The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.
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April 06, 2010
Breaking up big banks: As usual, benefits come with a side of costs
Probably the least controversial proposition among an otherwise very controversial set of propositions on which financial reform proposals are based is that institutions deemed "too big to fail" (TBTF) are a real problem. As Fed Chairman Bernanke declared not too long ago:
As the crisis has shown, one of the greatest threats to the diversity and efficiency of our financial system is the pernicious problem of financial institutions that are deemed "too big to fail."
The next question, of course, is how to deal with that threat. At this point the debate gets contentious. One popular suggestion for dealing with the TBTF problem is to just make sure that no bank is "too big." Two scholars leading that charge are Simon Johnson and
James Kwak (who are among other things the proprietors at The Baseline Scenario blog). They make their case in the New York Times' Economix feature:
Since last fall, many leading central bankers including Mervyn King, Paul Volcker, Richard Fisher and Thomas Hoenig have come out in favor of either breaking up large banks or constraining their activities in ways that reduce taxpayers' exposure to potential failures. Senators Bernard Sanders and Ted Kaufman have also called for cutting large banks down to a size where they no longer pose a systemic threat to the financial system and the economy.
…We think that increased capital requirements are an important and valuable step toward ensuring a safer financial system. We just don't think they are enough. Nor are they the central issue…
We think the better solution is the "dumber" one: avoid having banks that are too big (or too complex) to fail in the first place.
Paul Krugman has noted one big potential problem with this line of attack:
As I argued in my last column, while the problem of "too big to fail" has gotten most of the attention—and while big banks deserve all the opprobrium they're getting—the core problem with our financial system isn't the size of the largest financial institutions. It is, instead, the fact that the current system doesn't limit risky behavior by "shadow banks," institutions—like Lehman Brothers—that carry out banking functions, that are perfectly capable of creating a banking crisis, but, because they issue debt rather than taking deposits, face minimal oversight.
In addition to that observation—which is the basis of calls for a systemic regulator that spans the financial system, and not just specific classes of financial institutions—there is another, very basic, economic question: Why are banks big?
To that question, there seems to be an answer: We have big banks because there are efficiencies associated with getting bigger—economies of scale. David Wheelock and Paul Wilson, of the Federal Reserve Bank of St. Louis and Clemson University, respectively, sum up what they and other economists know about economies of scale in banking:
…our findings are consistent with other recent studies that find evidence of significant scale economies for large bank holding companies, as well as with the view that industry consolidation has been driven, at least in part, by scale economies. Further, our results have implications for policies intended to limit the size of banks to ensure competitive markets, to reduce the number of banks deemed "too-big-to-fail," or for other purposes. Although there may be benefits to imposing limits on the size of banks, our research points out potential costs of such intervention.
Writing at the National Review Online, the Cato Institute's Arnold Kling acknowledges the efficiency angle, and then dismisses it:
There's a long debate to be had about the maximum size to which a bank should be allowed to grow, and about how to go about breaking up banks that become too large. But I want to focus instead on the general objections to large banks.
The question can be examined from three perspectives. First, how much economic efficiency would be sacrificed by limiting the size of financial institutions? Second, how would such a policy affect systemic risk? Third, what would be the political economy of limiting banks' size?
It is the political economy that most concerns me…
If we had a free market in banking, very large banks would constitute evidence that there are commensurate economies of scale in the industry. But the reality is that our present large financial institutions probably owe their scale more to government policy than to economic advantages associated with their vast size.
I added the emphasis to the "probably" qualifier.
The Wheelock-Wilson evidence does not disprove the Kling assertion, as the estimates of scale economies are obtained using banks' cost structures, which certainly are impacted by the nature of government policy. But if economies of scale are in some way intrinsic to at least some aspects of banking—and not just political economy artifacts—the costs of placing restrictions on bank size could introduce risks that go beyond reducing the efficiency of the targeted financial institutions. If some banks are large for good economic reasons, the forces that move them to become big would likely emerge with force in the shadow banking system, exacerbating the very problem noted by Krugman.
I think it bears noting that the argument for something like constraining the size of particular banks implicitly assumes that it is not possible, for reasons that are either technical or political, to actually let failing large institutions fail. Maybe it is so, as Robert Reich asserts in a Huffington Post item today. And maybe it is in fact the case that big is not beautiful when it comes to financial institutions. But in evaluating the benefits of busting up the big guys, we shouldn't lose sight of the possibility that this is also a strategy that could carry very real costs.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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March 05, 2010
In the beginning, there was a lender of last resort
Steven Pearlstein, business columnist for the Washington Post, asks and answers the question "should the Fed stay out of the bank supervision business?"
"As the Senate begins to focus on how to fix financial regulation, one of the remaining unresolved issues is what role the Federal Reserve should have in supervising banks.
"The correct answer? None at all."
One of the centerpieces of the Pearlstein argument is this:
"The reality is that the Fed's primary focus is and will always be on monetary policy. Bank supervision will continue, as it has been, as a secondary activity that not only receives less attention from the top but will be sacrificed at those rare but crucial moments when the two missions might conflict. Indeed, by arguing that the Fed needs the insights gleaned from bank supervision to be more effective in making monetary policy, the Fed essentially acknowledges this hierarchy in its priorities. Bank supervision is important enough that it ought to be somebody else's top priority."
If you might allow me a moment of personal indulgence, there was a time when I had some sympathy with the sentiment that the "Fed's primary focus is and always will be on monetary policy." I, of course, knew the story of the creation of the Fed, motivated by the need to provide an elastic currency to avoid disruptive fluctuations in prices and a lender of last resort to stop liquidity stress from becoming a full-blown financial crisis. But that was a story from the past. The modern world began in 1935 with the statutory creation of the Federal Open Market Committee, which would eventually evolve, with its central bank brethren in the rest of the world, into the institution described by Pearlstein as being primarily focused on monetary policy.
I felt that way until Sept. 11, 2001. On an average day in the week ending Sept. 5 of that year, the Federal Reserve extended $21 million in discount loans to banks, a reasonably representative volume. On Sept. 12, discount loans amounted to over $45 billion. As a result, the U.S. financial system did not collapse.
The horrible circumstances of 9/11 have been thankfully unique, but there is a case to be made for the proposition that the most important role of the central bank in the recent financial crisis was not in the realm of traditional monetary policy but in the exercise of variations on the lender-of-last-resort function. In fact, in times of acute financial stress, this role must always be so. Witness this remark by Alan Greenspan on Oct. 20, 1987:
"… in a crisis environment, I suspect we shouldn't really focus on longer-term policy questions until we get beyond this immediate period of chaos."
Which brings us to the question of the Fed's role in bank supervision. More precisely, it brings us to comments from Atlanta Fed President Dennis Lockhart, who delivered remarks on Wednesday to the New York Association for Business Economics:
"… the Fed must play a central role in a defense structure designed to prevent or manage future crises. My key argument is the indivisibility of monetary authority, the lender-of-last-resort role, and a substantial direct role in bank supervision. Only the Fed can act as lender of last resort because only the monetary authority can print money in an emergency. To make sound decisions, the lender of last resort needs intimate hard and qualitative knowledge of individual financial institutions, their connectedness to counterparties, and the capacity of management.
"There is sentiment in Washington that would separate these tightly linked functions that are so critical in responding to a financial crisis. Removing the central bank from a supervision role designed to provide totally current, firsthand knowledge and information will weaken defenses against recurrence of financial instability. Flawed defenses could be calamitous in a future we cannot see."
If this advice goes unheeded, I fear we might discover its wisdom in the worst possible circumstances.By Dave Altig, senior vice president and research director at the Atlanta Fed
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February 19, 2010
Should the Fed stay in regulation?
One of the central issues in the postcrisis effort to reform our regulatory infrastructure is who should do the regulating. The answer to some in Congress is none of the above:
"… under consideration is a consolidated bank regulator, one aide [to Alabama Senator Richard Shelby] said. The idea is supported by [Connecticut Senator Christopher] Dodd, who proposed eliminating the Office of Thrift Supervision and Office of the Comptroller of the Currency, and moving their powers, along with the bank-supervision powers of the Federal Reserve and the Federal Deposit Insurance Corp., to the new agency.
"Negotiators are still deciding how to monitor firms for systemic risk, including how to define and measure it, what authorities to give a regulator and which agency is best suited to get the power, a Shelby aide said."
As reported in The New York Times:
"The Senate and the Obama administration are nearing agreement on forming a council of regulators, led by the Treasury secretary, to identify systemic risk to the nation's financial system, officials said Wednesday…"
Though the idea of a council to provide regulatory and supervisory oversight is still contentious (the Times article offers multiple opinions from Federal Reserve officials) the formation of a council is not necessarily the same thing as removing the central bank from boots-on-the-ground, or operational, supervisory responsibility. In other words, there is still the question of how to monitor systemic risk and which agency is best suited to get the power.
Earlier this week I made note of a new International Monetary Fund (IMF) paper by Olivier Blanchard, Giovanni Dell'Aricca, and Paulo Mauro, taking some issue with the proposal that central banks consider raising their long-run inflation objectives. Though that part of the paper seemed to attract almost all of the attention in the media and blogosphere, the discussion in the IMF article expanded well beyond that inflation target issue. Included among the many proposals of Blanchard et al. was this, on systemic risk regulation and the role of the central bank:
"If one accepts the notion that, together, monetary policy and regulation provide a large set of cyclical tools, this raises the issue of how coordination is achieved between the monetary and the regulatory authorities, or whether the central bank should be in charge of both.
"The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators. They are ideally positioned to monitor macroeconomic developments, and in several countries they already regulate the banks. 'Communication' debacles during the crisis (for example on the occasion of the bailout of Northern Rock) point to the problems involved in coordinating the actions of two separate agencies. And the potential implications of monetary policy decisions for leverage and risk taking also favor the centralization of macroprudential responsibilities within the central bank."
Consistent with the even-handedness of the Blanchard et al. paper, the authors did not come to this conclusion without noting the legitimate issues of those who would separate regulatory authority from the central bank:
"Against this solution, two arguments were given in the past against giving such power to the central bank. The first was that the central bank would take a 'softer' stance against inflation, since interest rate hikes may have a detrimental effect on bank balance sheets. The second was that the central bank would have a more complex mandate, and thus be less easily accountable. Both arguments have merit and, at a minimum, imply a need for further transparency if the central bank is given responsibility for regulation."
But, they conclude:
I wonder, then: Would a regulatory council of which the Federal Reserve is a member, combined with operational supervisory responsibilities housed within the central bank, be a tolerably good response to Blanchard's and his colleagues' admonitions?
"The alternative, that is, separate monetary and regulatory authorities, seems worse."
By Dave Altig, senior vice president and director of research at the Atlanta Fed
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December 23, 2009
Change the bathwater, keep the baby
What have we learned from the experience of the last two years? The Wall Street Journal offers up one discouraging conclusion:
"For much of the past century, America has served as the global model for the power of free markets to generate prosperity…
"In the 2000s, though, the U.S. quickly went from being the beacon of capitalism to a showcase for some of its flaws…
"But one thing is certain: America's success or failure over the next decade will go a long way toward defining what the world's next economic model will be."
One of the article's implied alternatives for the world's next economic model seems a bit of a stretch:
"The troubles in the U.S. stand in sharp contrast to the relative success of other countries, notably China. With a system that is at best quasi-capitalist, China's economic output per person grew an inflation-adjusted 141% over the decade, and hardly paused for the global crisis, according to estimates from the International Monetary Fund. That compares with 9% growth in the U.S. over the same period."
Let's put that comparison to rest right away:
The theory of economic growth is rich, interesting, and somewhat unsettled, but it stands to reason that emerging economies, where the fruit hangs low, can for a time grow much faster than advanced, fully developed countries. Furthermore, I find it reasonable to assume that, contrary to representing an alternative economic model, the Chinese experience over the past decade is itself evidence that even incomplete movements in the direction of free markets can pay large dividends. But even if you doubt that interpretation, the gap between the material circumstances of the average American and Chinese citizen is so large as to make comparisons about the success of the respective economic models premature by several decades.
In fact, the picture above nicely illustrates what I believe is a more on-the-mark observation in the WSJ article:
"At least twice in the past century, the U.S. has re-emerged from deep crises to reinvent capitalism. In the 1930s, the Depression compelled Franklin Roosevelt to introduce Social Security, deposit insurance and the Securities and Exchange Commission.
"After the brutal stagflation of the 1970s and early 1980s, then-Federal Reserve Chairman Paul Volcker demonstrated the ability of an independent central bank to get prices under control, ushering in an age in which powerful, largely autonomous central banks became the norm throughout the developed world."
So what, then, is the alternative model waiting in the wings to replace the current one? It's not given a name, but the features are clear in the article:
"Policy makers' focus now, though, is on the financial sector that failed so spectacularly. Progress has been slow, and key pieces are missing, but the contours of a new system are taking shape. Banks will face stricter limits on their use of borrowed money, or 'leverage,' to boost returns. The Fed will keep a closer eye on markets during booms, and possibly step in to curb excessive risk-taking—a U-turn from its previous policy of mopping up after bubbles burst.
"Such changes would amount to a grand bargain: Give up some of the growth and dynamism of the U.S. economy for a safer, more equitable brand of capitalism—one that could avoid the kind of busts that turned the 2000s into such a disaster."
OK, but here is the central question: How can we be sure that the "new system" will be an improvement on the one it replaces? Some of the most significant failures of the last couple of years occurred in highly regulated industries. So the absence of regulation is not really at issue, but rather what kind of regulation we will have, and how it will be implemented. And there is the obvious point that regulatory change is not really reform if it undermines a system's existing strength. Some of the reform proposals on the table, for example, have the potential to seriously compromise "the ability of an independent central bank to get prices under control," the very feature of our current system that the article identifies as an historical source of resilience.
I worry about a regulatory change that commences from the proposition that we must "give up some of the growth and dynamism of the U.S. economy for a safer, more equitable brand of capitalism." In their introduction to a comprehensive set of reform proposals from New York University's Stern School of Business, professors Viral Acharya and Matthew Richardson have this to say:
"There are many cracks in the financial system, some of which we now know, others no doubt we will discover down the road.… A common theme of our proposals notes that fixing all the cracks will shore up the financial house but at great cost. Instead, by fixing a few major ones, the foundation can be stabilized, the financial structure rebuilt, and innovation and markets can once again flourish."
One of those major cracks is the "too-big-to-fail" distortion. Is it important to remember that too-big-to-fail is itself a creation of regulation, not markets? I think so.
By David Altig, senior vice president and research director at the Atlanta Fed
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December 08, 2009
Another rescue plan comes in below the original price tag
Though the tab to taxpayers could still be substantial when all is said and done, it now appears the taxpayer cost of the Troubled Asset Relief Program (TARP) will be substantially lower than was thought not too long ago:
"The Obama administration expects the cost of the Troubled Asset Relief Program to be $200 billion less than projected, helping to reduce the size of the budget deficit, a Treasury Department official said yesterday.
"The administration forecast in August that the TARP would ultimately cost $341 billion, once banks had repaid the government for capital injections and other investments. Congress authorized $700 billion for the program in October 2008."
There is precedent for such good news. Travel back for a moment to the formation and operation of the Resolution Trust Corporation (RTC), the agency formed to purchase and sell the "toxic assets" of failed financial institutions following the savings and loan crisis of the 1980s. As noted in a postmortem by Timothy Curry and Lynn Shibut of the Federal Deposit Insurance Corporation (FDIC), the cost projections for the RTC ballooned in the early days of its operations:
"Reflecting the increased number of failures and costs per failure, the official Treasury and RTC projections of the cost of the RTC resolutions rose from $50 billion in August 1989 to a range of $100 billion to $160 billion at the height of the crisis peak in June 1991..."
In the end, however, the outcome, though higher than the very first projections, came in well below the figures suggested by the worst case scenario:
"As of December 31, 1999, the RTC losses for resolving the 747 failed thrifts taken over between January 1, 1989, and June 30, 1995, amounted to an estimated $82.7 billion, of which the public sector accounted for $75.6 billion, or 91 percent, and the private sector accounted for $7.1 billion, or 9 percent."
While people may debate the approaches taken, it is heartening to see evidence that TARP, like the RTC before it, is ultimately costing considerably less than estimated.
By David Altig, senior vice president and research director of the Atlanta Fed
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November 12, 2009
Small businesses, small banks, big problems?
In a speech on Tuesday, Federal Reserve Bank of Atlanta President Dennis Lockhart drew some connections between the current commercial real estate (CRE) problems and the prospects for a small business-led recovery.
The starting point was an observation made in an earlier macroblog post that identified the important role small businesses have traditionally played in job creation in the economy and how they had been disproportionately negatively affected in this recession.
What are the connections between CRE and small business? An obvious direct link running from small businesses to CRE is that small businesses are an important source of demand for many types of commercial space. A link from CRE to small businesses is that CRE problems in banks could potentially affect credit availability for small businesses.
The problems currently facing the CRE industry have been building for some time for both property owners and the holders of CRE debt:
- The income generated by nonresidential/nonowner-occupied CRE has generally been falling as vacancy rates on commercial space rose, and capitalization rates–the ratio of income to valuation–have climbed sharply.
- The decline in CRE valuations has created a significant amount of "rollover risk" when CRE loans and mortgages mature and need to be refinanced (about $340 billion in CRE debt is estimated to mature in 2010 and 2011). At the same time, delinquency rates on CRE loans have been increasing sharply, especially for CRE lending for residential construction and development purposes.
Small business lending
Banks have already responded to the generally weakened economic conditions and reduced creditworthiness of borrowers by raising credit standards for all types of lending, including commercial loans, credit cards, and home equity. But there is a risk that additional bank problems, such as the realization of substantial CRE losses, could further constrain bank lending right at the time when credit is needed to support economic growth.
President Lockhart draws the connection between further bank problems and the prospects for small business-led recovery by observing that small businesses depend significantly on the banking sector as a source of financing. (A 2003 Federal Reserve survey of financial services used by small business showed over 50 percent of small businesses had a credit line or bank loan. In addition about half of small businesses use a personal or business credit card.)
The dependence of small businesses on banks is particularly problematic if the banks facing the most severe CRE problems also are a significant source of loans to small businesses.
It turns out that much of the CRE exposure is concentrated among the set of 6,880 or so smaller banking institutions (banks with total assets under $10 billion). Based on the June 2009 Bank Call Report data, these banks represented 20 percent of total commercial bank assets in the United States but hold almost half of the CRE loans.
It seems reasonable to assume that the banks with high exposure to CRE (say, those with CRE exposure as measured by a CRE loan book that is more than three times their tier one capital) are likely to take a conservative approach toward additional loan growth. The bad news is that the banks with the highest CRE exposure also account for about 40 percent of all commercial loans under $1 million–the types of loans most likely used by small businesses.
It is important to recognize that this analysis does not automatically imply small businesses will not be able to get needed funding when demand increases. For instance, even if banks with high CRE exposure are unable to expand lending as demand increases, it is possible that other banks that are less constrained will be able to step in to provide the needed financing. Also, small businesses depend a lot on other sources of financing, such as credit cards, and the large card issuers tend to have low CRE exposure.
Today, the number one challenge for small businesses remains poor sales rather than access to credit. But tomorrow, it will be important that small businesses also have access to funding if they are going to play their traditional role as an engine of growth.
By John Robertson, a vice president in the Atlanta Fed’s research department
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November 06, 2009
What is systemic risk, anyway?
On October 30, the Center for Financial Innovation and Stability at the Federal Reserve Bank of Atlanta held a conference on Regulating Systemic Risk. The presentations mostly focused on the recent financial crisis and possible regulatory responses to those developments.
Oddly enough, the term systemic risk hardly came up even though it was a major part of the conference's title. Then again, maybe it wasn't so odd.
Systemic risk is a relatively new term that has its origin in policy discussions, not the professional economics and finance literature. A search of EconLit turned up the following: The first appearance of the term systemic risk in the title of a paper in professional economics and finance literature was in 1994. That appearance was in a review of a book written by a World Bank economist, not a journal article by an economist at a university.
Given its origin in policy discussions, perhaps it is not so surprising that the term "systemic risk" often is used with no apparent precise definition in mind. If it arose from a theoretical analysis as did a term it sometimes is confused with—systematic risk— there would be a very precise definition.1
The G10 Report on Consolidation in the Financial Sector (2001) suggested a working definition:
"Systemic financial risk is the risk that an event will trigger a loss of economic value or confidence in, and attendant increases in uncertainly [sic] about, a substantial portion of the financial system that is serious enough to quite probably have significant adverse effects on the real economy."
While this is a reasonable definition in terms of the concerns in mind, the precise definitions and measurement of terms such as "confidence," "uncertainty," and "quite probably" are likely to be elusive for some time, if not forever. Furthermore, the definitions probably include a lot more than what usually seems to be meant by systemic risk. For example, the risks of an earthquake, a large oil price increase, and a coup fit in this definition. Or maybe "systemic risk" should include such events?
Even George G. Kaufman and Kenneth E. Scott (2003) define "systemic risk" in imprecise terms:
"Systemic risk refers to the risk or probability of breakdowns in an entire system, as opposed to breakdowns in individual parts or components, and is evidenced by comovements (correlation) among most or all the parts."
To me, this definition is better than the G-10 definition because it does not confuse the event being analyzed (the breakdown) with the cause (the loss of confidence). Even so, a precise definition of "breakdown" may be elusive even if the term is evocative.
Darryll Hendricks (2009), who is a practitioner, suggests a more theoretical definition from the sciences in which the term originated:
"A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse."
This definition includes many words that aren't used in everyday English and is quite abstract, focusing on the mathematics to characterize the situation. That said, this definition has a better shot at being more precise in terms of economic and financial analysis of actual situations than does the G10's definition. But the economic content of this definition as it stands is zero.
One solution is the following: Kaufman and Scott's definition is a reasonably clear, tentative definition of the term that doesn't use too many other words that require definition. Hendricks's more theoretical definition or something like it probably is a helpful start to ways of thinking about systemic risk in analytical terms.
Group of Ten. 2001. "The G10 Report on Consolidation in the Financial Sector."
Hendricks, Darryll. 2009. "Defining Systemic Risk." The Pew Financial Reform Project.
Kaufman, George G., and Kenneth E. Scott. 2003. "What is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?" Independent Review 7 (Winter), pp. 371-91.
1In the context of the capital asset pricing model, systematic risk is the risk associated with changes in the overall stock market. It can be defined similarly in other theories of asset returns.
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September 01, 2009
Us and them: Reviewing central bank actions in the financial crisis
With all the focus on the financial crisis in the United States, folks in this country might sometimes lose sight of the fact that this crisis has been global in nature. To provide some perspective on the global dimensions of the crisis, we are providing a few summary indicators of financial sector performance and central bank policy responses in the United States, the United Kingdom, the Euro Area, and Canada. Based on this general review, we surmise that some of the experiences have been remarkably similar, while others appear to be quite different. To pre-empt the question: Why these four regions? The reason is simply that the data were readily available. We encourage readers to use data from other areas, and let us know what you find.
The first chart compares relative changes in monthly stock market price indices for 2005 through the end of August. During the crisis, market participants significantly reduced their exposure to risky assets, which helped push equities lower. All indices peaked in 2007, except Canada, which technically peaked in May 2008. Canada outperformed relative to the others in early 2008 but suffered proportionally similar losses thereafter. The United Kingdom, Euro Area, and Canada bottomed in February 2009 while the United States bottomed in March 2009. The Euro Area to date has experienced the strongest rebound in equities, increasing by almost 40 percent since the trough in February. However, Europe also had the largest peak-to-trough decline, almost 60 percent. Canada and the United States have jumped by about 33 percent since their respective lows in February and March, while U.K. stock prices have risen by about 30 percent since February.
The second chart compares long-term government yields. As the crisis unfolded in late 2007, yields on 10-year U.S. Treasuries sank as global flight to quality helped push yields lower. Yields on U.S., U.K., and Canadian bonds have all moved lower than they were prior to the onset of the crisis. Interestingly, in the Euro Area, prior to the crisis, sovereign yields were at or below bond yields in the other countries but are now slightly above those. In fact, Euro Area yields haven't moved much since the beginning of the crisis in late 2007.
The third chart contrasts monetary policy rates in the four regions. The chart shows that all the central banks lowered rates aggressively, but there are some subtle differences in the timing. For the United Kingdom, Euro Area, and Canada, the bulk of policy rate cuts came after the financial market turmoil accelerated in the fall of 2008, whereas in the United States the majority of the cuts came earlier.
The Fed was the first to lower rates, cutting the fed funds rate by 50 basis points in September 2007 at the onset of the crisis. The Fed continued to lower rates pretty aggressively through April 2008, with a cumulative reduction of 325 basis points. Once the financial turmoil accelerated again in the fall of 2008 the Fed cut rates again by another 200 basis points.
The Bank of Canada's cuts followed a generally similar timing pattern to the Fed but with differences in the relative magnitude of the cuts. In particular, the Bank of Canada rate lowered rates by 150 basis points through April 2008 and then by another 275 basis points since September 2008.
Similarly, the Bank of England cut rates three times in late 2007/early 2008, totaling 75 basis points. But like the Bank of Canada, the bulk of their policy rate cuts didn't come until the increased financial turmoil in the fall of 2008. Between September 2008 and March 2009, the Bank of England cut the policy rate by 450 basis points.
Unlike the other central banks, the European Central Bank (ECB) did not initially adjust policy rates down as the crisis emerged in late 2007. In fact, after holding rates steady for several months it increased its rate from 4 percent to 4.25 percent in July 2008. It started cutting rates in October 2008, and from October 2008 to May 2009 the ECB reduced its refinancing rate by 325 basis points. Of the four regions, the ECB currently has the highest policy rate at 1 percent. For some speculation about the future of monetary policy rates for a broader set of countries, see this recent article from The Economist.
The final chart compares relative changes in the size of balance sheets across the four central banks. The balance sheet changes might be viewed as an indication of the relative aggressiveness of nonstandard policy actions by the central banks, noting that some of the increases can be attributed to quantitative easing monetary policy actions, some to central bank lender-of-last-resort functions, and some to targeted asset purchases.
The sharpest increases in the central bank balance sheets came in the wake of the most intense part of the financial crisis, in the fall of 2008. There had been relatively little balance sheet expansion until the fall 2008. Prior to that, the action was focused mostly on changing the composition of the asset side of the balance sheet rather than increasing its size. The size of both U.S. and U.K. balance sheets has more than doubled since before September 2008, although both are now below their peaks from late 2008. Note that in the case of the Bank of England, quantitative easing didn't begin until March 2009, and the subsequent run-up in the size of the balance sheet is much more significant than in the United States. Prior to that, the increase in the Bank of England balance sheet was associated with (sterilized) expansion of its lending facilities.
In contrast, the Bank of Canada and ECB increased their balance sheets by about 50 percent—much less than in the United Kingdom or United States. By this metric, nonstandard policy actions have been less aggressive in Canada and the Euro Area. Why these differences? This recent Reuters article provides a hypothesis that focuses on institutional differences between the Bank of England and the ECB. In a related piece, this IMF article compares the ECB and the Bank of England nonstandard policy actions.
Note: The Bank of England introduced reforms to its money market operations in May 2006, which changed the way it reports the bank's balance sheet data (see BOE note).
By John Robertson, vice president and senior economist, and Mike Hammill and Courtney Nosal, both economic policy analysts, at the Atlanta Fed
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April 15, 2009
Déjà vu all over again
I have, recently, been experiencing a strange sense of familiarity watching the Congressional Budget Office's (CBO) efforts to monitor the budgetary implications of the Troubled Asset Relief Program (TARP). On the one hand, the long-term costs are rising:
"Since January, CBO has raised its estimate of the net cost (on a present-value basis) of the transactions covered by the TARP by $152 billion for 2009 and by $15 billion for 2010. Those revisions stem from three factors—changes in financial market conditions, new transactions, and a small shift in the anticipated timing of disbursements."
On the other hand, the CBO wants to book less spending in the near term than what the Treasury has in mind, for reasons that have to do with accounting procedures and the pace of actual TARP spending:
"Budget accounting issues are clouding the deficit forecasts for this year. The above estimate of this year's deficit to date includes outlays of about $290 billion for the Troubled Asset Relief Program (TARP). Although the Treasury has been recording most spending for the TARP on a cash basis, CBO believes that the budget should record the program's activities on a net present-value basis adjusted for market risk. Using that approach, CBO estimates that outlays of $140 billion should be recorded for the TARP through March. That approach would yield an estimated deficit of $803 billion for the first half of the year."
After a few minutes of pondering why it seemed like I had seen this before, I flashed back to my early days in the Federal Reserve System and the saga of the Resolution Trust Corporation, the Congress-created vehicle that helped the country work its way through the aftermath of the 1980s savings and loan crisis. In August 1989, here's what the Congressional Budget Office was thinking:
"The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (Public Law 101-73) is a complex measure affecting federal government taxes, premiums, spending, borrowing, and regulation. While the bill strengthens the government's system for insuring commercial banks, its primary focus lies in addressing the huge liabilities forced on the government by failed and insolvent savings and loan institutions.
"… The legislation establishes a new Resolution Trust Corporation (RTC) to merge or close currently insolvent insured thrifts. The RTC is to spend a total of $50 billion on this task… The $50 billion in resources available to the RTC are sufficient, in the Administration's estimate, to cover the government's liabilities for currently insolvent thrifts with $10 billion left over to help defray interest costs…"
The CBO, however, was not convinced that the RTC's resolutions would come so cheap.
"… many observers, including CBO, doubt that this level of resources is enough."
And in January 1990, the CBO was unhappy with the Treasury's accounting procedures:
"Last year's Financial Institutions Reform, Recovery, and Enforcement Act effectively excluded about $30 billion of deposit insurance spending from budget totals in 1990 and 1991, by having the funds borrowed through a newly chartered, government-sponsored enterprise, the Resolution Financing Corporation (REFCORP).
"REFCORP's status as a government-chartered enterprise is critical to the budgetary treatment of its borrowing. Normally, the U.S. Treasury conducts any necessary financing for the government. Treasury borrowing finances the deficit; it does not reduce the deficit. Otherwise, the budget would always be balanced. But because REFCORP is technically private, the funds that it borrows and turns over to the (on-budget) Resolution Trust Corporation count as offsetting collections. These funds offset the associated spending to resolve failed savings and loans. …
"CBO believes that REFCORP is a government entity, that its borrowing is government borrowing, and that the budgetary treatment that has been adopted is inappropriate."
By accounting for things the way they thought they should be accounted for, the CBO estimated as of August 1991 that the costs of the resolution process would in fact be quite a lot higher than initially assumed:
"CBO now believes that the RTC will pay total losses of about $155 billion (in 1990 dollars) for a caseload of about 1,500 institutions."
What is more, the whole process was taking quite a bit more time than originally hoped:
"CBO assumes that the RTC continues resolving institutions through calendar year 1994, more than two years longer than originally scheduled."
In August 1992, even that time frame was looking optimistic…
"CBO assumes that the RTC or a successor will deal with a heavy caseload through 1998…"
But the news wasn't all bad:
"CBO estimates the cleanup's cost at $135 billion. Sobering as this figure is, it actually represents a glimmer of good news: CBO's former estimate was about $155 billion."
Movement in the right direction notwithstanding, Congress did not exactly jump at the opportunity to extend the RTC's life span. From the January 1994 Economic and Budget Outlook:
"The savings and loan cleanup is forging ahead after a prolonged interruption in its funding. From April 1992 until December 1993, the Resolution Trust Corporation (RTC) had only very limited authority to incur losses. It was largely confined to selling off its portfolio of assets and to resolving the occasional institution that could be closed or merged at little or no loss to the government; hence, the RTC recorded negative outlays in both 1992 and 1993.
"The Congress brought this drought to an end in late 1993 with the Resolution Trust Corporation Completion Act."
And when Congress eventually acted, the picture was brighter yet:
"There is good news on the RTC front: the agency will not fulfill the gloomy predictions that were common even a year or two ago. CBO now estimates the total value of losses covered by the RTC since its inception in 1989 at about $90 billion (expressed, by convention, in 1990 dollars)."
And that is about where it ended up:
"The total tab for the RTC lies somewhere between the sunniest and gloomiest projections made during its early years. CBO now estimates the total value of losses covered by the RTC and its successor through 2000 at about $90 billion (expressed, by convention, in 1990 dollars). …
"Four and a half years ago, CBO feared that the RTC's costs alone could be as high as $185 billion, and some outside experts were even more pessimistic. (The Bush Administration, in contrast, originally stated that $50 billion would be sufficient.)"
So there you have it. The last great experiment in working through financial crisis took longer than expected, involved some accounting pushing and shoving at the outset, confronted a skeptical Congress, and cost more than initially projected, but quite a lot less than feared.
Make of it what you will.
By David Altig, senior vice president and research director at the Atlanta Fed
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April 01, 2009
Snapping ropes and breaking bricks
James Hamilton of Econbrowser is concerned about the current state of monetary policy. On the blog, Jim writes:
"I would suggest first that the new Fed balance sheet represents a fundamental transformation of the role of the central bank. The whole idea behind open market operations is to make the process of creating new money completely separate from the decision of who receives any fiscal transfers. In a traditional open market operation, the Fed buys or sells an existing Treasury obligation for the same price anyone else would pay for the security. As a result, the operation itself does not involve any net transfer of wealth between the Fed and the private sector. The philosophy is that the Fed should base its decisions on economy-wide conditions, and leave it entirely up to the market or fiscal authorities to determine where those funds get allocated.
"The philosophy behind the pullulating new Fed facilities is precisely the opposite of that traditional concept. The whole purpose of these facilities is to redirect capital to specific perceived priorities. I am uncomfortable on a general level with the suggestion that unelected Fed officials are better able to make such decisions than private investors who put their own capital where they think it will earn the highest reward."
After I looked up "pullulating," I found much to agree with in Professor Hamilton's description—or at least I did up to that last sentence. I certainly share his discomfort with a presumption that "Fed officials are better able to make… decisions than private investors," but that doesn't quite capture my view—and I emphasize my view—of how nontraditional policy is supposed to work. My own description of what the "fundamental transformation" of central bank policy is all about appears, hot off of the virtual press, in the first quarter issue of EconSouth, the Atlanta Fed's regional economics publication:
"I have a simple way of thinking about how monetary policy works. Imagine a long rope. At one of end of the rope are short-term, relatively riskless interest rates. Farther along the rope are yields on longer-term but still relatively safe assets. Off at the other end of the rope are multiple tethers representing mortgage rates, corporate bond rates, and auto loan rates—the sorts of interest rates that drive decisions by businesses and consumers. In the textbook version of central banking, the monetary authority grabs the short end of this allegorical rope, where the federal funds rate resides, and gives it a snap. The motion ripples down and hopefully reaches longer-term U.S. Treasury rates, which then relay the action to other market interest rates, where the changes reverberate throughout the economy at large.
"That's the story in normal times, and over the past year and a half the Federal Open Market Committee (FOMC) has done a fair bit of rope-snapping. In August 2007 the FOMC set the federal funds rate target—the overnight rate on loans made between banks—at 5.25 percent. As of December 2008, the rate target was lowered to a very low range of 0–0.25 percent. As the committee noted then (and reiterated in January), 'weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.'
"These FOMC statements held another extremely important message: 'The focus of policy going forward will be to support the functioning of financial markets and stimulate the economy.' In a speech to the National Press Club on Feb. 18, Federal Reserve Chairman Ben Bernanke elaborated:"
'Extraordinary times call for extraordinary measures. Responding to the very difficult economic and financial challenges we face, the Federal Reserve has gone beyond traditional monetary policy making to develop new policy tools to address the dysfunctions in the nation's credit markets.'
"One way to view the effects of those credit market dysfunctions is to imagine that someone had placed a series of bricks at strategic points along the segment of rope connecting short-term interest rates to broader market rates. With these bricks in place, it is simply not enough for a central bank to keep snapping short-term interest rates: The bricks—dysfunctions in the markets—will keep the impulse from being transmitted to the interest rates that are directly connected to market outcomes. Thus, a new set of policy instruments is needed, instruments that allow the monetary authority to circumvent blockages in the monetary transmission mechanism."
The "policy instruments" I have in mind, of course, are the pullulating new facilities that have Jim Hamilton worried. But it is worth emphasizing that many of these facilities are motivated by "unusual and exigent circumstances," a point emphasized in the recent Treasury-Federal Reserve statement (which is discussed in some detail by Tim Duy):
"As long as unusual and exigent circumstances persist, the Federal Reserve will continue to use all its tools working closely and cooperatively with the Treasury and other agencies as needed to improve the functioning of credit markets, help prevent the failure of institutions that could cause systemic damage, and to foster the stabilization and repair of the financial system."
How long will those conditions persist? Returning to my EconSouth commentary:
"No set timetable exists, but one would presume that as long as the bricks of market dysfunction are lying around, the tools will be necessary. Eventually, of course, markets will heal, the bricks will crumble, and the stage will be set to a return to business as usual in monetary policy and the economy. The sooner the better, but in the meantime it's helpful to have the tools in hand to start cracking the bricks."
That's my story, and I'm sticking to it.
By David Altig, senior vice president and research director of the Atlanta Fed
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