Fiscal policy alone cannot repair the damaged trust in the financial system. Monetary policy has come to its limits as well.
Bradford Delong, professor of economics at University of California, Berkeley 5 January 2009
For every monetary economist interested in history, the past 15 months have been fascinating. A year and a half ago, there was considerable confidence in the world financial system. Yes, there had been a great outburst of irrational exuberance in American housing finance. Yes, perhaps a trillion dollars of financial wealth would be lost in the workout. Yes, mortgage companies and banks were going bankrupt. But we economists believed portfolios were diversified. All over the globe, practically every investor held a small part of the risk associated with American mortgage finance. And so, we thought that in the end, the workout would be smooth.
Now we find that was not the case. Now every investor worldwide has recognized that their portfolio is much riskier and longer duration than they had counted on. And everybody wants to dump their risk onto somebody else. But the economy as a whole cannot shrink its risk in a day or a month, or even a year. So the desire for safer portfolios starts in motion a process that pushes down financial asset prices worldwide. This is trouble, because we need healthy and high financial asset prices in order for those businesses that ought to expand to be able to acquire financing on terms that make it profitable to expand.
Four factors impose haircuts on the values of financial assets. The first is default – perhaps your counterparty simply will not be around when the financial asset you hold matures. The second is duration – even if you are certain that your counterparty will be around, and even if you are certain you understand the situation, and even if you don’t care about risk, you would still rather have your money now than at its maturity date in the future. The third factor is information – maybe you don’t understand what you are buying; if it is such a good deal for you to buy it at this price, why is the seller so eager to sell the asset to you? The fourth is risk – that even if your counterparty will be around, and even if you don’t care about getting your money now rather than later, and even if you understand the security perfectly, you still are not sure how valuable the security will be to you in your particular situation when it matures.
Duration is not an issue in this financial crisis: central banks have pushed the time value of money down to zero in nominal terms, and negative in real terms. Default is only a very minor issue in this financial crisis. But risk is a big issue: banks feel they should be holding less-risky portfolios than they currently hold because just one more bad shock may see them--or at least their stockholders’ equity and their executives’ option wealth-- disappear, so risky assets are at a deep discount. And information is a big issue: everyone is scared that the assets others are trying to sell are, for some reason they don’t fully understand, assets that nobody would wish to buy.
Alan Greenspan hopes that another $250 billion of capital for the U.S banking sector would bring information and risk discounts back to normal levels and resolve the financial crisis – at bank capitalization ratios of 15 percent as opposed to the 10 percent that we used to think of as normal a couple of years ago. But he cautions that “[simple] linear calculations, of course, can only be very rough approximations….”
I hesitate to disagree with Alan Greenspan – by my count, I have been wrong seven out of the ten times that I have, in my mind, had significant disagreements with his policies over the past quarter century. But I fear that he is wrong: that $250 billion will not be enough of a recapitalization of the banking system to return risk and information discounts to their normal levels.
First, the big information problem: banks fear that what is being sold to them is simply not worth buying. Government guarantees of assets can resolve that problem – government issuance of safe Treasuries and purchases of risky assets can resolve that problem – but government or private injections of capital into the banking system cannot.
Second, the big risk problem is not so much a fear of long-run default as a fear of a deeper short-run liquidity squeeze. It is not a fear that investing in risky assets will be bad in the long run, but a fear that investing in risky assets robs you of the cushion needed in the short run, should there be another negative shock, and should the government then decide that it must, for political reasons, confiscate the equity of financial institutions that come back to it for more liquidity support. Thus in my view banks are more likely to sit on additional capital injections than to increase their risk tolerance and seek to invest them at higher long-run yields.
This is a bad situation. With financial asset prices at their current low levels, the businesses that should be expanding cannot raise the money for expansion on terms that make expansion profitable, while the businesses that should be contracting are contracting rapidly. We need either a substantial increase in financial asset prices now, in order to give the businesses that should be expanding the incentive to profitably expand, or we need massive increases in government spending to provide the demand the private sector is not. We would rather have the first if we have the choice – private-sector demand we know will be for things that people regard as useful, while government-sponsored stimulus programs have a different, more political, logic – but we may not have the choice. We need fiscal policy by all world governments: for the next one to three years, they all need to spend more and not to tax more.
But we cannot rely on fiscal policy forever – at least not without resorting to price controls of dubious long-term utility. Eventually the rising national debt will begin to exert its own drag on private confidence and private spending. There must be an alternative. Monetary policy – the conventional lowering of interest rates – has reached its limit. If private-sector demand is to recover in the short run, it will have to be driven by appropriate banking policy.
Thus I am swinging around toward a more radical proposal than Greenspan’s large-scale bank recapitalizations. Has the U.S. government taken formal and complete ownership of Fannie Mae and Freddie Mac, and given them the mission of borrowing at the Treasury rate and buying up and refinancing mortgages on terms that make a profit for the Treasury? This would be a financial operation on a scale never seen before. But as the government bought and the supply of risky assets on offer to the private sector shrank, their price would go up and the mortgage-backed assets that suffer the biggest information problems would disappear from the market. And as asset prices went up, the banking sector would recapitalize itself.
Or so it would work, unless the large scale of the intervention cracked financial sector-confidence in the U.S. Treasury bond as the safe asset standard for the global economy.
The global financial crisis we have now, bad as it is, is not the worst thing that could happen. The worst thing would be a collapse of confidence in the American economy, and a collapse in the value of the dollar. That might be a plus in the short-run for the American economy: employment in import-competing manufacturing would rapidly rise. But it would be a disaster for the world economy as a whole – and especially for economies, such as China, that rely on exports to the United States to fuel much of their growth.
Thus the U.S. needs to be somewhat cautious. Its freedom of action is limited by the requirement, for the sake of the global economy, that it retain its position as sage anchor for the world economy as a whole.
Fortunately, for reasons that no economist of my acquaintance even pretends to understand, the past fifteen months show no sign of having shaken confidence in the dollar as the global economy’s sage asset, to any degree whatsoever. The American government still has enormous power and flexibility--through monetary, fiscal, and banking policy – to try to handle the crisis.
Only when further expansionary moves by the American government trigger sharp declines in the dollar will there be reason to fear that this crisis will trigger an extended and prolonged depression.
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Paralyzed Finance
Fiscal policy alone cannot repair the damaged trust in the financial system. Monetary policy has come to its limits as well.
Bradford Delong, professor of economics at University of California, Berkeley
5 January 2009
For every monetary economist interested in history, the past 15 months have been fascinating. A year and a half ago, there was considerable confidence in the world financial system. Yes, there had been a great outburst of irrational exuberance in American housing finance. Yes, perhaps a trillion dollars of financial wealth would be lost in the workout. Yes, mortgage companies and banks were going bankrupt. But we economists believed portfolios were diversified. All over the globe, practically every investor held a small part of the risk associated with American mortgage finance. And so, we thought that in the end, the workout would be smooth.
Now we find that was not the case. Now every investor worldwide has recognized that their portfolio is much riskier and longer duration than they had counted on. And everybody wants to dump their risk onto somebody else. But the economy as a whole cannot shrink its risk in a day or a month, or even a year. So the desire for safer portfolios starts in motion a process that pushes down financial asset prices worldwide. This is trouble, because we need healthy and high financial asset prices in order for those businesses that ought to expand to be able to acquire financing on terms that make it profitable to expand.
Four factors impose haircuts on the values of financial assets. The first is default – perhaps your counterparty simply will not be around when the financial asset you hold matures. The second is duration – even if you are certain that your counterparty will be around, and even if you are certain you understand the situation, and even if you don’t care about risk, you would still rather have your money now than at its maturity date in the future. The third factor is information – maybe you don’t understand what you are buying; if it is such a good deal for you to buy it at this price, why is the seller so eager to sell the asset to you? The fourth is risk – that even if your counterparty will be around, and even if you don’t care about getting your money now rather than later, and even if you understand the security perfectly, you still are not sure how valuable the security will be to you in your particular situation when it matures.
Duration is not an issue in this financial crisis: central banks have pushed the time value of money down to zero in nominal terms, and negative in real terms. Default is only a very minor issue in this financial crisis. But risk is a big issue: banks feel they should be holding less-risky portfolios than they currently hold because just one more bad shock may see them--or at least their stockholders’ equity and their executives’ option wealth-- disappear, so risky assets are at a deep discount. And information is a big issue: everyone is scared that the assets others are trying to sell are, for some reason they don’t fully understand, assets that nobody would wish to buy.
Alan Greenspan hopes that another $250 billion of capital for the U.S banking sector would bring information and risk discounts back to normal levels and resolve the financial crisis – at bank capitalization ratios of 15 percent as opposed to the 10 percent that we used to think of as normal a couple of years ago. But he cautions that “[simple] linear calculations, of course, can only be very rough approximations….”
I hesitate to disagree with Alan Greenspan – by my count, I have been wrong seven out of the ten times that I have, in my mind, had significant disagreements with his policies over the past quarter century. But I fear that he is wrong: that $250 billion will not be enough of a recapitalization of the banking system to return risk and information discounts to their normal levels.
First, the big information problem: banks fear that what is being sold to them is simply not worth buying. Government guarantees of assets can resolve that problem – government issuance of safe Treasuries and purchases of risky assets can resolve that problem – but government or private injections of capital into the banking system cannot.
Second, the big risk problem is not so much a fear of long-run default as a fear of a deeper short-run liquidity squeeze. It is not a fear that investing in risky assets will be bad in the long run, but a fear that investing in risky assets robs you of the cushion needed in the short run, should there be another negative shock, and should the government then decide that it must, for political reasons, confiscate the equity of financial institutions that come back to it for more liquidity support. Thus in my view banks are more likely to sit on additional capital injections than to increase their risk tolerance and seek to invest them at higher long-run yields.
This is a bad situation. With financial asset prices at their current low levels, the businesses that should be expanding cannot raise the money for expansion on terms that make expansion profitable, while the businesses that should be contracting are contracting rapidly. We need either a substantial increase in financial asset prices now, in order to give the businesses that should be expanding the incentive to profitably expand, or we need massive increases in government spending to provide the demand the private sector is not. We would rather have the first if we have the choice – private-sector demand we know will be for things that people regard as useful, while government-sponsored stimulus programs have a different, more political, logic – but we may not have the choice. We need fiscal policy by all world governments: for the next one to three years, they all need to spend more and not to tax more.
But we cannot rely on fiscal policy forever – at least not without resorting to price controls of dubious long-term utility. Eventually the rising national debt will begin to exert its own drag on private confidence and private spending. There must be an alternative. Monetary policy – the conventional lowering of interest rates – has reached its limit. If private-sector demand is to recover in the short run, it will have to be driven by appropriate banking policy.
Thus I am swinging around toward a more radical proposal than Greenspan’s large-scale bank recapitalizations. Has the U.S. government taken formal and complete ownership of Fannie Mae and Freddie Mac, and given them the mission of borrowing at the Treasury rate and buying up and refinancing mortgages on terms that make a profit for the Treasury? This would be a financial operation on a scale never seen before. But as the government bought and the supply of risky assets on offer to the private sector shrank, their price would go up and the mortgage-backed assets that suffer the biggest information problems would disappear from the market. And as asset prices went up, the banking sector would recapitalize itself.
Or so it would work, unless the large scale of the intervention cracked financial sector-confidence in the U.S. Treasury bond as the safe asset standard for the global economy.
The global financial crisis we have now, bad as it is, is not the worst thing that could happen. The worst thing would be a collapse of confidence in the American economy, and a collapse in the value of the dollar. That might be a plus in the short-run for the American economy: employment in import-competing manufacturing would rapidly rise. But it would be a disaster for the world economy as a whole – and especially for economies, such as China, that rely on exports to the United States to fuel much of their growth.
Thus the U.S. needs to be somewhat cautious. Its freedom of action is limited by the requirement, for the sake of the global economy, that it retain its position as sage anchor for the world economy as a whole.
Fortunately, for reasons that no economist of my acquaintance even pretends to understand, the past fifteen months show no sign of having shaken confidence in the dollar as the global economy’s sage asset, to any degree whatsoever. The American government still has enormous power and flexibility--through monetary, fiscal, and banking policy – to try to handle the crisis.
Only when further expansionary moves by the American government trigger sharp declines in the dollar will there be reason to fear that this crisis will trigger an extended and prolonged depression.
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