Ben Bernanke is a much better economist than John Taylor

Writing in Thursday’s Wall Street Journal, John Taylor takes the Federal Reserve to task for its “interventionist” behavior.

Taylor’s main complaint with the Fed’s conduct of monetary policy is that it is unstable and unpredictable (verging on the whimsical!).  He argues that this stems in part from the Fed’s mandate to pursue low unemployment in addition to price stability.  He further argues that a more predictable  “rules-based” monetary policy, focused solely on maintaining price stability, would be more appropriate.

The problem with Taylor’s argument is that his definition of “rules based policy” is too vague to be useful.

The epitome of a rules based monetary policy is the gold standard: if monetary policy is dictated by the quantity of gold, there isn’t much room for discretionary policy.  The United States operated under a gold standard from 1879 to 1914.  And since the United States did not have a central bank during that period, there was no entity to undertake discretionary monetary policy.   You can’t get much more rules based than that.

How did this arrangement work out for the United States?  Not too well. The US suffered continuous deflation from the mid-1870s until the the early 1890s (the period was known as the “Great Depression” before the collapse of the 1930s took the name)–and major financial crises in 1893 and 1907.

Nor did the gold standard generate economic stability during the interwar period.  Countries that remained on the gold standard the longest (e.g., Belgium, France, the Netherlands) experienced more severe declines in output than those that left relatively rapidly and were able to run a looser monetary policy.

Taylor’s designation of various periods as being characterized by rules-based monetary is arbitrary and inaccurate.  The monetary policy that led to high inflation and contributed to high unemployment during the late 1960s and 1970s was certainly discretionary.  The anti-inflation policy adopted by Paul Volcker and the Fed in the the late 1970s was also discretionary.  The same thing can be said about monetary policy under Greenspan and Bernanke.  What Taylor meant was that, in retrospect, policy under Volcker and the early years of Greenspan was “good” and the decade or so before and after was “bad.”  That would have been more accurate.

Taylor is similarly off-base when he suggests that the Fed’s only mandate should be long-term price stability–a definition which he makes elastic enough to be less-than-meaningful.  All signs suggest that the economy is fragile.  Monetary policy can help to strengthen it.  Taylor argues that when the Fed has to tighten up on monetary policy, as it eventually will, this will force banks to reduce their lending.  Given that banks are not exactly lending out money hand over fist, this concern is premature to say the least.  There was similar anti-inflation agitation following the tentative recovery during 1934-36.  The devastating recession of 1936-37 quieted those voices; will it take a return to recession to get John Taylor to rethink his position?

Finally, Taylor stumbles in his accusation that Fed policy is unstable and unpredictable.  Ben Bernanke has been, without question, the greatest champion of transparency at the Fed in its nearly 100 years of existence.  He is the first Fed Chairman to hold a press conference after gatherings of the Fed’s policy-setting committee, the Federal Open Market Committee (FOMC).  He has given a series of lectures, explaining the reasoning behind Fed decisions–an unprecedented step.  And the FOMC has taken the novel step of announcing what interest rate policy will be over the next year to two years.

John Taylor should pay more attention to the facts.

 

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Time to go negative!

Since the outbreak of the subprime meltdown, the Federal Reserve has shown itself ready, willing, and able to adopt unconventional monetary policies in order to reverse the downturn ushered in by the financial crisis. Recent Fed innovations have included quantitative easing in order to inject more money into the economy, intervention in the debt market to alter the maturity structure of interest rates, and announcing its future interest rate plans in order to make them more effective. These and other novel Fed policies have helped turn recession into recovery.  The recovery remains tentative, however.  In order to put it on a firm footing, the Fed needs to adopt an even more aggressive policy.

In the time-honored tradition of political candidates who are lagging in the polls, it is time for the Fed to “go negative.”

“Going negative” in this context does not mean launching verbal attacks on the values of the Bank of England, Bank of Japan, or the European Central Bank. Rather, it means paying negative interest rates on reserves that banks keep on deposit at the Fed. In other words, the Fed should make banks pay for the privilege of keeping money on deposit—something it has never done before. By adopting this policy, the Fed can increase banks’ incentive to lend and thereby contribute to strengthening the recovery.

Banks are required by law to hold an amount equal to a certain fraction of their deposits in reserves—that is, vault cash and deposits at the Federal Reserve. The most basic reason for this is that it encourages banks to keep sufficient resources at the ready to satisfy depositors who want to withdraw their money.

Historically, the Federal Reserve has not paid interest—positive or negative–on banks’ reserve balances. In October 2008, the Fed decided to start paying banks interest on those balances. The Fed currently pays banks 0.25 percent interest on the balances they hold–both on the amounts that banks are required by law to hold, as well as on any “excess” reserve balances they choose to hold. By paying interest on reserve balances, the Fed gives banks an incentive to leave additional funds on deposit rather than making loans.

Although 0.25 percent might seem like a pretty measly return, in the current environment it is not.

Deposits at the Fed are liquid—they can be called on whenever the bank needs them.  Loans to firms and households are usually not as accessible on short notice. Further, deposits at the Fed are safe.  The Fed has a monopoly in the business of creating dollar-denominated reserves, and so these deposits are not in danger being lost to failure or default. Sadly, the same thing cannot be said for most of the loans that banks make.  Finally, a rate of 0.25 percent is approximately equal to the yield on 2-year Treasury notes.  The fact that the Treasury is considering the possibility of issuing securities with negative yields—that is, securities for which buyers would pay the Treasury for borrowing their money–suggests that a positive 0.25 percent rate is attractive.

How would banks respond if the Federal Reserve began to charge them for the privilege of holding their reserves?

Although banks still might want to hold excess reserves in order to stave off an unexpected outflow of deposits, the incentive to hold these reserves would diminish.  Banks’ interest in finding alternative uses for the money entrusted to them—such as making productive loans—would increase.

What about required reserves?  Banks would still be obligated to hold these, of course, and so they would have to choose whether to hold them in the form of deposits at the Fed or as cash. Given the extra cost–and nuisance–of storing, guarding, and transporting large quantities of cash, banks would almost certainly be willing to pay for the convenience of holding a portion of their reserves on deposit at the Fed.

By giving banks an incentive to lend their deposits, rather than keeping them locked up, the Federal Reserve will encourage more bank lending. Increased bank lending to productive enterprises will give them the means to grow their business and will boost our sluggish economic growth.

Going negative could have positive results.

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Enforce the regulations that we already have

Republicans and Democrats are arguing over how many regulations we should add—or remove—from the financial services industry.  Before we think about altering the regulations, we should think about enforcing the ones we currently have.

Ever since the sub-prime meltdown erupted during 2008, politicians on both sides of the aisle have taken aim at the rules and regulations under which the financial system operates.

Democrats argue that the crisis resulted from the under-regulation of the financial system.  In response, the Democrats enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.  Dodd-Frank constituted the most extensive expansion of financial regulation since the reforms enacted in the aftermath of the Great Depression.

Republicans counter that the financial crisis was largely the result of too much government involvement in the financial system.  They blame the crisis on government sponsored entities like Fannie Mae and Freddie Mac, as well as, in the words of Republican presidential candidate Mitt Romney, “Washington mis- and over-regulation.”

During his State of the Union address last month, President Obama took up a slightly different theme, arguing that during the run-up to the crisis, “Regulators had looked the other way, or didn’t have the authority to stop the bad behavior.”

Evidence published last week by the New York Times suggests that, in fact, regulators did look the other way.

The Times story focused on the Securities and Exchange Commission (S.E.C.), which has jurisdiction over securities markets, including the authority to file fraud cases against financial firms.  In addition to monetary fines, firms that are found guilty of, or settle fraud charges are liable to be denied preferential treatment by the S.E.C.  This restriction is costly for firms that are so penalized, making it more expensive for them to raise money and, theoretically, harder to commit the same violations again.

The Times found that the S.E.C. routinely waived the non-monetary penalties for Wall Street firms, issuing at least 344 waivers during the last decade.

This not the first time that S.E.C. permissiveness has led to trouble.  In 2004, the five member commission voted unanimously to allow the largest Wall Street firms to judge for themselves how much capital to hold.  Since it is cheaper to borrow than to raise capital, the debt levels of these firms skyrocketed. When the subprime market collapsed, these heavily indebted giants either collapsed or required a government bailout.

Nor is the S.E.C. the only culprit.  During the savings and loan (S&L) debacle of the 1980s, the crisis was made more severe because deposit insurance authorities routinely granted regulatory forbearance—that is, allowed S&Ls to remain open long after their balance sheets revealed them to be lost causes.  Instead of giving troubled institutions  time to work their way out of trouble, regulatory forbearance gave these S&Ls more time to rack up larger losses that would eventually be borne by the taxpayer.

The debate between Republicans and Democrats over how much regulation is necessary will—and should–continue.  Before we worry too much about what regulations to enact, however, we should make sure that regulators enforce the regulations that we have.

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Three cheers for the IMF, the EU, and the ratings agencies!!!

Hungary’s new constitution came into force on January 1.  This was not good news.

Engineered by Prime Minister Viktor Orbán’s Fidesz party, the new constitution has a number of unsavory elements.

The Constitutional Court, which serves as a check on government power, has been weakened in several ways (e.g., packing it with new judges, having its jurisdiction curtailed, and restricting access to it).  The ordinary court system has also been assaulted by lowering the retirement age from 70 to 62, allowing the government to fill the judiciary with judges favorable to its views, as well as allowing the government to decide which judges hear which cases.  According to Princeton’s Kim Lane Scheppele: “The independence of the judiciary is over when a government puts its own judges onto the bench, moves them around at will, and then selects which ones get particular cases to decide.”

Other elements of the constitutional changes include:

  • Reforming the elections commission and parliamentary redistricting–both with the intent of securing the dominance of the Fidesz party.
  • Lengthening terms of important officials, including the public prosecutor, the head of the state audit office, the head of the national judicial office, and the head of the media board–all currently filled by Fidesz loyalists.
  • Requiring a two thirds super-majority in parliament, making it difficult to reverse these new rules.
  • Enacting a conservative religious social doctrine, even though the country is overwhelmingly secular (only 21 percent of the population attend any kind of church services), and deregistering over 348 of the previously recognized  362 religious communities (including those of the Methodists, Pentecostals, Adventists, Reform Jews, the Salvation Army, Jehovah’s Witnesses, Muslims, Buddhists, and Hindus).

The domestic opposition, human rights groups, and Secretary of State Clinton (among others) have protested; however, it is not clear how effective these moves will be.

Interestingly, the aspect of the Fidesz putsch that has been most effectively countered is the attempt to run roughshod over the central bank, the Hungarian National Bank.  The Fidesz measure would have merged the central bank with the national financial regulator and placed both under the head of the amalgamated agency.  This would have effectively demoted head of the previously independent central bank, András Simor.

It has long been accepted wisdom that monetary policy is too important to be left to the politicians.  The reason for this is that because monetary policy could be used for political purposes, such as lowering interest rate just before an election to help the governing party, it is best left to non-partisan officials.

Although international opposition to the non-economic aspects of the constitutional putsch have been appropriate, the response to the attempts to meddle with the central bank have been even more effective.  Hungarian loans from international agencies, needed to prop up the currency, have been endangered and Hungary’s credit rating has been downgraded to junk status.  These moves appear to have forced Orbán to back off  of his attempt to strangle the central bank.

The response was so swift and so effective because money was at stake. With lots of dubious European sovereign debt already floating around, nobody–including the IMF–is going to lend money to a country that is on the point of destroying a vital national institution.  Nor are the ratings agencies going to certify such countries as good credit risks.

Let’s hope that internal and external pressure will help to overturn the rest of Orbán’s putsch.

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Unfortunately, in Greece statistics is a combat sport

The Financial Times reports that Andreas Georgiou, the head of the independent Greek statistical agency Elstat, is facing a criminal investigation for allegedly inflating the scale of the country’s fiscal crisis and “acting against the Greek national interest.”

Georgiou, who worked at the International Monetary Fund for 20 years, was appointed in 2010 by agreement with the fund and the European Commission to clean up Greek statistics after years of unreliable reporting by the finance ministry.

The source of the accusations against Georgiou is a former member of the statistical agency’s board who was fired recently.  The specific allegation is that the 2009 deficit was exaggerated by Elstat “so it would become larger than that of Ireland and Greece would be forced to adopt painful austerity measures.”

Two observations:

First, it is a little hard to see what benefit a veteran international civil servant–brought in to clean up the national accounts–would receive by exaggerating the budget deficit.

Second, the charge should serve as a reminder of the importance of accurate economic data for making sound policy decisions.  Although Greece’s economic trouble cannot be laid solely at the feet of fudged books, dishonest statistics contributed to the mess.

It is a difficult to see how prosecuting the guy who is supposedly cleaning up the mess in in Greece’s national interest.

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Where will the new capital come from?

Writing in Thursday’s Financial Times, Pimco chief executive and chief investment officer Mohamed El-Erian argues that Europe’s first order of business should be to recapitalize its banks.

It is hard to argue with this prescription.  With the finances of Greece, Portugal, Spain, and Italy in dire straits and banks across the continent up to their eyeballs in the sovereign debt of other countries, the question is how will the recapitalization be financed.

According to El-Erian:  “Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalization must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.”

Swell, but with so many European sovereigns having difficulty borrowing it is hard to see where the money will come from for this recapitalization.  The only plausible sources seem to be the European Central Bank and the International Monetary Fund, neither of which has a clear mandate to act.

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Glenn Hubbard ignores some inconvenient facts

Writing in today’s Wall Street Journal about how to reduce government spending, Columbia University economist and former chairman of George W. Bush’s Council of Economic Advisors R. Glenn Hubbard chooses to disregard some important facts.

According to Hubbard, “President Obama’s answer is higher taxes.”

Well, not exactly.  What President Obama proposed was a combination of tax increases (primarily falling upon those with higher incomes), plus cuts in government programs, including cuts in such sacred cows as the social safety net.  Although Hubbard may disagree with the relative size of tax increases and spending cuts suggested by the president, it is wrong to characterize the president as saying that the answer lies only in higher taxes.

Hubbard continues: “The obvious place to begin is repealing ObamaCare and its expansion of spending.”  If by ObamaCare Hubbard means the Patient Protection and Affordable Care Act–which is what most critics mean when they talk about ObamaCare–Hubbard is mistaken.  According to the Congressional Budget Office(CBO), ObamaCare should reduce the government budget deficit.

When the new Republican majority took over the House this past January, they immediately introduced H.R. 2, the Repealing the Job-Killing Health Care Law Act (nice title!).  The CBO’s preliminary analysis of that stated: “Because CBO and JCT estimated that the March 2010 health care legislation would reduce budget deficits over the 2010–2019 period and in subsequent years, we expect that repealing that legislation would increase budget deficits.”

There are some useful ideas when you go further into the Hubbard op-ed.  I disagree with a lot of them, but they should certainly be part of the debate on how to attack our budget deficit.  Nonetheless, Hubbard should be able to motivate his arguments and stay closer to the facts.

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Great minds think alike

Apparently, the Economist agrees with my emphasis on the rise of technocracy.

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Send in the technocrats!

Winston Churchill said that democracy is the worst form of government except all those other forms that have been tried. The financial crisis has tested Churchill’s assertion.

In Greece, the austerity measures imposed on the country by the EU and the ensuing domestic unrest led Prime Minister George Papandreou to call for a referendum to approve the terms of the bailout that he had just negotiated.  In seeking public approval for the package, Papandreou drew the ire of the main proponents of the bailout–President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany.  Their threats to withdraw the deal if it was not speedily approved led Papandreou to resign.

Typically, in parliamentary democracies, when one party loses the confidence of the parliament, it becomes necessary to form a new government.  A new government can be formed under the outgoing leadership, under the leadership of the opposition, or new elections can be called.

Sadly, even though the major parties recognized that the bailout was necessary, none had the guts to take the blame for taking the deal.  The result was the appointment of a non-political European civil servant–former European Central Bank Vice President Lucas Papademos–to accept the deal.

In Italy, Silvio Berlusconi….Well, let’s just say that Berlusconi was a problematic leader on a number of levels.  He certainly demonstrated his inability to undertake the necessary reforms in a timely manner (he was, after all, prime minister on and off since 1994).

The solution?  Mario Monti, a former EU Commissioner and president of Bocconi University: another non-politician brought into an inherently political job to do what the politicians could not.

Here in the United States, democratic institutions and the politicians in charge on them are having trouble achieving important public policy goals.  Congress appears incapable of dealing with the budgetary situation through normal channels.  Instead, they found it necessary to appoint a super-committee (I have a hard time imagining Washington or Jefferson uttering the term “super-committee”). The outcome of that group’s deliberations is very much in doubt.

The super-committee framework isn’t the same thing as appointing a non-political “technocrat”, but it does suggest that the politicians are incapable of doing the people’s business unless they are somehow protected from voters who will be angry at them for making  unpopular, but necessary, decisions.

I wonder what Churchill would have thought of a technocracy.

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