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.

May 31, 2012

What is shadow banking?

What is shadow banking? Announcing a new index—hat tip to Ryan McCarthy—Deloitte offers its own definition:

"Shadow banking is a market-funded, credit intermediation system involving maturity and/or liquidity transformation through securitization and secured-funding mechanisms. It exists at least partly outside of the traditional banking system and does not have government guarantees in the form of insurance or access to the central bank."

As the Deloitte study makes clear, this definition is fairly narrow—it doesn't, for example, include hedge funds. Though Deloitte puts the size of the shadow banking sector at $10 trillion in 2010, other well-known measures range from $15 trillion to $24 trillion. (One of those alternative estimates comes from an important study by Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky from the New York Fed.)

What definition of shadow banking you prefer probably depends on the questions you are trying to answer. Since the interest in shadow banking today is clearly motivated by the financial crisis and its regulatory aftermath, a definition that focuses on systemically risky institutions has a lot of appeal. And not all entities that might be reasonably put in the shadow banking bucket fall into the systemically risky category. Former PIMCO Senior Partner Paul McCulley offered this perspective at the Atlanta Fed's recent annual Financial Markets Conference (video link here):

"...clearly, the money market mutual fund, that 2a-7 fund as it's known here in the United States, is the bedrock of the shadow banking system...

"The money market mutual fund industry is a huge industry and poses massive systemic risk to the system because it's subject to runs, because it's not just as good as an FDIC bank deposit. We found out that in spades in 2008...

"In fact, I can come up with an example of shadow banking that really didn't have a deleterious effect in 2008, and that was hedge funds with very long lockups on their liability. So hedge funds are shadow banks that are levered up intermediaries, but by having long lockups on their liabilities, then they weren't part and parcel of a run because they were locked up."

The more narrow Deloitte definition is thus very much in the spirit of the systemic risk definition. But even though this measure does not cover all the shadow banking activities with which policymakers might be concerned, other measures of the trend in the size of the sector look pretty much like the one below, which is from the Deloitte report:

The Deloitte report makes this sensible observation regarding the decline in the size of the shadow banking sector:

"Does this mean that the significance of the shadow banking system is overrated? No. The growth of shadow banking was fueled historically by financial innovation. A new activity not previously created could be categorized as shadow banking and could creep back into the system quickly. That new innovation might be but a distant notion at best in someone's mind today, but could pose a systemic risk concern in the future."

Ed Kane, another participant in our recent conference, went one step further with a familiar theme of his: new shadows are guaranteed to emerge, as part of the "regulatory dialectic"—an endless cycle of regulation and market innovation.

In getting to the essence of what the future of shadow banking will (or should) be, I think it is instructive to consider a set of questions that were posed at the conference by Washington University professor Phil Dybvig. I'm highlighting three of his five questions here:

"1. Is creation of liquidity by banks surplus liquidity in the economy or does it serve a useful economic purpose?

"2. How about creation of liquidity by the shadow banking sector? Was it surplus? Did it represent liquidity banks could have provided?...

"5. If there was too much liquidity in the economy, why? Some people have argued that it was because of too much stimulus and the government kept interest rates too low (and perhaps the Chinese government had a role as well as the US government). I don't want to take a side on these claims, but it is an important empirical question whether the explosion of the huge shadow banking sector was a distortion that was an unintended side effect of policy or whether it is an essential feature of a healthy economy."

Virtually all regulatory reforms will entail costs (some of them unintended), as well as benefits. Sensible people may come to quite different conclusions about how the scales tip in this regard. A good example is provided by the debate from another session at our conference on reform of money market mutual funds between Eric Rosengren, president of the Boston Fed, and Karen Dunn Kelley of Invesco. And we could see proposals by the Securities and Exchange Commission in the future to enact further reforms to the money market mutual fund industry. But whether any of these efforts are durable solutions to the systemic risk profile of the shadow banking sector must surely depend on the answers to Phil Dybvig's important questions.

David AltigBy Dave Altig, executive vice president and research director at the Atlanta Fed

May 31, 2012 in Banking, Financial System, Money Markets | Permalink


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How has liquidity varied in the U.S., or perhaps OECD countries, since WWII? How have taxes affected the emergence of "shadow banking" if at all?

Posted by: Tom Shillock | June 01, 2012 at 12:53 PM

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April 13, 2011

How has the financial system changed? (And what to do about it)

The subject of this post's title was, in essence, the centerpiece of the most recent edition of the Atlanta Fed's annual Financial Markets Conference, convened this year in Stone Mountain, Ga. (just outside Atlanta). In terms of formal papers, the conference was bookended by work that came to very similar conclusions but from very different angles. From the vantage point of recent developments in micro banking structure, Arnoud Boot offered this diagnosis:

"A fundamental feature of more recent financial innovations is their focus on augmenting marketability. Marketability has led to a strong growth of transaction-oriented banking (trading and financial market activities). This is at least in part facilitated by the scalability of this activity (contrary to relationship banking activities). It is argued that the more intertwined nature of banks and financial markets induces opportunistic decision making and herding behavior. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability."

Taking the very long view, Moritz Schularick presented (from a paper co-authored with Alan Taylor) pretty compelling evidence that the ongoing shift from relationship banking to transactions-based banking has fundamentally altered the nature of financial developments on real activity in modern economies:

"We first document and discuss our newly assembled dataset on money and credit, aligned with various macroeconomic indicators, covering 14 developed countries and the years from 1870 to 2008. This new dataset allows us to establish a number of important stylized facts about what we shall refer to as the 'two eras of finance capitalism.' The first financial era runs from 1870 to 1939. In this era, money and credit were volatile but over the long run they maintained a roughly stable relationship to each other, and to the size of the economy measured by GDP. The only exception to this rule was the Great Depression period: in the 1930s money and credit aggregates collapsed. In this first era, the one studied by Friedman and Schwartz, the 'money view' of the world looks entirely plausible. However, the second financial era, starting in 1945, looks very different. With the banking sector progressively more leveraged in the second financial era, particularly towards the end, the divergence between credit supply and money supply offers prima facie support for the credit view as against a pure money view; we have entered an age of unprecedented financial risk and leverage, a new global stylized fact that is not fully appreciated."

If there was agreement on increasing threats to financial stability, what to do about it (unsurprisingly) was somewhat more controversial. On the microprudential front, several conference participants—Viral Acharya, for example—looked to greater capital buffers as a key to greater financial stability. Others—George Kaufman commenting on Boot's paper, for instance—were more inclined to rely on market solutions. Boot, for his part, was highly skeptical of the self-correcting market forces and, while sympathetic to greater reliance on bank capital, believes much more is required:

"What we have also argued is that market discipline might be rather ineffective. We described this as a paradox. When particular strategies have momentum in financial markets, the market as a whole may underestimate the risks that these entail. How then can we expect market discipline to work? It appears to us that market discipline might not be present when banks follow financial market inspired strategies. Things are even worse because these strategies will lead to a high correlation in actual exposures between financial institutions because all see the same opportunities and hence herding occurs. Systemic risk would then be considerable and not checked by market discipline."

Earlier in the paper, Boot puts forward:

"We believe that heavy handed intervention in the structure of the banking industry—building on the Volcker Rule—might ultimately be an inevitable part of the restructuring of the industry. It could address complexity but also help in containing market forces that might run orthogonal to what prudential concerns would dictate (as the insights on market discipline in section 6 suggest). For now, the structural interventions in the banking industry are rather tentative. Other measures such as higher capital and liquidity requirements are clearly needed. But these primarily focus on individual institutions while a more system-orientation is crucial to identify externalities and interlinkages (Goodhart, 2009; and Calomiris, 2009). Anti-cyclical capital surcharges and other measures and surcharges depending on the degree of interconnectedness are needed as well to add some further comfort. We tend to subscribe to John Kay's (2009) notion of redundancy: having comfort in the stability of the financial sector dictates building redundancy into the regulatory and supervisory structures of banking."

With respect to "system-oriented" signals, Schularick was clear where he and his co-author think their research leads:

"These new results from long-run data, if they pass scrutiny, inform the current controversy over macroeconomic policy practices in developed countries. Specifically, the pre-2008 consensus argued that monetary policy should follow a 'rule' based only on output gaps and inflation, but a few dissenters thought that credit aggregates deserved to be watched carefully and incorporated into monetary policy. The influence of the credit view has certainly advanced after the 2008–09 crash, just as respect has waned for the glib assertion that central banks could ignore potential financial bubbles and easily clean up after they burst."

Credit and bank capital—along with sound fiscal policy and a little good luck—do appear to have been key to how well different economies fared during the recent financial crisis. At least that is the conclusion reached in a study by Stephen Cecchetti and his co-authors from the Bank of International Settlements:

"The macroeconomic performance of individual countries varied markedly during the 2007–09 global financial crisis.… Better-performing economies featured a better-capitalised banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part."

As we seek to shore up our financial timber to avoid a repeat of recent history, it is appropriate to remember that, while it is good to be lucky, fortune is probably not arbitrary in choosing where it will shine.

Photo of Dave Altig By Dave Altig
senior vice president and research director at the Atlanta Fed

April 13, 2011 in Financial System, Money Markets | Permalink


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Banking is one of many oligopolies that are government ignores.

"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise prices." (Adam Smith, The Wealth of Nations, 1776).

What does the American auto industry, the health care industry, wall street firms and the banking industry all have in common; other than they were all on the brink of failure?

These are industries where the production side of the industry is no longer a free market with many producers competing head-to head to earn the business of consumers, or customers, of the industry. Instead each of these industries are controlled by a relatively small number of very large corporations that have transformed these markets into oligopolies.

Adam Smith when he discussed “rational self interest” and competitive markets in his book Wealth of Nations, envisioned many consumers buying goods and services from many producers with everyone looking out for their self-interest. By keeping markets “free”, producers pursue their rational self-interest and this best meets the needs of the consumers and the citizens of our country, who are also looking out for their self-interest. Under this system, what is in the producers self interest is to provide the best product possible to the consumer, while striving to be a low cost producer for their niche.

This consolidation of markets began in the late 1960's early 1970's in the auto industry when it was transformed from a free market to an industry that was controlled by three giant corporations and one union. As this transformation was occurring the auto company's and auto union's self-interest became separated from what the consumer wanted and/or needed. Competition between the companies broke down and this gave an opening for foreign competition to enter our markets and the beginning of the end of the American auto industry as we knew it.

Other industries saw what was happening in the auto industry and saw that government was not objecting so naturally they followed the same path with little concern on any ones part that we were losing our free market system to a more centralized market system of oligopolies. As a result we now have major markets where the producing entities self-interest is not always in line with the self-interest of the consumer. What is in the self-interest of the entities in these industries is to keep the oligopoly alive. Thus the creation of special interests and lobbyists.

These oligopolies have bought the protection of our representatives in Washington and state capitals. I am always baffled by the fact that corporations and unions cannot vote in this country, however they are allowed to buy votes with their contributions.

We lost track of a key ingredient that Adam Smith identified as necessary in order for “rational self interest” to work. There must be many producers. In too many industries, the number of producers has shrunk and the ones remaining have gotten “too big to fail”. This is true in the auto industry, the banking industry, wall street, health care and will soon be true in the computer software industry.

When discussing the health insurance industry proponents for this specific oligopoly site the fact that the bigger the insured pool, the lower insurance premiums can be. However, I submit that this "bigger pool savings" is more than offset by the fact that the rational self-interest of the companies is not totally aligned with the rational self interest of the insured. The insurance industries self-interest is to keep the oligopoly alive. The self-interest of the insured is to have as many insurance companies as possible clawing to get his business and thus ringing out all excessive cost, including unconscionable salaries for top executives, to earn the consumers business.

The liberals are right that regulation is required and conservatives are right that a free market is the best way to meet the needs and wants of our citizens. The common ground is that regulation is essential to make our markets more free. We have too many industries where companies have too much power, their self interest is not aligned with the citizens of this country and they are too big to fail.

It is time that our politicians breakaway from the shackles of oligopolies, special interests groups and lobbyists. Use antitrust legislation to bring back free markets.http://freeourfreemarkets.org

Posted by: sbanicki | April 13, 2011 at 04:31 PM

A very good post, thank you.

Transactions-oriented banking would seem to require a transactions-oriented regulatory tool-kit modeled after what is done in best-of-breed trading houses today: transactions that increase corporate risk get capital charges, and transactions that decrease it get capital credits. Note that this policy is applied to *transactions*. The balance-sheet provides the direction and intensity of the charges, but the charge is applied to the transaction.

While the details are certainly profoundly complicated, it does seem that transactions-oriented capital regulation has the potential to remediate liquidity problems. The expectations of late-entrants into a crowding market will be dampened by the higher capital charges. Momentum-trading will be less profitable. Counter-cyclic trade charges are a correction to the distribution of expectations of return that are proportional to market depth. It will decrease liquidity demand at precisely the time when liquidity is drying up.

If successful this policy allocates the costs of liquidity risk to the late-comers who actually cause the problem, and it protects the capital of the early-adopters who are the innovators in the market.

The downside is that this will tend to slow price competition in financial services. But in an industry that experiences 35% annual decline in profit margins, that might actually be a good thing. Extreme volatility in the profitability of financial services has the potential of rather spectacularly bad outcomes, as we have seen.

Posted by: Alan King | April 17, 2011 at 10:40 AM

Moritz Schularick's comments on "the divergence between credit supply and money supply" are interesting.

But the "divergence" is only the result of an error in measuring money supply, and this in turn is the result of viewing money not as the sum of credit plus currency but as cash balances. The error of viewing money as cash balances is an error common to the Austrians, the monetarists and the Keynesians. So far as I know only one economist has not agreed with this view: Joseph Schumpeter. And unfortunately, Schumpeter did not do any serious work on money.

In an era when currency is only about 50% of M1, a completely new model of money is required, one that views money as credit plus currency, not cash balances.

I have developed a complete model of money as credit but understanding it calls for unlearning a lifetime's thinking of money as cash balances.

In any case the end result, a graph showing what I call Corrected Money Supply from 2001 to 2011 can be viewed at http://www.philipji.com/Mc2001-2011.gif

If the fact that it accurately tracks the rise of money supply until the beginning of 2006 when housing starts ceased to grow, the contraction of money during the recession and its rise to dangerous levels in recent months is interesting, the logic behind the article can be seen at http://www.philipji.com/riddle-of-money/

In the absence of an accurate monetary aggregate any attempt to identify and prevent bubbles is impossible.

Posted by: Philip George | April 17, 2011 at 11:34 AM

I really like this concept. I just want to know as it consists of how many templates. Better-performing economies featured a better-capitalized banking sector, a current account surplus, high foreign exchange reserves and low private sector credit-to-GDP. In other words, sound policy decisions and institutions reduced their vulnerability to the financial crisis. But these economies also featured a low level of financial openness and less exposure to US creditors, suggesting that good luck played a part. Thanks for sharing this great post.

Posted by: home business | April 18, 2011 at 05:09 AM

Great article, short and precise. What bothers me although is the fact that the jury is impressed by a presentation like this. This just proves that the application of law often does not have anything to do with justice, but more so with who's better at presenting. While the details are certainly profoundly complicated, it does seem that transactions-oriented capital regulation has the potential to remediate liquidity problems. The expectations of late-entrants into a crowding market will be dampened by the higher capital charges. Momentum-trading will be less profitable. Counter-cyclic trade charges are a correction to the distribution of expectations of return that are proportional to market depth. It will decrease liquidity demand at precisely the time when liquidity is drying up. What bothers me although is the fact that the jury is impressed by a presentation like this. This just proves that the application of law often does not have anything to do with justice, but more so with "who's better at presenting".

Posted by: Business Plan | April 19, 2011 at 07:45 AM

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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

April 1, 2009 in Federal Reserve and Monetary Policy, Financial System, Money Markets | Permalink


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The Fed has terrible judgment. Just look at the past several years, it ignored cheap money from overseas ramping up credit growth because inflation was low while asset inflation was going to the moon, when the you-know-what hit the fan in August 07 they all believed it would be contained to housing and business capex would pick up the slack, then they started cutting rates when the problem was not the cost of money but in open market operations (ask some people off-the-record about dudley's performance at that time), and then the sharp eases that gave china and the other dollar-linked nations a boost that inflated energy and food prices then raising U.S. inflation to the point where the FOMC was adamant in having the forwards price a fed funds hike by year-end 2008. this fed has been wrong and wrong-headed all along the way and now Bernanke and the Fed are viewed as stewards of the financial order in need of broader regulatory power? as my grandmother used to say -- Oy! econmkts.blogspot.com

Posted by: steven blitz | April 01, 2009 at 03:07 PM

I'm not an economist, but heck, it's never stopped me before, so here goes.

No one in the private economy is spending their buck, so you spend the government buck.

When banks leave the field of battle, the Fed and the Treasury step in and provide a minimal amount of lending/spending, thus limiting the near term damage to ordinary people of all sizes and stripes.

This all works a lot better if the Fed and Treasury don't have to pay any interest on their borrowing.

Yield curve gets an upward, healthier slope. Credit markets notice this.

Once the now chastened (and poorer) private money returns to the playing field, the Fed and the Treasury recall their money and lessen the sovereign debt.

Depression avoided. At least for now.

Posted by: Beezer | April 02, 2009 at 09:45 AM

I follow Prof Altig's logic, but disagree on the bricks. Are the bricks market related, or there because of fiscal and fed policy? Had the elected wonks let AIG and the rest go bankrupt, surely we would have seen a melt down in the market. However, all the intervention has created a different conundrum. We are still in a liquidity trap. Since the Fed action of last Wednesday, long term rates have seeped higher. Only active Fed action will keep those long term rates low, since expectations are driving them higher. The short end of the curve is complacent. It's hard to snap the rope when rates are zero.

Fiscal policy is dismal, since it is anti-growth, and highly inflationary. The rhetoric coming out of the Congressional chambers is not helpful either. The government has bred a climate of fear-and the savings rate has climbed significantly higher.

It brings me back to the bricks. I am convinced that all of the insolvent banks and counter parties should have been allowed to fail, or taken a lot of pain. The market would have unfrozen quicker (bankruptcy does that) and we would be hurt but recovering. Now we are limbo.

When we watch Washington instead of LaSalle and Wall Street, we are in trouble.

Posted by: jeff | April 02, 2009 at 10:28 PM

While the analogy makes sense, I do not believe it is the Fed's job to fix these 'bricks'. I could understand this in the case of panic, but we are beyond that. Liquidity in particular appears under control - large bid-ask spreads are natural in a recession on complex products that have not gone through a deep recession along with massive gov't interventions.

Higher long rates are not a problem, its actually a necessary condition for banks to generate attractive returns on new loans which could draw new private capital. If the fed wants cheap loans to consumers and businesses then the gov't will have to directly or indirectly provide all of the loans, with no expectations of willing private capital. If consumers and businesses can not afford high rates then much safer to use fiscal policy to soften the blow. Not least it encourages good behavior, not the over leveraged. Also If inflation sets in rates will presumably go up considerably, creating a recession far worse than what we have already.


Posted by: GB | April 05, 2009 at 01:10 AM

What is needed is for the Federal Reserve to think out of the box and seriously consider ways to enforce significantly negative short term interest rates.

In order to achieve that, it should not add numerous policy instruments but remove the one that blocks the system : cash banknotes (you know, the actual green paper thing !).
It is easier than one thinks : just consider the percentage of one's expense that one actually settles with paper cash : 5%,3% ? The US (and most of the industrial world actually) has already the "plastic" infrastructure in place. Volker is wrong about the ATM being the only innovation in finance since the 70's ! Ubiquitous retail electronic payment is a very significant one and is indeed a big difference between today and the 30's.
Roosevelt had to abolish (in practice) private ownership of gold to monetarily kick start the New Deal. The equivalent for Obama is to abolish paper cash. Once this is done (actually, once it is announced with a short deadline !), the Fed can get rates into negative territory. Reserves at the Fed would COST money to depositing banks, that would transmit this cost to deposit holders,that would impact the whole yield curve both on treasuries and corporates.

Bottom line : the Fed is back in the game with a full powered monetary policy. As a non-negligible side benefit, underground economy, especially the illegal one, finds it much more difficult to operate.

If it is so easy, why hasn't this been done in Japan ? Two reasons,the second being the most important :
- It would have sent the Yen to the bottom, raising the ire of the US at that time.
- The social groups that were the biggest holder of cash at the end of "The Bubble" in Japan were (and are still) at the same time the biggest "constituencies" of the LDP.

Posted by: Charles Monneron | April 05, 2009 at 10:05 PM

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September 30, 2008

On rescues and bailouts

I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have, however, found it helpful to think through the following (not entirely original) scenario:

I am sitting on my back deck one fine afternoon and notice smoke coming from the kitchen window of my neighbor Joe. The color and volume of the smoke—and the fact that I know that Joe is not home—leave no doubt that the kitchen is on fire.

I begin to calculate my possible responses. I think Joe has a sprinkler system installed, so it is possible that safeguards already in place will soon put the fire out. Of course, I’m not entirely sure the system is up to the task—or even if it exists—so I consider a limited intervention in the form of running inside my own house and calling the fire department. They are a pretty efficient unit, but in the best of circumstances it will take them some time to arrive. So I also contemplate the most extreme measure available to me: grabbing my garden house, breaking down Joe’s back door, and addressing the fire directly.

It’s a hard choice, so I begin to think about the costs and benefits of each option. If I rely on the uncertain quality (or existence!) of the sprinkler system, or wait for the fire department to arrive, the fire could spread rapidly and possibly threaten my property. On the other hand, if I rush in with my hose, I could get hurt—the direct intervention could be costly, too. What’s more, my intervention might not do the trick—the fire could be too big, my garden hose too inadequate a firefighting tool.

I decide to throw caution to the wind, grab the hose, and burst into Joe’s house. I am able to successfully quell the flames, escaping with only a few minor burns and watery eyes. I feel pretty good about the whole business, but the truth is I discovered that the sprinkler system was indeed operating and may have put out the fire on its own (though it hadn’t yet). And just as the last flicker expires, I hear the fire engines in the distance. They may have arrived in time to spare my house (though it is clear that the fire was spreading quickly). So, I wonder. Did I do the right thing?

Actually, my dilemma deepens. When the fire marshal arrives, he discovers that the cause of the fire was a cigarette, foolishly left to burn near a stack of old papers. I knew all along that old Joe was the reckless sort, and now I fear that by stepping in and containing the damage that Joe had brought upon himself I may just be encouraging more such carelessness in the future.

Then again, the kitchen is a total loss, and the smoke has permeated Joe’s house and ruined more than a few pieces of furniture. Though it is obvious that Joe has been spared total ruin, will he really feel that his actions have gone without consequence? Will he feel that the fates have bailed him out?

I wonder.

UPDATE: I'm getting some ribbing over the similarity between my scenario and the analogy offered today by a certain well-known candidate for high political office. Though I did note that my story is not entirely original, I assure you that the present coincidence is, well, entirely coincidental.

September 30, 2008 in Banking, Financial System, Money Markets | Permalink


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Dave Altig of the Atlanta Fed explains the rescues-and-bailouts dilemma:I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have [Read More]

Tracked on Sep 30, 2008 8:52:26 PM


Well what Joe learns is partially up to him.

But Joe IS your neighbor. His property values affect your property values. And the fire threatened the house of your cousin, who lives next door to him.

Let's imagine that the cause was not merely a careless act of a misplaced cigarette, but was rather induced by Joe's son Charley, a Gothic type, who had been experimenting with homemade explosives in the basement.

Charley was in over his head and thought that past experience with harmful chemicals proved that they could never combust spontaneously in his absence.

Furthermore, some of the chemicals in Charley's possession required the consent of an adult to purchase, a "technicality" Charley had never complied with. Should Charley's father be punished?

However, the whole analogy of a neighbor's house on fire is completely unacceptable because it does not convey the possible consequences of the offending conduct.

This catastrophe in the interbank market that is beginning to amplify through the "real" economy is not merely a "house fire".

There is a small but quantifiable chance it could cause millions of premature deaths worldwide over the next ten years.

A far more apt analogy would be if the glorious Government researchers at Fort Detrick Maryland had been searching for a "defensive" response to an al Qaeda biological attack and had inadvertently released a highly virulent strain of smallpox into the population that threatened to kill 30% of the people worldwide.

But they never intended to do such a harmful thing.

Should the Secretary of Defense lose his job over such an occurrence?

Matt Dubuque

Posted by: Matt Dubuque | September 30, 2008 at 03:43 PM

Sorry, I don't feel *at all* like Joe's neighbor. I feel much more like the unwilling neighbor of a problem gambler.

Also on the face of it, it appears that Joe has a wealthy aunt (let's call her Sen. Auntie Em) he has ingratiated himself with. This is an aunt that he can intermittently tap for funds when he can't make his boat payment or those infrequent (but readily predictable) times when he burns his house down.

Makes the case for helping Joe a little less compelling, yes?

Posted by: IdahoSpud | September 30, 2008 at 03:43 PM

I suppose the question of whether Joe is careless again depends on whether he will be ever again be offered tens of millions of dollars in bonus to do so.

The real problem is that the incentives are skewed even without intervention.

Posted by: Anurag | September 30, 2008 at 03:54 PM

On the other hand, your other neighbors suffered no loss and will feel free to behave recklessly in the future, confident that you will save them.

Posted by: Erik | September 30, 2008 at 03:58 PM

The comparison isn't adequate. The risk/reward ratio in the case above should'nt motivate you to rescue joe's house at the risk of losing your own life.

To be brutal: that's why banks can't recapitalize at the moment unless at the cost of massive shareholders dilution.

To come back to your story: the owner would have called joe and asked 'if I go in now, do I get half the ownership of your house??'

Posted by: Marc | September 30, 2008 at 04:44 PM

The primary problem with this analogy is that it assumes an unlimited supply of water. But this type of fire, the more water you use, the less effective it becomes. Indeed, it won't be long before the water is actually fueling the fire.

The secondary problem is that it assumes Joe has morals. Forget it! He never had any and never will. The idea that the Joes of the world are affected by morality is something dreamed up by the government.

Posted by: Anonymous | September 30, 2008 at 06:10 PM

But Joe has only been occupying this house which actually is owned and guaranteed by his wealthy uncle and if it burns, it doesn't matter - he has partied there for a long time, all the while profiting considerably from the saved rent. Further, since as a neighbor he has been so ostentatious and selfish, and because we have a buffer zone in between our houses, I am willing to bet that my damages will be relatively minor in the hope that this pest of a neighbor will be effectively smothered by his benefactor.

Posted by: BR | September 30, 2008 at 08:16 PM

Just a mark of your obvious thoughtfulness Dave ... Don't disown the post!!

Posted by: Guhan | September 30, 2008 at 09:03 PM

Matt Dubuque

The interbank lending market remains in a coma threatening us all, irrespective of what the Dow Jones Industrial Average may be doing on a short-term basis.

As Senior Economist Gordon Sellon of the Kansas City Federal Reserve discussed in his seminal paper "Monetary Policy and the Zero Bound: Policy Options When Short-Term Rates Reach Zero" published in the Fourth Quarter 2003 edition of the Kansas City Federal Reserve's "Economic Review", the Federal Reserve should now consider under taking "twist" operations in the open market.

That paper is available here at the bottom of the link:


A "twist" operation by the Federal Reserve in the current context would consist of the Fed SELLING 3-month Treasury Bills while simultaneously PURCHASING 5-year Treasury Notes. Such operations, applied judiciously, would affect the term structure of various markets in a positive way.

Such "twist" operations are not without precedent. It was performed during the Kennedy Administration:


I urge people to STUDY Sellon's critical paper at the link provided above to grasp some of the subtleties involved here before engaging in uninformed knee-jerk criticism.

This is not a cure-all, but it is clear that it should be on the short list of our policy options.

Matt Dubuque

Posted by: Matt Dubuque | October 01, 2008 at 09:30 AM

I like your metaphor - the only thing I think you missed is that the water hose used to put out the fire may bankrupt me and my children due to future taxes to pay for it. Makes me think more about taking some fire damage vs bankruptcy

Posted by: GR | October 01, 2008 at 09:53 AM

The best way to approach the liquidity & then part of the insolvency in the non-banks is to get the commercial banks out of the savings business (REG Q in reverse but excluding the non-banks).

What would this do? The CBs would be more profitable, there would be an immediate increase in the supply of loan-funds (non-inflationary liquidity), both long-term & short-term interest rates would be considerably lower, and the economy would crawl out of this depression.

Posted by: flow5 | October 01, 2008 at 05:57 PM

Just like“Banks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements – Testimony of Treasury

“These measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businesses” Testimony of Treasury

A commercial bank becomse a financial intermediary only when there is a 100% reserve ratio applied to its deposits.

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

From a systems viewpoint, commercial banks as contrasted to financial intermediaries: , never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs).

The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free gratis legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), as fixed by the Board of Governors of the Federal Reserve System.

Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. If the member banks hold 80 percent of all bank assets, an expansion of credit by the nonmember banks and no expansion by member banks will result, on the average, of a loss in clearing balances equal to 80 percent of the amount being checked out of the nonmember banks.

From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bank’s clearing balances, and probably its free/gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

That is, CB time/savings deposits, unlike savings accounts in the “thrifts”, bear a direct, one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

Consequently, the effect of allowing CBs to “compete” with financial intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB TDs.

Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its "open market power", to prevent any outflow of currency from the banking system.

However, disintermediation for financial intermediaries- (non-banks), is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures.

In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the "thrifts" with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process. Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

Professional economists have no excuse for misinterpreting the savings investment process. They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.

From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity or turnover of existing money. Here investment equals savings (and velocity is evidence of the investment process), whereas in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money (money supply).

The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct. Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

How does the FED follow a "tight" money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business (REG Q in reverse-but leave the non-banks unrestricted-compensated for transition). What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts. Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

Dr. Leland James Pritchard (MS, statistics - Syracuse, Ph.D, Economics - Chicago, 1933) described stagflation 1958 Money & Banking Houghton Mifflin,

“The Economics of the Commercial Bank Savings-Investment Process in the United States” -- “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7
“Profit or Loss from Time Deposit Banking” -- Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

Posted by: flow5 | October 01, 2008 at 06:00 PM

I never liked this blog much, and now I like it even less.

Posted by: whaaa? | October 01, 2008 at 07:51 PM

Can I just say thank-you for publishing this blog. Could we make it mandatory reading for members of Congress?

Posted by: Mr. ToughMoneyLove | October 01, 2008 at 09:57 PM

Question: Will the water from your water hose corrupt the DNA on the cigarette remains and wipe any remaining finger prints from the paper ashes, door handle, etc? If so, the fundamental incentive for putting out the fire before the investigators arrive may become clear.

Posted by: Ken | October 01, 2008 at 10:01 PM

Yes, what a fine analogy.

The problem is the water table is running real low in the county.

For years Joe and his friends in the McMansion subdivisions have been watering their lawns knowing full well that the water table is low.

You have to decide if putting out the fire in Joe's house is the best idea.

Putting it out might be it. The water might run out for the whole county. If so everyone will have to move out and go somewhere else.

You also know that Joe has insurance and an insurance agency standing behind him. While losing his property because the lack of water will probably raise everyones insurance payments, at least no one would have to abandon the county and the county will be able to continue looking for a new source of water and live to fight another day.

So you really must choose between putting out the fire at the risk of loosing everything and perhaps even being unable to stop the fire from spreading if the well runs dry before it's out or creating a backfire that might help save everyone from facing the fire coming from Joes' house.

Posted by: Chris | October 02, 2008 at 11:57 AM

Whatever happened to 'individual responsibility and accountability?' I believe you've entered a highly contentious area of individual risk vs. the perceived common good.

When did you become big brother? When did you become his keeper? Where's your name on his deed/mortgage? When were you hired as security for his property? Are you his insurance company? Is he required to ask permission from you before he smokes his cigarettes, buys a newspaper, turns on the stove, yearly furnance checks, plugs in electrical appliances? Do you check his house for smoke and carbon monoxide detectors? Do you come over and replace the batteries yearly? Is he allowed to walk, talk, and chew gum at the same time....hahahahaha

And BTW, I'm your next door neighbor. I've noticed that you leave your lights on all nite. I'm concerned. What are you doing? Do you remember to turn off the stove after cooking and that woodburning fireplace is used way to often and is a fire hazard. When did you last get your electrical wiring replaced? Hmmmmmmm

Point; I will not demand that you comply to my standards. Therefore, as an adult I shall take precautions with my own home and wish my neighbor good luck as he does me.

"They that can give up essential liberty to obtain a little temporary safety deserve neither liberty nor safety." B. Franklin

Posted by: rps | October 02, 2008 at 01:44 PM

It's a good analogy. I have traded in the credit market for 20 years. This has been a market unlike I have seen. In 1987, we had a heart attack. But the market worked its way out of the mess. The Fed provided the correct action.

This has been with us for over a year, and has been brewing for longer than that. Kind of like a cancer.

I am against a bail out of gigantic proportions. However, it is mission critical that we get the credit interbank market operating again. It is the lifeblood of our economy. The government must do something targeted toward that.

What is the critical problem? Counter party risk. No one trusts the other's balance sheet. Do you blame them?

There is only one way I know of to alleviate counterparty risk. It's a clearing house, similar to the ones used by futures exchanges. If you go to www.cme.com, you can get a good description of how a clearing house works.

So going forward we don't necessarily need more regulation, but we do need a different market structure with a clearing house being an integral part of it.

Looking backward, it's really tough to figure out what to do. I am not in favor of suspending mark to market-because they didn't mark the stuff to market for years on their books. But we do need to get this stuff off their books. If this is through a RTC type vehicle so be it. As long as the government buys the stuff for pennies on the dollar, then we should be okay long term.

The other thing that concerns me is the politics around the issue. In the next administration, they really should not raise taxes-and they should do everything that they can to lower trade barriers. My worry is that they will do the opposite-replaying 1932.

Posted by: Jeff | October 02, 2008 at 11:20 PM

Aside from the fact that making up a ridiculous analogy proves nothing, the real situation involved giving $700 billion to an administration which has proven that not only *could* it f*ck up a two-car parade, but has repeatedly done so, while stealing vast sums.

And it's made by somebody who won't suffer when the administration does steal the money and laughs, handing the problem over to the Obama administration for Bailout II.

Posted by: Barry | October 03, 2008 at 01:03 PM

The analogy is stupid, as it leaves out several features of what is really going on, like the obscene paychecks on Wall Street, the fraudulent CDS sold by AIG to European banks to enable them to get around inconvenient capital requirements, and the big lie that the troubles of Wall Street are having such a terrible effect on Main Street that we must give them hundreds of billions of dollars. It is truly disgusting.

The Fed publishes a daily commercial paper report, as well as the weekly H.8 release that lists banking assets and liabilities. The CP report shows that nonfinancial companies are NOT having any trouble getting funded, while the H.8 shows that the expansion in bank credit continues unabated. Banks will not lend to each other because they know the balance sheets of other banks, like their own, are largely fictitious. But they are making loans to nonfinancial companies, and that's all that matters for the larger economy.

Posted by: NotTheSameJeff | October 04, 2008 at 03:33 PM

I think we need to add the part where Joe is standing in front of his house afraid to go in and put out the fire himself, but will be just happy enough to let his neighbors do it.

Posted by: Jim | October 04, 2008 at 11:12 PM

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