Balance Sheet Fictions

Wow. I never thought Enron would be matched or surpassed in terms of balance sheet gimmickry, but it seems that Lehman accomplished just that according to the court-ordered report on Lehman's demise. Dylan Ratigan does a great job explaining how Lehman accomplished this feat:

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Along these lines, Frank Partnoy makes the case that financial firms still doctor up their balance sheets--though not as deceptively as Lehman or Enron--primarily by use of off-balance sheet accounting tricks. These "balance sheet fictions" as he calls them were an important part of the financial crisis (e.g. SIVs) and he wants them to be addressed by financial reform legislation too. Partnoy argues that unless the abuse of off-balance sheet accounting gets included, financial reform will not work. Here is a short video clip where he explains his concerns.

A Quick History of Foreign-Held U.S. Public Debt

Bruce Bartlett has an interesting article that traces the history of the U.S. public debt that is foreign held. Here is an excerpt:

Until the 1970s foreigners owned less than 5% of the national debt. This began to change after the big run-up in oil prices. As oil exporters suddenly acquired vast financial resources they found it convenient to park them in Treasury securities, which provided liquidity and safety. By 1975 the foreign share of the national debt rose to 17%, where it stayed through the 1990s, when China began buying large amounts of Treasury bills. At the end of last year foreigners owned close to half of the publicly held national debt.

Here is the table from his column:

Assorted Musings

Here are a few musings:

1. Reflationists receive a smackdown over at Naked Capitalism. There the guest blogger Washington takes to task all those observers who claim we can inflate our way out of the debt crisis. He notes that any inflation benefit will be offset by problems from higher interest rates and creditors fleeing the United States. I am not sure the reflationists of the world ever claimed we should (or even could) eliminate all of our debt problems with inflation, only that we could lighten the real debt burden enough to allow for faster economic recovery. The slightly higher inflation could also be part of a plan that would do more than just lower real debt burdens. It would also increase inflationary expectations--if the higher inflation were perceived to be permanent--and thereby increase current spending.

2. Speaking of smackdowns, George Selgin provides one to the central banks of the world. He argues central banks by default tend to create financial instability:

The present financial crisis shows how central banks can fuel the financial booms that make severe busts possible. Unfortunately, theoretical discussions of central banking badly neglect its role in fostering financial instability, in part because they ignore its history and political origins.

If you find this topic interesting see his talk last year at the CATO monetary policy conference.

3. Further evidence from Marco Del Negro, Gauti Eggertson, Andrea Ferrero, and Nobuhiro Kiyotaki that monetary policy does not run out of ammunition once the policy interest rate hits the lower zero bound:

This paper extends the model in Kiyotaki and Moore (2008) to include nominal wage and price frictions and explicitly incorporates the zero bound on the short-termnominal interest rate. We subject this model to a shock which arguably captures the 2008 US financial crisis. Within this framework we ask: Once interest rate cuts are no longer feasible due to the zero bound, what are the effects of non-standard open market operations in which the government exchanges liquid government liabilities for illiquid private assets? We find that the effect of this non-standard monetary policy can be large at zero nominal interest rates. We show model simulations in which these policy interventions prevented a repeat of the Great Depression in 2008-2009.

The authors conclude, then, that the Fed can have meaningful influence on the economy even when short-term interest rates are at zero percent. If so, then why did not the Fed do more in late 2008 and early 2009 to prevent The Great Nominal Spending Crash?

A Step in the Right Direction

So it seems likely that Janet Yellen will be the next Vice Chair of the Fed. I believe she is a great choice for several reasons. First, unlike Bernanke and other Fed apologists, she acknowledges U.S. monetary policy may have played a role in the housing boom:

[I]f a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy. However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets. Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.

Second, as noted above she is open to some form of macroprudential regulation. I have become convinced by Claudio Borio, William White and others at the BIS that this is an important idea given the current realities in the financial system. Third, Yellen acknowledges that the Fed is a monetary superpower. Just admitting this point means she is taking seriously the Fed's role in creating global liquidity conditions. Any candidate who brings such fresh thinking on these three issues to the Board of Governors would be a welcome change in my view. Yes, there are areas where I disagree with her--she thinks monetary policy is limited at the zero bound, I do not--but on balance she brings a perspective to the Fed that if followed makes its less likely the Fed will repeat the monetary policy mistakes it made in the early-to-mid 2000s. Making Janet Yellen the next Vice Chair is a step in the right direction for improving the Fed.

A Note to the Financial Crisis Inquiry Commission

President Obama's Financial Crisis Inquiry Commission (FCIC) is under way and taking testimony from economists and other experts on what they believe were important contributors to the crisis. I was interested to see what was being said about the role U.S. monetary policy may have played in creating the crisis. Surprisingly, the only public testimony that looks closely at monetary policy's role is that of Pierre-Olivier Gourinchas.*His testimony amounts to two main points: (1) the conduct of the Fed in the early-to-mid 2000s was largely warranted given the threat of deflation and the weak employment growth then and (2) it was not so much a saving glut as it was an excess demand for safe debt instruments only available in the United States that caused excessive amounts of credit to be channeled to the U.S. economy. On both points there are alternative perspectives that paint a far less favorable view of U.S. monetary policy at the time. In case the FCIC is wondering, here are my own views on these two points:

(1) There is a good explanation for the deflationary pressures and the weak recovery in the labor market in the early-to-mid 2000s that does not justify the Fed's monetary policy at the time: strong productivity growth. Productivity growth accelerated for several years after the 2001 recession peaking in late 2003, early 2004. These rapid productivity gains were the cause of the deflationary pressure, not weak aggregate demand. In fact, by 2003 the aggregate demand growth rate was accelerating and reached about 6.5% growth in 2004. The rapid productivity gains most likely also account for much of the weak employment recovery that lasted through mid-2000s. Firms were not hiring as much labor in the recovery because less was immediately needed given the productivity surge. There is a significant empirical literature that shows productivity shocks typically lead to fewer hours worked in the short-run. Unfortunately, the Fed saw deflationary pressures and thought weak aggregate demand instead of productivity gains. It failed to make the important distinction between benign and malign deflationary pressures. [Update: For more on this distinction see here.]

Given the productivity growth-origin of both the deflationary pressures and weak employment recovery, the Fed's actions were not warranted at the time. Moreover, the Fed's response meant it was pushing real short-term interest rates into negative territory just as the rapid productivity gains were pushing up the neutral real interest rate. This interest rate disequilibrium was at the heart of the credit boom.

(2) The saving glut theory and the excess demand for safe debt instrument variation told by Gourinchas fails to acknowledge that some of the increase in excess saving from abroad is itself a result of U.S. monetary policy. As I wrote before:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

Guillermo Calvo makes a similar point. He argues that after 2002 it was fear of currency appreciation due to the Fed's easy monetary policy that drove the demand for U.S. assets, not excess foreign demand for safe debt instruments. Likewise, Maurice Obstfeld and Kenneth Rogoff argue that global savings in part had its origins with U.S. monetary policy:

We emphasize that this increase in global saving starting in 2004 plays out largely after the period Bernanke (2005) discussed in his “saving glut” speech, and arguably was triggered by factors including low policy interest rates. In our view, the dot-com crash along with its effects on investment demand, coupled with the resulting extended period of monetary ease, led to the low long-term real interest rates at the start of the 2000s. However, monetary ease itself helped set off the rise in world saving and the expanding global imbalances that emerged later in the decade. (p.22)

All of these authors and myself agree there were more factors in this crisis than just an overly accommodative U.S. monetary policy in the early-to-mid 2000s. However, monetary policy did play one of the more important roles and if the FCIC, policymakers, and the public conclude differently I fear we are doomed to repeat history.

*John B. Taylor submitted brief answers to a questionaire from the commission. His response, however, was not part of the public testimony.

A Question for the James Kwaks and Simon Johnsons of the World

Mark J. Perry has an interesting piece comparing the banking system in Canada with that of the United States. He notes that Canadian banking system has done much better than the U.S. one not only during this crisis but also during the Great Depression. He lists a number of reasons for the better Canadian performance during the recent crisis. Let me suggest another important difference: Canada had a better monetary policy during this time.

Now of the reasons provided by Perry, I believe the most important one is the extensive branch banking in Canada. As Perry notes, the U.S. has been plagued by unit-banking laws for years; it was not until 1994 that interstate branch banking was legal in the United States. Because of this difference Canadian banks had (1) better geographical diversification of their assets and (2) quicker access to reserves in the event of a bank run (i.e. draw on a branch bank's reserves). That is most likely why over 9000 U.S. banks perished during the Great Depression but zero shut down in Canada at that time. It is also a key reason why almost 3000 banks failed during the S&L crisis in the United States and only two shut down in Canada. One issue, however, associated with the extensive branch banking in Canada is the high concentration of asset ownership. Perry says this is a plus since it allows better coordination between policymakers and key players in the banking system during a crisis. Other observers like James Kwak and Simon Johnson are against high concentration of asset ownership. Their argument is that having a few banks control most of a nation's assets makes for a too-big-to-fail moral hazard problem as well as making the banks too influential. So here is a question to the James Kwaks and Simon Johnsons of the world: how do you reconcile your view of banking with the banking experience in Canada?

The New Maestro of Monetary Policy?

Move over Alan Greenspan, here is allegedly the real maestro of monetary policy. Scott Sumner makes a similar argument about this country's conduct of monetary policy.