities to the public with yields of 3 percent to 4 percent. With investors around the world clamoring to buy risk-free Treasuries, the market should be able to absorb the jump in supply without a significant increase in yields.

Contrast that with likely yields on the troubled assets for which there currently is no market. No one can be sure how big a haircut there will be on the assets Treasury buys, though if it's 50 percent or more, their yields should be 10 percent or higher.

That is, the government will be borrowing at 3 percent to 4 percent to buy assets yielding 10 percent or even 12 percent. Conservatively, that spread on an investment of $700 billion should generate income of $40 billion to $60 billion annually.

Now that it music to my ears! I just hope that if this investment income does appear it is not earmarked for new spending, but used to reign in the existing structural budget deficit.