Financial Crisis? Yes, But What Kind?
Ostensibly to combat the ongoing financial crisis and recession, on Tuesday, the Federal Reserve reduced the Fed Funds rate to what is effectively considered zero (ZIRP) and indicated that they might continue this policy for an extended period of time. In addition they reduced the discount rate for lending by the Fed to large institutions to 0.5%. These incredible steps have generated a lot of commentary about whether the Federal Reserve is running out of steam with monetary policy alone.
I'm not a Financial expert, but I am still trying to grapple with the logic of some of these drastic actions - more as an observer trying to apply some common sense to the situation we are facing. I admit I could be wrong in my simplified observations here and would love to see people like Paul Krugman address this in more detail.
The Fed has been flooding the market with money for the past 2-3 months, and their monetary base (dollars) has skyrocketed. However, I have been looking at a wide range of financial and economic indicators and it appears to me that at least after the initial actions by the Fed back in the Sep/Oct timeframe, money supply is not the real problem. Arguably, there is plenty of liquidity in the market and most financial institutions (except the sickest ones) appear to have adequate cash already, without the need for a ZIRP. If anything, the main problems we are facing now appear to be tied much more closely not to the financial meltdown earlier this year but rather to the not unexpected vagaries of the business cycle downturn that started late last year and intensified in Q4 due to the financial crisis. In other words:
1. Many businesses are unhealthy due to demand destruction from a strong business cycle downturn and might be having a harder time raising money through loans to sustain their business through the downturn. (However, once we emerge out of the downturn, I would imagine their ability to raise money will keep improving).
2. Consumers who have lost jobs or who are facing foreclosures are having trouble finding credit (However, this is almost entirely to do with their credit-worthiness and not money supply. As is the case in typical downturns, consumers with worse credit ratings will have more trouble finding credit).
3. Consumers and businesses that are currently doing fine are probably reluctant to apply for more credit in the current economic environment and are partially trying to pay down debt (or reducing their monthly payments through refinancing), rather than borrowing more money.
To state it differently, we don't seem to have a money supply problem - if anything, the problem might be that a section of the country is having a harder time getting loans and another section of the country is not keen to increase their debt (even as the money supply has skyrocketed). The former is typical in recessions and the latter is a change towards more savings-orientation - something that has been somewhat lacking in the preceding years. In this environment, other than helping group #3 indirectly (lower interest rates that facilitate the refinancing of existing debt on better terms), what is a ZIRP really going to accomplish?
Banks that are really reluctant to lend because of the recession are more likely to be inclined to borrow from the Fed at 0.5% and park that money in longer-term Treasury securities yielding say 2-3X more (I suppose this is why the Fed is making noises about getting into the long-term Treasury market to bring those yields down and force banks to loan the money elsewhere). Worse, what worries me is that by flooding the financial sector with >$1T in cash, the Fed is doing something that is only marginally helpful in addressing the current problem and drastically increasing the risk of another big bubble when the economy eventually bounces back (with or without any "secular stagnation") - after all, all this floating money will be looking for the "next big thing". In contrast, a large and targeted stimulus spending plan seems to be a much better approach to put extra money to use. (Targeted tax cuts to help the struggling section of the population might be considered but I question the effectiveness of merely increasingly money supply to consumers in that manner since they are more likely to use that to pay down debt. Infrastructure spending on the other hand would also have the benefit of creating jobs and stimulating broader economic growth).
As I was thinking about this issue I was searching for additional data and interestingly enough came across a paper from October 15, 2008 by Chari, Christiani and Kehoe of the Minneapolis Federal Reserve (h/t David Sirota), titled "Facts and Myths about the Financial Crisis of 2008". I hope that Calculated Risk and Paul Krugman take some time to read it and comment on it because this paper totally challenges some of the entrenched conventional wisdom about the current crisis. Not only do these authors point out that there is no money supply problem, they also assert, based on data, that even the lending side of the world is not really in crisis. Here are the three myths they claim to dispel in their paper:
The financial press and policymakers have made the following three claims about the nature of the crisis.
1. Bank lending to nonfinancial corporations and individuals has declined sharply.
2. Interbank lending is essentially nonexistent.
3. Commercial paper issuance by nonfinancial corporations has declined sharply, and rates have risen to unprecedented levels.
Here we examine these claims using data from the Federal Reserve Board and Bloomberg. Our argument that all three claims are false is based on data up until October 15, 2008.
Some key observations from the paper are:
(a) "...bank credit has not declined during the financial crisis. Indeed, bank credit appears to have risen relative to trend in the month of September."
(b) Based on "data for loans and leases made by U.S. commercial banks.....no evidence of any decline during the financial crisis."
(c) Based on "data for commercial and industrial loans....no evidence that the financial crisis has affected lending to nonfinancial businesses."
(d) Based on "data for consumer loans....no evidence that the financial crisis has affected consumer lending."
(e) Based on "data for interbank loans made by all U.S. commercial banks....at least in the aggregate, interbank lending is healthy. The second claim, that the volume of interbank lending has fallen sharply, is false, at least as of October 15."
(f) Based on "data for the stock of commercial paper outstanding for financial and nonfinancial corporations....while commercial paper issued by financial institutions has declined, commercial paper issued by nonfinancial institutions is essentially unchanged during the financial crisis."
There's a lot more in the 41-page paper. I recommend you read this paper in its entirety, forward the link to financial bloggers and financial news media and ask them to discuss the paper.
Sirota also provides a link to this WSJ piece "Credit Crisis Skeptics Challenge Conventional Wisdom" which discusses the Minneapolis Fed paper. Some excerpts (emphasis mine):
Consulting firm Celent also disputes that overall financial conditions have suffered all that much over the course of a financial crisis most agree began in August 2007. Octavio Marenzi, head of the firm, said in report released Tuesday that Fed data show that over the course of the troubles, lending by U.S. commercial banks has actually increased by 15% overall. Like the Minneapolis Fed researchers, he argues that lending between banks is solid, while consumer credit has grown in tandem with bank lending to businesses.
Credit crisis skeptics are rare birds. If anything, critics have lambasted policy makers as slow to react to the credit crisis and its impact on the economy, though those voices have subsided in light of the radical actions of the Federal Reserve and Treasury.
Fed chief Ben Bernanke has moved very aggressively across a number of fronts to aid financial markets, arguing that the economy can’t function without a healthy financial sector. There’s no doubt the Fed chief sees financial troubles as a big problem, and the fact the economy has lost over a million jobs over the last three months probably has something to do with that conviction.
The Minneapolis Fed paper even earned a rare rebuke from other Fed economists. Researchers at the Federal Reserve Bank of Boston, in a recently published paper, argued that a focus on aggregate data is misleading, and that they so-called myths about the crisis are actually facts.
The Boston Fed researchers argue that when it comes to all sorts of data regarding the financial sector’s performance, there are “many…confounding factors.” Any effort to understand the truth of developments requires a “more thorough analysis” than a series of simple plot points on a graph can offer, they said.
As it turns out the Minneapolis Fed authors responded to the Boston Fed critics in their paper. They discuss the criticisms in some detail but I want to highlight a small portion (emphasis mine):
A recent paper by Cohen-Cole, Duygan-Bump, Fillat, and Montoriol-Garriga at the Federal Reserve Bank of Boston (hereafter referred to as the BF paper) comments on an earlier version of this paper. The authors of the BF paper begin by claiming that the three claims we document as myths are indeed facts. Puzzlingly, they then go on to agree that the claims are, indeed myths. Instead they want to argue that if we look at disaggregated data the financial crisis is very serious. Unfortunately, they bring very little disaggregated data to the discussion and mostly conduct an exercise in speculation.
Back to the WSJ piece:
Indeed, untangling the implications of borrowing data is a difficult thing to do. The most recent National Federal of Independent Business November survey was pretty bleak in terms of what it found out about economic conditions.
But the report found that among small businesses “no “credit crunch” has appeared to date beyond the normal cyclical tightening of credit.” The NFIB found that worries about interest rates and financing were a concern to only 3% of respondents, compared with 37% in 1982. And that’s as commentators are comparing the current recession increasingly to those dark days.
By and large, the story of the NFIB report was that if credit is going untapped, it’s largely because company operators are not choosing to pursue the credit. It’s not that companies can’t get the extra money, it’s that they don’t want or need it because of the broader slowdown in economic activity.
Let's hope that there is more discussion on this in the broader financial community.