The Atlanta Fed's macroblog provides commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues.

Authors for macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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August 26, 2008

Deep questions from Jackson Hole

If one were to judge importance by press attention, the key events of this past weekend’s annual Jackson Hole economic symposium hosted by the Federal Reserve Bank of Kansas City would be the bookend contributions of Fed Chairman Ben Bernanke’s opening address and Willem Buiter’s 141 pages worth of Fed criticism. Understandable, in the former case for obvious reasons and in the latter for the grand theoretical pleasure of Buiter’s (shall we say) forthright critique and discussant Alan Blinder’s equally forthright (and witty) defense of the Fed. (The session’s tone is nicely captured in the reports of Sudeep Reddy from the Wall Street Journal and Bloomberg’s John Fraher and Scott Lanman.) [Broken link to the Bloomberg article fixed.]

Though Professor Buiter’s (of the London School of Economics and Political Science) assertions were certainly provocative, for me the truly thought-provoking aspect of the symposium was the collective effort to address some deep questions that still seek answers. There are a lot of them, but here are a few at the top of my list.

How do you know “loose” monetary policy when you see it?
Charles Calomiris—whose paper received attention at Free exchange, and is summarized by the author himself at Vox—says it is the real (or inflation-expectations adjusted) federal funds rate. I suspect that conforms to the definition favored by many, but the significance of defining the stance of monetary policy in this way was hammered home by Tobias Adrian and Hyun Song Shin:

…some key tenets of current central bank thinking [have] emphasized the importance of managing expectations of future short rates, rather than the current level of the target rate per se. In contrast, our results suggest that the target rate itself matters for the real economy through its role in the supply of credit and funding conditions in the capital market.

There is a fair amount at stake in understanding which of these views is correct:

Chart of Interest Rate Spreads

Are longer-term interest rates relatively high while the real federal funds rate is so low because policy is quite loose and inflation expectations are rising? Or are the elevated long-term rates a sign that policy is really restrictive? Or is the picture just a symptom of a combination of currently weak returns to capital (keeping short-term rates low), the prospect of better times ahead (and higher long-run returns to capital), and a return to more realistic pricing of risk, all of which would be consistent with the proposition current policy is neither too easy nor too tight? The question is not academic.

Is there crisis after subprime?
A primary component of Calomiris’ thesis is (in the words of his Vox piece) “loose monetary policy, which generated a global saving glut.” That global saving glut connection would come up again, most prominently in MIT professor Bengt Holmstrom’s discussion of the contribution by Gary Gorton (itself an essential read if you have any questions at all about the way subprime markets work, or what they have to do with SIVs, CDOs, and ABXs).   The starting point of Holmstrom’s argument—a variation on earlier themes from Ben Bernanke (for the general audience) and Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas (for the economists in the crowd)—goes something like this: Surplus saving in emerging economies has driven up the demand for liquid assets. Liquidity being a specialty of the United  States in particular, the excess demand drives down interest rates here, stimulates spending, and expands deficits on the country’s current account.

The story, I believe, goes back to the late 1990s. One important difference between then and now is that the liquid assets most in demand at the close of the past decade were highly concentrated in long-term Treasury securities. Another is the fact that the related private-asset appreciation in the late 1990s was manifested in equity markets. After the tech-stock bust, however, the fundamental global imbalances remained and found a new home in debt created by the subprime housing market. As Professor Holmstrom and others noted, collateralized debt markets, based as they are on leverage and low levels of information flows, are much more complicated animals than equity markets.

The question that remains is obvious. What is there to stop the next crisis if global imbalances persist? And if they do, is “better” monetary policy—whatever that might be —a sufficient condition for avoiding future problems?

Which leads me to…

Is there a better way to prepare for future bouts of financial market turmoil?
One answer—shared by many at the symposium—is that we can do so imperfectly at best, and that ultimately governments or markets or both just have to clean up the mess afterward. That approach feels a bit costly at the moment, so it seems a prudent thing to explore proactive measures that may at least mitigate the impact when problems arise. On this front, the biggest buzz of the symposium was probably generated by Anil Kashyap, Jerome Stein, and Raghuram Rajan, who proposed the development of “insurance policies” that would infuse the banking sector with fresh capital when they need it most. I’ve run on too long now, so for further elaboration I will refer you again to Sudeep Reddy – or to the paper itself.

A related reading PS: You will find more on the Chairman’s speech at Free exchange, at Calculated Risk (here and here), and at the William J. Polley blog. On Professor Buiter’s session you will find no shortage of commentary. The Daily Reckoning, naked capitalism, Economic Policy Journal, and Equity Check provide what I am sure is just a sampling.

August 26, 2008 in Federal Reserve and Monetary Policy , Interest Rates | Permalink


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{the biggest buzz of the symposium was...“insurance policies” that would infuse the banking sector with fresh capital when they need it most.}

David --- such 'options on contingent capital' were proposed by [Myron] Scholes shortly after the LTCM crisis. I will look for the reference, but I believe it was an interview in Risk magazine.

Posted by: MW | August 26, 2008 at 02:06 PM

I have a question of my own. Why is the Fed holding the discount rate so low (i.e., making medium-term ultra-low-interest loans) that banks can perform arbitrage with GSE debt for zero-risk profits?

See http://dealbreaker.com/2008/08/trade_of_the_day_buy_freddie_p.php

Posted by: Nemo | August 26, 2008 at 02:24 PM

Deep questions from Jackson Hole

I am just a Ph.D. chemist, but I believe that this question is unasked because the answer is a YES that's too hot to touch!

In your opinion,
will asset-market extreme mispricing be well-deterred,
if and when
real inflation-corrected asset-market price histories are well-apparent to the people?

Exampling such histories, please see first and last charts here:
“Real Dow & Real Homes & Personal Saving &
Debt Burden” at

Posted by: Ed | August 26, 2008 at 05:24 PM

The subprime risk problem resulted from the banking sector’s lack of macroeconomic imagination, in filtering the interpretation of “risk statistics” for a product with little economic history.

The Fed has done a good job of responding to the crisis, after a not so great job of assessing the risk ex ante, although in the latter matter it was constrained by a dysfunctional alignment of related regulatory responsibility, beyond its own scope at the time.

The current Treasury yield curve is quite reasonable, even healthy. What is obviously not healthy in the same context are credit spreads, including mortgage spreads, which is why the combination of the treasury curve and credit spreads make monetary policy meaningfully tighter than indicated by the funds rate on its own.

The global savings glut is a bad, distractive economic paradigm. It explains nothing because it is not meaningful. It matters not whether the explanation for the imbalances is that China has not purchased enough imports (savings glut), or the US has purchase too many (expenditure glut). The result is the same. Foreign surpluses fund US deficits, and wouldn’t exist without them. The two are co-dependent, rather than causal, in either direction. Sub-prime was created by an aggressive domestic intermediation machine, and sold to a foreign one – not vice versa. Foreign surpluses did not cause the US to go and buy more houses.

Posted by: JKH | August 26, 2008 at 08:40 PM

All insurance schemes are subject to agency problems. They are either solved through a combination of risk premia/underwriting standards, or by regulation.

So the introduction of an "insurance capital" scheme would hardly present a solution to the current problem. What its proponents miss is that, the more insurance, the more asymmetric the returns, the more risk the banks will want to take.

The Fed tends to see "moral hazard" as a problem to be addressed in the future. And yet, as any market participant will tell you, the belief in a "Fed Put" created moral hazard that landed us in the present crisis, and that the cost of each successive hazard-generated crisis is higher.

The credit crisis is part of a continuum that began with the 1998 LTCM rescue. What's clear is that this is still very much a minority view among Jackson Hole participants and Fed Governors.

Posted by: David Pearson | August 27, 2008 at 10:17 AM

As the finanical industry loses public support for bailouts, we will continue the approach towards the zero bound.

While many may see this as a bad thing as it requires fiscal policy stimulus and therefore politically guided spending, they should be reminded that 'nonpolitical' monetary policy got us here.

It appears the financial infrastructure may have shot itself in the foot this time (as it did in Japan) and is making itself irrelevent as people start to realize the financial drain banks attach to the economy.

Posted by: Winslow R. | August 27, 2008 at 12:55 PM

JKH -- I am not sure your argument fully address Bernanke's argument, which is explicitly casual. He claims that if an expenditure glut drove the US deficit, it should have manifest itself in higher us and global rates -- with the high rates needed to pull funds into the US. Conversely, if high savings abroad drove deficits elsewhere (whether in the US or increasingly in europe), rates would be expected to be low both in the US and globally, with the low rates inducing more borrowing. In effect, Bernanke argues that US market rates tell you whether there is an expenditure glut or a savings glut.

In that sense, a rise in savings v investment in the emerging world (a fact shown in the IMF's WEO data) would induce lower rates, and lower rates could reasonably be expected to push up home prices and encourage non-residential investment. Perhaps not to the extent that they did -- the internal dynamics of the US credit market played a role -- but certainly directionally it would tend to work in that way. Some part of the US and European economy would need to borrow at the low rates and run a deficit that is the counterpart to the emerging world's surplus.

Dr. Altig -- I will confess I always find the academic discussion of "liquidity" as a speciality of the US rather frustrating. After all recently the US seems to have produced an enormous quantity of highly illiquid assets(which are causing a bit of trouble in the banks, last i checked). Even some Agency bonds i suspect are increasingly illiquid. Setting aside the fact that Europe's government bond market isn't as homogenous as the US bond market (a function of a single issuer v multiple issuers), I am not sure there is a meaningful difference in Europe's ability to create safe and liquid assets v the United States ability to do so. I certainly would have accepted a slight loss of liquidity by holding bunds rather than treasuries in exchange for an asset that has held its external purchasing power better over the last five years. And I don't think that there is strong evidence that the US is all that much better at Europe at creating "liquid" assets that private investors want to hold -- I would note that all net foreign purchases of Treasuries and Agencies (from june 06 to june 07 -- the last data points based on the survey data) came from the official sector.

It often seems to me that the United States comparative advantage at supplying liquidity is asserted rather than proven. Are Fannie and Freddie pass-throughs (China holds a lot of them) significantly more liquid than Italian treasury bonds, and held by the PBoC for that reason?

It seems like the most parsimonious explanation for large central bank inflows into the US is not the intrinsic quality of the US market but rather policy decisions on the part of key emerging economies to peg their currencies primarily to the dollar.

Finally, I don't find a story that argues that there has been one continuous deterioration in the US external deficit since 1997 all that compelling. It glosses over two facts: over that time the sources of funding changed from private investors to official investors and the sectors running the deficit in the US changed from the corporate sector to the household and government sectors. Understanding the sources of that shift strike me as important -- afterall one potential result of the end of .com driven investment (and the associated fall in private demand for US assets, net of US demand for foreign assets) would have been smaller deficits -- not bigger deficits combined with bigger net official flows.

Did Holmstrom's comment (which i need to read) or the discussion that followed recognize the enormous role the official sector now plays in the financing of the US deficit -- and the possibility that central banks might be buying dollar assets not because of the intrinsic desirability of dollar asset but rather becuase of a policy decision to peg to the dollar? Caballero, Farhi and Gourinchas do not, and as a result their paper never struck me as offering a useful model of the world we currently live in. Central banks -- not private investors -- are the ones buying us assets right now, and domestic savers in the emerging world increasingly have wanted to hold their own assets not foreign assets (see all the hot money moving into China. Both Dr. Feldstein and Dr. Summers understand the role the official sector now plays in financing the US well (total official asset growth is running at about two times the size of the US deficit), so i would expect the issue came up -- though it doesn't appear in your (quite useful) summary.

Posted by: bsetser | August 27, 2008 at 01:23 PM

While I like the paper on insurance policies, it seems that the authors are ignoring major parties who should buy the insurance. The FDIC is one regulatory authority which should own such insurance, as long as it isn't perceived as weekening their incentive to regulate properly.

Posted by: some investor guy | August 27, 2008 at 04:29 PM

bsetser – I was perhaps unnecessarily excessive in my characterization of the savings glut thesis, although I think you would acknowledge it is a debatable subject that indeed has been debated vigorously at times. The level of interest rates certainly fits well with the savings glut thesis, and taken as evidence it certainly suggests a savings glut rather than an expenditure glut. Nevertheless, I keep doubting that the savings glut is the critical explanation for low rates per se. My own preferred explanation is that the expected path of the funds rate, given the level of inflation and inflation expectations, has weighed heavily in the outcome. E.g. I think this factor was largely overlooked as an explanation for the yield curve “conundrum”. The yield curve was historically steep when the funds rate started its historic ascent from the low level of 1 per cent. The curve at the start discounted a substantial cyclical increase in the funds rate, arguably including the actual extent of the ensuing funds rate increase. Considered on that basis, there was little reason for treasury yields to move higher from the start, notwithstanding the unusual departure from the yield pattern of the typical tightening cycle. And I would add that the expected path of the funds rate is a valuation input that can be considered by foreign as well as domestic investors in the process of bidding on treasury bonds.

Posted by: JKH | August 27, 2008 at 05:01 PM

Contingent capital options:
Scholes, M., (1999), "Liquidity options: Scholes explains", Risk, Volume 12, Number 11, November, pp. 6

Posted by: MW | August 27, 2008 at 08:14 PM

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