David E. Lindsey

Imagining Financial Armageddon, Making Emergency Loans in the Crisis, and Pursuing QE1

With the funds rate objective having reached 5–1/4 percent by mid-2006, for a time the economy actually did seem well balanced. The FOMC on August 8 held the rate steady. The statement foresaw that “inflation pressures seem likely to moderate” because of contained inflation expectations and previous tightening that, along with other factors, restrained aggregate demand. The next paragraph of the statement repeated only part of the previous statement, deleting the excessively obvious reference to the consistency of its future actions with its objectives: Nonetheless, the Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.1

Understanding the Basics from a Contemporary Perspective

What does the Fed think about how the economy functions and how the institution itself makes, conducts, and discusses its monetary policy? This chapter elucidates the general principles of the Fed’s views. Thus, it affords useful background for the detailed chapters that follow on the Bernanke era, which of course can’t avoid these issues. Federal Reserve personnel and conventional macroeconomists predominately see eye to eye, though both suffer lacunas.

Taxing and Spending: Taking a Closer Look at Fiscal Policymaking and Communication

The fiscal logjam in Washington brought vividly to mind the time Bill Dennis, my friend from Earlham College, asked me in early 2004 to address his class. He was teaching Washington interns, who were taking a semester with The Fund for American Studies, with the credits coming from Georgetown University. A student asked a very perceptive, skeptical question implying that the Bush tax cuts of 2001 and 2003 were ill-advised. Influenced by Keynesian orthodoxy but to my eternal shame, I responded that the first cut was appropriate under the prevailing recessionary conditions, but of course it would need to be rescinded during the ensuing phase of economic expansion. But instead another tax cut had been enacted in May 2003, despite Chairman Greenspan’s protestations. The second tax cut had happened even though the recession had ceased in November 2001 according to the National Bureau of Economic Research and four years of structural federal fiscal surpluses had ended in the same year according to the Congressional Budget Office.1 Prompted by Grover Norquest’s pledge of no additional tax revenue, a large segment of Republicans later became unwilling to approve counteracting hikes in tax revenue. My answer to Bill’s student has got to rank among the most nave utterances of all time. I abjectly apologize to that student, who I bet—based on the astuteness of his question—is reading this book!

Concluding the Book

The financial crisis was underway when I got an email on March 30, 2009, suggesting that had I been in charge, the crisis would have been entirely avoided. I replied that day: Just for fun, I decided to analyze your comment … I, like Greenspan, but unlike Rubin and Summers, supported privatizing and opposed government policies toward Fannie Mae and Freddie Mac at the time (1990s until the middle of the last decade), though to no avail. But, like Greenspan, Bernanke, and Geithner, though unlike Yellen, in this decade I missed the sharp relaxation of standards for sub-prime and Alt-A housing loans and the disastrous consequences of massive securitization. Unlike Rubin, Summers, Geithner, and Greenspan, but like Volcker, I opposed at the time (1999) the relaxation of Glass-Steagall in Gramm-Leach-Bliley that allowed the merging of commercial and investment banking but still didn’t give investment banks access to the Fed’s discount window. Unlike Greenspan, Bernanke, Geithner, and Yellen, I opposed at the time the Fed’s pre-commitment to low short rates after the summer of 2003 that contributed to the housing bubble, partly by keeping long rates down at first and then from rising when the Fed’s tightening started in mid-2004. Unlike Paulson, Geithner, and Bernanke, but like Volcker, I opposed at the time (March 2008) the Fed’s taking over

Prosecuting the Guilty, Revealing Crisis Lending, and Endangering Fed Independence

30 billion of Bear Stearns’s assets so JPMorgan could buy it more safely. Later on (September 2008), that decision kept any private buyers from purchasing Lehman without, according to Paulson’s dictum, government aid, and Lehman’s resultant bankruptcy was the proximate, though not the ultimate, cause of the current crisis. I conclude that, had I been in charge all along, the crisis would have been reduced only by about one third! I am forced to admit that even my hypothetical influence is far smaller than I realized.

Experiencing Deflation or Disinflation around the World

The absence of criminal charges after the financial crisis naturally brought to mind the lack of a dog’s nocturnal barking, which Holmes noted in that interchange with Dr. Watson in “Silver Blaze” by Sir Arthur Conan Doyle.1 This chapter initially examines that subject in some detail.

Strengthening Financial Regulations

Masaaki Shirakawa spent 39 years at the Bank of Japan, becoming its governor in April 2008. Exactly six years earlier, as adviser to the governor, he evaluated the experience of the first year of QE in a prophetic paper. He drew a skeptical tentative conclusion about the efficacy of the initiative, emphasizing the difficulty for a central bank to provide stimulus once the economy had begun to experience the zero bound on short rates. At the time he understandably focused on the buildup of excess reserves at banks: [T]he author would like to again emphasize the importance of the fact that Japan’s economy is confronting zero interest rates … Based on this, in a situation where there is little room for a further decline in short-term interest rates, the effects of monetary easing will necessarily be limited. The fact that economic activity has not been stimulated despite an aggressive increase in reserves since March 2001 seems to be consistent with what such standard theory predicts. This kind of conclusion may frustrate readers who seek to find a monetary policy solution. Some may argue that, without other options, the Bank of Japan should try unconventional monetary policy even if the effects are not certain. However, given the difficulty of the problems facing Japan’s economy, before jumping to such conclusion, economists are expected to present sober analysis of the situation fully utilizing all the information and knowledge available.1

Introducing the Book

In the spring of 2009 I received a prescient message from Philip Wellons, who had recently retired from Harvard Law School, where he had been deputy director at the Program on International Financial Systems. He correctly saw that new legislation would be required to facilitate an orderly resolution of insolvent but inter connected financial firms other than commercial banks: On financial regulation: we need to improve the regulatory structure. I would like to see a comprehensive approach across financial markets, including insurance. We can’t simply go back to reliance on capital adequacy regulation. Too many of us can’t gauge risk well—Basel II was a complex mess built on rating agencies. But I don’t see shifting to general principles as the alternative—they only work with homogeneous populations (think Bank of England and London 40 years ago), and world finance is diverse. I don’t see us going back to the 1980s’ idea of segregating (and thoroughly regulating) the deposit takers, while freeing all other financial activities. Now non-deposit takers, and relations among all financial entities, are too large and complex. I end up thinking we need to address the “too big” part of “too big to fail.” Go after the big guys with scalpels and cleavers. Insure deposits and some other liabilities, but let the weak fail. People who accept the need for deposit insurance and special regulation and supervision for banks have a conceptual disconnect now. They said in the past that we treat deposit-taking banks as special because politics will force the government to bail the banks out to forestall runs. Now it looks as though the collapse of certain non-banks could also bring the financial system to its knees. It was the complexity of Lehman…s counterparty relationships that scared people, raising the worries about systemic effects … The threat last fall was not the same as a run on banks because last fall no one knew what each contract gave counterparties in a default. The fear is that the consequences would be at least as devastating as a bank run. The game changed when U.S. government bailed out non-banks. Now that we all know politicians will step in, financial regulators better anticipate and try to reduce the potential exposure over non-banks, as regulators now do with deposit takers … The genie is out of the bottle. S/he ran off with the cow as it left the barn.1

Cruising on QE2, Twisting Again, and Designing Even More Preemptively

In December 1965, the US central bank, the Federal Reserve or “Fed,” unexpectedly raised the interest rate it charged on loans to banks by a half percentage point. President Lyndon Johnson was not pleased. “Those Marble Tower Boys!” was his derisive comment.1

Reaching for QE3 and Then Postponing Tapering

Having been reappointed by President Obama, and confirmed by the Senate on a 70–30 vote, Ben Bernanke began his second term as chairman in early February 2010. Heavy purchases of securities under QE1 ended as scheduled in March. But the economy turned more sluggish as it entered the second half of the year. The FOMC decided on August 10 to maintain the overall size of its assets by reinvesting the proceeds of maturing holdings of housing-related securities in long-term Treasuries. And later that month at the Jackson Hole Symposium, the chairman signaled that another round of large-scale asset purchases could well be forthcoming: A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009 … I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.1