Bernanke: The World's Central Banker

Back in October I argued that the reason the Fed was not engaging in massive monetary stimulus, as folks like Scott Sumner were stressing, is not because they didn't think it would work but because they were worried that it would; following the crisis the Fed became the world's central banker, not just the U.S.'s:

I have no reason to think this is true, but perhaps Bernanke is influenced by another scholar of the Depression - Charles Kindleberger. Kindleberger argued that the Great Depression became a cataclysmic international event because of the unwillingness of the U.S. and inability of the U.K. to supply public goods to stabilize the international system. Those public goods include maintenance of a system of stable exchange rates and open markets ...

In other words, perhaps Bernanke is acting as the world's central banker. If Bernanke believes that a U.S.-led currency war would have adverse consequences for the global economy, then perhaps he is willing to prolong the U.S. recovery in order to prevent a large global downturn. Such a deterioration of the global economy would also affect the negatively affect the U.S. of course. So while, ceteris paribus, a dollar devaluation would help the U.S., ceteris is not paribus. A U.S. devaluation would prompt a series of actions in Frankfurt, Tokyo, and Beijing. The resulting exchange rate instability would spook financial markets and hamper trade. Cries for protectionism would grow louder, and the net effect would be sharply negative.

Faced with that scenario, perhaps Bernanke has opted instead to try to stabilize markets and defuse an explosive global political economy by allowing other countries to beggar the U.S. some in the short run. Again, I don't know if this is the case, but it seems more persuasive to me than "Bernanke doesn't understand the monetarist lessons from the Depression".

Then in December I noted that the Fed was operating as the world's lender of last resort, and concluded "This provides further evidence that the Fed's behavior cannot be understood out of a global context." Well, now we get even more information about the extreme actions the Fed took to stabilize the global financial system:

The biggest borrowers from the 97-year-old discount window as the program reached its crisis-era peak were foreign banks, accounting for at least 70 percent of the $110.7 billion borrowed during the week in October 2008 when use of the program surged to a record.

There is a lot of detail in the report, which summarizes some 90,000 pages of documents released under FOIA request, but notable foreign firms that received funding include Societe Generale, Dexia SA, Bank of Scotland, Norinchukin Bank, Bank of China, Deutsche Bank AG, Arab Banking Corp., and others. These are some of the world's largest financial institutions, and the Fed's support for them likely prevented the crisis from being much, much worse. So, of course, Ron Paul is apoplectic:

“The American people are going to be outraged when they understand what has been going on,” U.S. Representative Ron Paul, a Texas Republican who is chairman of the House subcommittee that oversees the Fed, said in a Bloomberg Television interview.

“What in the world are we doing thinking we can pass out tens of billions of dollars to banks that are overseas?” said Paul, who has advocated abolishing the Fed. “We have problems here at home with people not being able to pay their mortgages, and they’re losing their homes.”

The American people likely will be outraged, because people like Ron Paul won't stop misinforming them until they are. What the Fed was thinking as it passed out tens of billions was that the if the global economy collapsed that would have pretty profound negative implications for the American people, including those with mortgages to pay. (Anyway who does Paul think he's kidding? He wouldn't support a Fed program to refinance mortgages. Hell, he's a liquidationist. If he were honest, he'd be applauding people losing their homes, as a necessary step in the purge.) Meanwhile, if the Fed acted quickly it could not only halt the downward spiral but do so with very little risk. And, in fact, "all the discount window loans made during the worst financial crisis since the 1930s have been repaid with interest."

Note that the ECB has done some similar stuff, but only on a regional level. That, in a nutshell, is the difference between the role of the two central banks in the global economy.

If I'm interpreting him right, then Bernanke's actions have been terribly misunderstood. And probably underrated.

Who is to Blame?

Who should we blame for our current economic difficulties? I have been thinking about this question for the past week. Not because I wonder who we should blame, but because I am puzzled by the quest to find the person or persons who are responsible. The consensus places primary responsibility on Alan Greenspan. A few, such as Fred Bergsten, blame the IMF as well (for what, exactly, remains unclear). There appears also to be a consensus that Bernanke is to blame for failing to respond correctly to financial weakness (whatever that means) in order to make things better.

I find the search for a culprit puzzling for two reasons. First, the blame game rests on faulty reasoning. Those who assign blame implicitly compare what did happen with a utopian counter-factual of what would have happened had a different policy been followed. Greenspan is to blame because he cut rates too much and fueled the housing bubble. Asserting that these rate cuts were mistaken (and thus G is to blame) requires one to believe that not cutting rates would have produced a much better outcome. Yet, what would have happened had G not cut rates? We might have had a severe rather than a mild recession in the early 2000s. Then we would blame him for not cutting rates (fully unaware, of course, that cutting rates would have produced a housing bubble). So, when we assign blame we assume that the path not taken was a better path without having any good reason to believe this.

Second, when we assign blame we assume that individuals can control highly complex systems. Yet, our understanding of the relationship between monetary policy instruments and economic activity has not yet reached the status of Newtonian mechanics. There is considerable uncertainty about how financial markets work, and how they respond to changes in monetary policy. Whatever imperfect understanding does exist is constantly in flux as financial markets innovate. Is it reasonable to expect the Fed to anticipate the emergence of the new and highly complex financial instruments that drove the sub-prime lending boom? How reasonable is it then to argue that the housing bubble was foreseeable (and foreseen) by Greenspan? This is, of course, the inverse of the first flaw in reasoning; we assume that the future consequences of our current decisions are knowable and we can therefore avoid bad futures.

So why do we insist on assigning blame? I don't know, maybe it reflects our discomfort with the uncertainty that pervades all of the decisions we make and our inability to accept how little direct control we have over the broader forces that shape our lives. Or, perhaps it reflects the exigencies of democratic politics. In a world in which we expect so much from our government, we have lost the capacity to distinguish between those things that a government can be reasonably expected to do and those things we think it should be able to do. As a consequence, we expect unreasonable things from our government, and these expectations create opportunities that those seeking office can exploit to their electoral advantage.

Why Monetary Policy is Easier

As the political discussion of fiscal stimulus to address the non-recession (AKA "downside risk"), familiar patterns emerge.

"Mr. Bush (when did the NYT decide that President Bush no longer deserves the title?) is scheduled to spell out his criteria for the stimulus package in a speech on Friday at a manufacturing company in Frederick, Md."

The Democrats are unwilling to wait to see the details before passing judgment. "Senator Harry Reid of Nevada, the Democratic majority leader, said it was “encouraging that the president has acknowledged the economic problems challenging our nation.” But he complained that Mr. Bush seemed to be following a go-it-alone approach that could “unnecessarily politicize the inevitable bipartisan negotiations” that will be necessary."

It's a good thing we are not in a recession, cause if we were we'd be in deep trouble.

Krugman on the Fed and the Financial Crisis

"What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.

Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed."

Pushing on a String?

Keynes argued that the Great Depression persisted in part because of a "liquidity trap" wherein banks are unwilling to lend regardless of the nominal interest rate. In such a world, monetary policy is useless--he equated trying to use a monetary expansion to stimulate lending to trying to move a weighty object by pushing on the end of a string.

One might ask if global credit markets have now entered a period in which monetary policy amounts to pushing on a string. Credit markets are frozen because banks are uncertain about which banks among them hold how much bad debt (non-performing sub-prime mortgages and associated instruments). Because no one wants to lend to banks who hold a lot of this debt, and no one knows who these banks are, no one is willing to lend to any banks. Consequently, credit markets freeze. The underlying problem is an information asymmetry of the kind that for which Joseph Stiglitz won a Nobel Prize (well, not technically a Nobel, but you get the point).

Yesterday's announcement that US and European central banks will cooperate to provide liquidity to credit markets is best interpreted in this context. "The Fed has not only opened its vault doors to the banking industry, they are now trucking it to their place of business," said Scott Anderson, a senior economist at Wells Fargo, in a written report. "If that doesn't get the banks excited about lending again, nothing will...The Fed's action attempts to deal with a difficult problem confronting the world's central banks: Financial institutions globally are so worried about losses from U.S. mortgage securities and other exotic investments that they are hoarding cash, unwilling to lend it to each other except at unusually high premiums."

I don't know whether to be scared or reassured by this latest development. That is, does this unprecedented action mean that the central banks have things well in hand, or does it mean that things are worse than we realize?

Your Move Now, Jean-Claude

Now that the Ben cut the discount rate by a half point (after adding liquidity to keep the federal funds rate from rising), the European Central Bank must decide whether it wants to keep on course to raise its rate. "The bank's president, Jean-Claude Trichet, hinted earlier this month that he would lift interest rates again to cool inflation from an expanding economy, a stance he appeared to reaffirm earlier this week by declaring that the period of recent financial market turmoil was largely over."

Monetary interdependence could make this interesting, not least because rising rates in Euroland and falling rates in the U.S. may push the euro up against the dollar, thereby sparking more pressure from Sarkozy...