Lehman, PSI and the consequences of credit policy: The third lever of macroeconomics

May 2nd 2013, 19:20  by G.I. | WASHINGTON, D.C.

ECONOMICS undergrads learn early on about two levers to manage the macroeconomy: fiscal policy and monetary policy. Events of the last five years make clear that there is a third lever that while poorly understood and difficult to model, it is at times critical: credit policy.

By credit policy (or banking policy or financial policy) I mean anything that affects how the financial system influences aggregate demand. Of course, we’ve always known aggregate demand depends on both the central bank’s policy rate and the spread over that rate paid by households and firms. But before the cirisis the relationship between the policy rate and what borrowers paid was assumed to be either constant, or endogenous to monetary policy or the business cycle.

Free exchange: Bond shelter

America’s ability to issue debt is helped by a resemblance between Treasuries and money

Mar 10th 2012 | from the print edition

IN A financial landscape full of oddities, the prospect of America being paid interest by its creditors when its national debt is rocketing is one of the oddest. The Treasury recently disclosed it is exploring how to let investors enter negative yields when bidding at debt auctions. Clearly, demand for American government debt is driven by much more than a hunger for returns. Financial-market participants use Treasury bonds and bills as collateral to secure lending, for instance. And for risk-averse investors such as foreign central banks, money-market funds and retirees, America’s debt is uniquely suited to storing savings without much due diligence. In short, its government debt is a lot like money.

This analogy is not perfect, of course. Treasury bonds are less useful for buying things and government debt carries at least the possibility of default. But in terms of liquidity, risk and returns, few things come closer to money. In a recent paper* Arvind Krishnamurthy and Annette Vissing-Jorgensen of Northwestern University quantify the money-like properties of American debt by comparing its supply from 1926 to 2008 with market-based measures of safety and liquidity. They find that when the supply of Treasuries is lower (as measured by the debt-to-GDP ratio), demand goes up, widening the spread between their yields and those on AAA-rated corporate bonds.

Too big to fail: Fright simulator

How to deal with a collapsing bank under the Dodd-Frank rules

Nov 12th 2011 | NEW YORK | from the print edition

[Greg Ip] OF ALL the questions unleashed by the bankruptcy of MF Global, a broker, the most important is whether America is prepared to deal with a bigger collapse, on the scale of another Lehman Brothers. The Dodd-Frank reform law creates an alternative to letting a systemically important firm go bankrupt, known as “resolution”. But it also prohibits bail-outs: shareholders and creditors must bear losses.

The Economist simulated the failure of a global bank at its Buttonwood Gathering on October 27th in New York (a video can be seen here). Larry Summers, a former treasury secretary and once Barack Obama’s top economic adviser, was joined by five other ex-officials and a prominent bank lawyer to play the parts of officials at the Treasury, the White House and regulatory agencies on a Friday afternoon in April 2013. The group was confronted with a teetering, $1 trillion bank-holding company called New Jefferson. Without their intervention, it would not open on Monday, an event guaranteed to send markets into free fall.

Economics focus: Pulling for the home team

Central-bank lending to government serves a valuable, though risky, purpose

Nov 5th 2011 | from the print edition

[Greg Ip] IT CANNOT be pleasant to start a new job with a continent’s fate resting on your shoulders. On November 1st, Mario Draghi’s first day as president of the European Central Bank (ECB), peripheral-government bond yields shot up and stockmarkets sank on fears that Greeks might reject a rescue plan agreed days earlier. On November 3rd, as The Economist went to press, Mr Draghi was presiding over his first policy meeting. Much is riding on what the ECB decides then and in coming weeks because it alone currently has the means to stem the intensifying crisis. It has bought Greek, Portuguese and Irish debt; since early August, it has also purchased Spanish and Italian bonds. But its purchases have been intermittent and begrudging. Without a firm commitment to buy as much as needed to prevent yields on Italian and Spanish bonds rising so high that both countries become insolvent, investors have less incentive to return. The ECB’s reluctance to make such a commitment is understandable: its legal mandate and doctrinal persuasion bar it from directly supporting governments. Yet throughout history central banks have been lenders of last resort to their governments. In 1694 the English monarchy was broke and in need of a loan so that it could wage war with France. A group of financiers agreed to lend the crown £1.2m in return for a partial monopoly on the issue of currency. Thus was born the Bank of England.

Central banking and the crisis: Emergency manoeuvres

With developed economies in dire straits, central bankers have taken the tiller. Not all of them are happy about that.

Aug 13th 2011 | from the print edition

[Greg Ip]

COMETH the hour, cometh the central bankers. On August 8th the European Central Bank (ECB) began buying Italian and Spanish bonds in an effort to stop the sovereign-debt crisis from crippling two of the continent’s largest economies. And a day later America’s Federal Reserve made an unprecedented commitment to keeping interest rates at more or less zero for two more years to keep a stalling economy out of recession.

In both cases the dramatic steps were taken in the face of political failures to get to the heart of the problems at hand. The fact that they took both banks well outside their normal zones of operation was underscored by the internal dissent both moves faced, dissent rarely seen in the consensus-driven world of central banking.

The initial market reaction was positive, at least on one side of the Atlantic. Yields on Italian and Spanish bonds fell sharply relative to Germany’s. In America Treasury yields fell and stocks rose—but not for long, as equity markets fell again on August 10th. No one should see this as a fundamental turnaround. The ECB’s earlier bond-buying hasn’t saved smaller countries from punitively high government-bond yields; the Fed’s previous interventions haven’t spurred a robust recovery. The big issues of America’s stagnant economy and Europe’s debt crisis remain in the hands of elected politicians who still seem inadequate to the task. But at least central banks have shown themselves ready and able to act.

The entire article is linked here.

America’s bail-out maths: Hard-nosed socialists

America’s loathed TARP may turn a profit. That could be a problem

Jun 9th 2011 | WASHINGTON, DC | from the print edition

[Greg Ip] THE federal government is bowing out as America’s most hated fund manager. On June 3rd the Treasury reached an agreement to sell the rest of its holdings in Chrysler, a carmaker, to Italy’s Fiat. Ten days earlier it began to sell its stake in American International Group (AIG) through a public offering of the insurer’s shares. General Motors has returned to the stockmarket (the government still owns 26% of it) and Ally Financial, a former financing arm of GM and Chrysler, will soon follow. In March the Federal Reserve began selling mortgage-backed bonds it inherited from AIG.

Nobody liked the bail-outs, not even the
rescued. Tim Geithner, who oversaw them first at the New York Federal Reserve and now as treasury secretary, this week quipped to bankers: “I’m glad to not have as much equity in all of you as a group anymore.” “So are we,” one shot back. The public was the most outraged, yet on a narrow reckoning of profit and loss, taxpayers have little cause for complaint.

The entire article is linked here.

Central banks: A More Complicated Game

The West’s financial crisis has shaken public confidence in its leading central banks. Yet it has also led to an expansion of their duties and powers

Feb 17th 2011 | WASHINGTON, DC | from the print edition

[Greg Ip] IN TWO days, two prominent central bankers, one on each side of the Atlantic, headed for the exit. Few people were surprised when Kevin Warsh tendered his resignation from the Federal Reserve on February 10th. Rather more people were taken aback when rumours started to fly that Axel Weber would stand down as president of Germany’s Bundesbank and thus rule himself out as the next president of the European Central Bank (ECB), a job for which he had been the front-runner. The rumours were confirmed on February 11th.

The timing was coincidental. Yet the two men have something in common. Both were uneasy about changes in the way that central banks conduct themselves—specifically, about the unprecedented forays into financial markets by the Fed and the ECB. Mr Weber publicly opposed the ECB’s decision last May to start buying the bonds of member countries’ governments. His colleagues, he believed, were intruding dangerously into fiscal policy. Mr Warsh, similarly though more quietly, fretted that the Fed’s policy of quantitative easing (QE)—the purchase of government bonds with newly printed money—was fomenting new imbalances in the global economy and steering the Fed into treacherous political waters.

Since the financial crisis in 2007 central banks have expanded their remits, either at their own initiative or at governments’ behest, well beyond conventional monetary policy. They have not only extended the usual limits of monetary policy by buying government bonds and other assets (see chart). They are also taking on more responsibility for the supervision of banks and the stability of financial systems. Their new duties require new “macroprudential” policies: in essence, this means regulating banks with an eye on any dangers for the whole economy. And their old monetary-policy tasks are not getting any easier to perform. Central banking is becoming a more complicated game.

The entire article is linked here.

Book Review: The Financial Crisis

• All The Devils Are Here: The Hidden History of the Financial Crisis. By Bethany McLean and Joe Nocera. Portfolio; 380 pages; $32.95.Viking; £14.99. Buy fromAmazon.com, Amazon.co.uk

[Greg Ip] THE latest book on the financial crisis has an odd title. You begin reading “All the Devils Are Here”, a line from Shakespeare’s “The Tempest”, expecting to encounter satanic bankers and corrupt government cronies preying on a defenceless public. In fact the people who emerge are infinitely more interesting: arrogant, desperate, even clueless—but, with a few exceptions, not devils.

The legacy of Larry Summers

Dec 13th 2010, 22:10 by G.I. | WASHINGTON

[Greg Ip] FOR two years the Obama Administration’s economic policy has been caricatured from the right as an invasive expansion of government and from the left as a cowardly capitulation to Wall Street free market fundamentalism.

How can it be both things at once? It helps to understand the philosophy of the man who most embodies that policy, Larry Summers, who today delivered perhaps his final public speech as Barack Obama’s National Economic Council director. The “Summers Doctrine” fuses microeconomic laissez faire with macroeconomic activism. Markets should allocate capital, labour and ideas without interference, but sometimes markets go haywire, and must be counteracted forcefully by government.

Think this economy is bad? Wait for 2012.

By Greg Ip

Washington Post Outlook, Sunday, October 24, 2010; B03

We’re barely two years past the banking crisis, still weathering the mortgage crisis and nervously watching Europe struggle with its sovereign debt crisis. Yet every economic seer has a favorite prediction about what part of the economy the next crisis will come from: Municipal bonds? Hedge funds? Derivatives? The federal debt?

I, for one, have no idea what will cause the next economic disaster. But I do have an idea of when it will begin: 2012.

Yes, an election year. Economic crises have a habit of erupting just when politicians face the voters. The reason is simple: They are born of long-festering problems such as lax lending, excessive deficits or an overvalued currency, and these are precisely the sort of problems that politicians try to ignore, hide or even double down on during campaign season, hoping to delay the reckoning until after the polls close or a new government takes office.