Yeah, the Fed Did It.

(More precisely, the Fed aggravated it; the Fed could have prevented most of it; the extent to which we depend on the Fed's good judgment should shrink, not grow.)

I believe we've been having a three-component economic crisis, each component building on and worse than the one before it, with overambitious or overconfident regulators/legislators making each component far worse than it needed to be. The three components I see are

• the trend-following housing (and financial services) bubble, which the Fed worsened slightly by false reassurances;
• the security-seeking, trend-breaking cash crunch which the Fed worsened greatly by too-tight monetary policy;
• the longer-run tech-based employment recalculation. (All right, the Fed is not guilty here but it mostly hasn't happened yet, and our sensitivity to the mistakes the Fed made this time is growing with time. Cheer up, the worst is yet to come.)

bubble: I've commented on the housing bubble before, and how I think it was worsened by regulators and legislators (and raters) who denied the problem. Investor irrationality was real, but part of that irrationality was the willingness of investors to trust pronouncements by Greenspan and Bernanke, by Barney Frank and others on both sides of the aisle, and of course their willingness to believe that AAA meant "safe". I'm not arguing that interest rates were or weren't too low. (I do not believe that was the problem.) I'm not saying that the regulators were (or are, or will be) stupid or malevolent. I am saying that they were, quite obviously, wrong, and that those who relied on their assurances did very badly. (Those who simply said "prices are rising, I'll bet everything I can borrow that the trend will continue" did exactly as badly; there are always some of those.) I'd fix that (following Arnold Kling) mainly by going back to a world of high down payments. You could still give 100% financing if you wanted, but any federal support (including FDIC guarantees for a bank that offers mortgages) should depend on at least 20% down payment. Leverage would shrink generally, and underwater mortgages would be extremely rare. This would reduce homeownership rates, of course, and that may be regrettable, but it's not obvious that people are helped by encouraging them to make commitments they are likely to break, or be broken by. Of course this version of Kling's reform won't happen; what we're getting instead is expanded trust in that which failed before, to which we add taxpayers having to guarantee more than 95% of mortages, still being pushed on those who can't afford them.

cash crunch: As I've said before, I've become a semi-Sumnerite:

the real problem right now is not a “real” problem. The real problem is a nominal problem. When the growth rate of nominal GDP falls sharply there is always a severe recession. We have a severe nominal shock, a problem which has been understood by economists at least as far back as Hume. At the time, it always looks like the “real problem” was some symptom of the monetary shock, such as financial panic. Thus in the 1930s people thought the collapsing financial system caused the Great Depression, only later did we discover it was too little money.

Investors' efforts to minimize individual risk ended up adding to systemic risk. Actually it seems to me that we knew by February 2008, when Roubini said,

"Cash is king in 2008,"... the U.S. went into recession in December and will stay there for at least a year.

The Federal Reserve under Bernanke ignored what Bernanke had written academically; it brought down interest rates and then declared a "liquidity trap". It did expand the monetary base, but not nearly enough to satisfy demand -- and they neutralized part of their monetary expansion in fall 2008, by paying interest on excess reserves, encouraging hoarding by banks. Cash remained king, mostly because people were worried about too much risk in their portfolios. Here I would agree with Sumner that we should target NGDP (nominal GDP, aggregate cash flow) but I worry that buying Treasury bonds with cash, exchanging one low-risk item for another, might not succeed; we need to cope with people trying to shed risk. The Fed's purchases of mortgage-backed securities seems like a really bad idea: this is not absorbing risk in the sense of variability, it's buying a bet that already failed and attempting to prop up a market that should go downwards because there are too many houses out there for a while. So,

• I'd make NGDP measures tradable in the form of Shiller's trills, creating a permanent market growing to perhaps a billion trills, paying one-tenth of one percent of our GDP, owned by citizens or foreigners but not by our own government.
• Like Sumner, I would announce that we're targeting a 5% growth trend in trill yield (i.e., in NGDP), based on the pre-2008 trend so that if it rises too fast or too slow in one year we compensate the next; this is "level targeting".
• I would give the Fed a stock-bonds-cash portfolio to be rebalanced daily, where the cash can be effectively imaginary (set it at last year's NGDP, most will never be printed) and all stocks are treated equally via a Wilshire Index fund; this rebalancing portfolio is the key difference between me and everybody else, hence probably totally wrong, but it makes sense to me. If investors starts selling stocks, the Fed will automatically buy, or sell if everyone else is buying, so this couple-of-trillion portfolio would automatically tend to stabilize the market. It would probably make money for taxpayers, too.
• How would it stabilize the NGDP trend? When trills (next year's trills; buy them now!) start to fall, the Fed would change the portfolio proportions, giving cash for stocks and perhaps bonds, absorbing risk and satisfying the demand for cash. When trills start to rise above the price level target, the Fed portfolio proportions would change back.
• Actually, I might make this last item more indirect: I might start a prediction market on the proportions required to achieve the actual NGDP target. In effect, I'd be giving knowledgeable parties something to bet on, so that they'd make money by getting it right. I don't want them able to make money by betting on the actual cash value of a trill's annual yield: that's (2008 yield)*(1.05^N), so the "right answer" is known in advance. Bet on the unknown path to that, instead. The Fed would use this prediction market to guide the proportions.

Instead of this, of course, we're giving the Fed a more complex mission as if its people had enhanced credibility. Since their credibility with me has gone way down, I don't find this reassuring.

employment recalculation: Kling talks about recalculation, reallocation of resources including labor in the constant search for "sustainable patterns of specialization and trade", and the unemployment this causes. Sumner acknowledges that some recalculation was required at the beginning, but mostly he just means the structural issues of too big a housing sector (and finance.) Delong and Krugman point to aggregate-demand-based unemployment and say that structural unemployment is on the way, but not yet a big deal. (Of course current unemployment is made worse by underwater mortgages which keep people from moving where the jobs are, and therefore by low-down-payment policies. And it's made directly worse by the cash crunch which motivates companies to sit on their cash, and it's made worse by regulatory uncertainty (and especially health care) and inflation uncertainty. But this is talking about aggregate demand v. structural, with recalculation as part of a slightly different story.)

I'd agree with them all, mostly, but add that recalculation is growing as an issue in a way they haven't (to my knowledge) discussed. My feeling is that overall technological productivity will gradually become the biggest factor in continuing unemployment, in the sensitivity of unemployment rates to (failures in) NGDP trends. I think that our increasing wealth and productivity means that a sharply decreasing fraction of the population is generating stuff we actually need, and a less-sharply decreasing fraction of the population is generating stuff we think we need. When money-trends continue, this doesn't matter because people buy whatever they were planning to buy. When money-trends fail and people want to hide their money, only the essentials keep going and that's a shrinking part of the economy. In the long run, (almost?) all production of goods and services is optional. In the short-to-medium run it would be enough to have the Fed do its job, making sure money-trends continue so people are comfortable buying stuff they want, not just what they think they need. In the long run, we will also need a negative income tax.

My approach to this stuff would be even more drastic, and therefore more unlikely, than my approaches to the preceding problems. So I won't finish this part of this post.

Footnote, since this is stuff that wasn't part of the way I thought through 2008: Aggregate cash flow is NGDP, Nominal Gross Domestic Product, the sum of all the money we pay (or get paid) for all the goods and services we use (and produce). You can divide that by your best guess at an inflation multiplier to get "Real GDP", the theoretical "constant-dollar" value of all those goods and services, but your paycheck and mortgage payment and grocery bill are paid in actual nominal cash flowing around and around, keeping our individual financial plans going by fulfilling the promises that we need to make economics ("sustainable patterns of specialization and trade", as per Arnold Kling) work. If expected NGDP drops, then you're already in a recession. I didn't really follow this argument when Tyler Cowen first recommended Sumner's blog. In the end, it's not that complicated. Think of a zillion spreadsheets carrying business plans and personal plans forward a few years, each projecting current trends. Aggregate cash flow -- that's "Nominal GDP". NGDP. Money. Some of those spreadsheets, some of those plans, will fail and others do better than expected, but generally the aggregate cash flow rises each year as population goes up, as productivity goes up, and as inflation goes on. If it falls or rises a little away from the expected trend implicit in all those individual plans, we adapt. If it falls sharply below trend, then cash isn't going around as expected and plans start failing simply because cash isn't going around: businesses fail and it's not their fault. Things are broken. We have a recession, a bad one.

In fact, people act by plans and promises, betting on their projections, so we get a recession as soon as the expected NGDP growth fails so that people stop buying and employers stop hiring.

Q: That sort of sounds almost convincing. Very odd. But isn't the future causing the present here?

A: Gee, thank you. It's actually close to tautological: expected NGDP is the aggregate of expected cash flow, and your belief that you're no longer going to be able to buy the goods and services you expected to buy will immediately change your behavior, the recession hits as soon as you expect it. So it's your beliefs about the future causing your behavior in the present.

In the current case we had a small recession because a whole lot of investors had believed our regulators and legislators who downplayed the risks of the bubble. They -- the investors -- had believed in the AAA ratings. When they hit reality they bounced, and needed more cash.

Q: But is this the Fed's fault? I mean, apart from Greenspan and then Bernanke denying the bubble?

A: The Fed has a dual mandate: they are supposed to manage inflation and unemployment, by managing the money supply. I'm saying that I mostly believe Sumner: the Fed did expand money somewhat, but they could have avoided most of the pain we've felt if they'd done more. So yeah, it's their fault.

Q: Done more? Done what? Lowered interest rates below zero?

A: Well, first by not paying interest on (excess) reserves, which was and is contractionary. Second, by announcing an inflation target or better an NGDP level-targeting sequence. Third, by expanding their open market purchases; preferably by starting the kind of automatically daily-rebalancing portfolio I described above.

Q: I understand why paying interest on reserves is contractionary; why are they doing it?

A: I don't really understand, but I think it's simply a way to give the banks money so they don't fail, while pretending that it's not Main Street bailing out Wall Street. I'm getting very cynical in my old age.

Ryan Avent of the Economist said

It's getting ever more difficult to avoid concluding that the Fed's inflation target is not the 2% we'd all come to expect, but something much closer to zero. This obviously impacts economic behaviour. The Fed could potentially have a significant effect on conditions simply by letting markets know that it's not actually happy with the current inflation trajectory.

Recently (Sept 2010) Bernanke has said that, with good effect; let's hope he goes further. There's some evidence that it will happen, e.g. Calculated Risk's Fed's Lockhart: The Approaching Monetary Policy Decision Dilemma

I think a consensus is building for QE2 in early November.

But I don't trust Bernanke to follow through, or at least I don't trust the Fed he leads...and that's what it depends on.

Or then again (I hope), maybe not.

Update: I see Avent saying in The perils of prediction: Forget forecasts, trust markets | The Economist that

I like to point out that in June of 2008 the Federal Reserve forecast real GDP growth in 2009 of 2.0% to 2.8%, when in fact the economy shrank in 2009 by over 2%. Of course, this doesn't mean that central banks have no basis on which to make policy. All they need do is look at the evidence in front of them. Markets...

I trust markets a lot more than I trust the Fed.

Perhaps I should note that Sumner does not blame the Fed for failure to predict, as he said in TheMoneyIllusion » The Fed doesn’t have a crystal ball

All the major investment banks with their million dollar Ivy League employees missed this crisis (and its eventual impact), and yet the Fed was supposed to have predicted it? The Fed pays much lower salaries than Wall Street.

Indeed, I wouldn't blame the Fed for the housing bubble recession-trigger at all if Greenspan (and then Bernanke) had simply said "Bubble-detection is not part of my job, I can't help you with that." But this is not what I understood them to be saying.

update: Ah-ha! An actual reputable economist, Nick Rowe, says at least that

If I had my druthers, the Fed would buy stocks. Something like the S&P500 index.

This is not equivalent to saying that the Fed should do a large part of its monetary policy via a rebalancing portfolio somewhat similar to what investment people prescribe for individuals, but it's a start. Yay!

(Or then again, maybe not.)

upd: The same Nick Rowe is quoted approvingly by Brad Delong in Against Money-Financed Fiscal Expansion, For Open Market Operations in Equity Indexes

OK. Start with the Fed buying bridges. That will work. Now, wouldn't it be nice if the Fed could also sell those bridges again later, if it needs to, as it probably will. Bridges aren't very liquid. And, the Fed is good at clipping coupons on bonds, but perhaps not very experienced at collecting tolls on bridges. Hmmm. Maybe if the Fed just bought shares in bridges instead, that would be as good as bridges, but even better from the practical point of view. Hmmm. Why stop at bridges? Why not buy shares in everything? Why not just buy the Wilshire 5000, or some such index?

Excellent. The right index identified, along with the need for later sale; we are close to portfolio rebalancing.

Financial "Reform" thoughts; bubble

I've written a few notes on the housing bubble, but things have changed. We are adopting a financial reform bill which relies on increased discretionary power for regulators, to deal with bubbles and crashes on a case-by-case, company-by-failed-company basis. Broad discretion for case-by-case regulation is the traditional recipe for encouraging regulatory capture, so I'm agin it. Besides that, I have a problem. Our regulators have a really bad track record for interpreting bubbles and crashes. As Matthew Yglesias » The Fed and the Housing Bubble says, Greenspan

essentially spent this period egging the bubble on, touting ARMs, downplaying the possibility of a national bust, etc. Similarly, Ben Bernanke’s 2006 Economic Report of the President specifically considered and rejected the possibility of a housing bubble. The point, to my mind, isn’t merely that these guys were wrong. Nor is it that their wrong analysis led to bad policy. It’s that their wrong statements and absence of accurate ones themselves helped egg the bubble on.

In my mind, at least, our regulators have seriously downgraded credibility. You may want to say their actual impact on the bubble (and crash) was quite small, and I disagree but that disagreement is tentative. If, on the other hand, you want to say that their actions and announcements show them to be trustworthy bubble-crash handlers; in that case I disagree much more strongly and much less tentatively.

Bubbles will happen, but this is how I would limit the next housing bubble: I would define a "standard mortgage", a low-risk mortgage, as requiring the traditional 20% down, and also requiring that the originating bank (or whoever) has contracted to retain a minimum 20% of the mortgage value. Then I would say that Federal financing can't be used to support any non-standard mortgages.

That doesn't rule out 0% down mortgages as totally private transactions, and anyway you could still borrow the 20% down from your parents (or your credit card if you're totally insane). I would just make it a constraint on Federal (or agency) action, e.g. FDIC insurance can only apply to banks which apply these constraints to any mortgages or MBSs or loans to mortgage-holders they may have; similarly, Fannie and Freddie (if they continue to exist) can't touch mortgages which don't have those properties; similarly, the Federal Reserve can only buy mortgage-backed securities based on mortgages respecting these constraints, and so on. It's all about incentives and risk and leverage -- and speculation. Liar loans would be harder because the originating bank would have to hold on to a significant chunk of each. Prices would not rise as fast or as far; we would no longer see mortgages used as rent-with-option-to-buy-if-the-price-goes-up, or at least the taxpayer would not be on the hook for losses if we did. That way, even when a future Greenspan or Bernanke (or Frank, as legislator) makes the stupidly optimistic bubble-encouraging remarks that the past Greenspan and Bernanke and Frank did make, there will be limits on the damage that people can do by following them. And even in a downturn few houses would be underwater, so labor mobility would not be much damaged.

I would do other things too, personally: I would say Fannie and Freddie can't take new business, I would say that no new mortgages shall have interest-deductibility, I would get the government out of the business of having those who own a home subsidized by those who don't, I would stop pushing home-ownership on those who really can't afford it. (I don't think subprime mortgage push does any favors for the recipients.) And so on. But all that is secondary; I would start with the "standard mortgage".

I claim this would work (unless I'm wrong, as usual); I also claim this won't happen because it's more profitable for political contributors to have a complex set of relationships with regulators where the regulators have lots of discretion so that regulatory capture will gradually set in, and then the taxpayers will bail them out on a case-by-case basis because Too Big To Fail is embedded in the legislation. It seems to me that that's what we're getting. The guys who brought us the bubble and crash have won, and we lost.

Blowing Bubbles: everybody's wrong except me

Back in September I posted some of my Bubble Thoughts about the housing bubble pop which I had anticipated and the "resulting" crash which I had not, saying

Personally, I did see the bubble as such, earlier than some...I sent a message titled "Housing bubble warning" on June 5, 2003. Was I prescient? No, I was just quoting the Economist of that time...

I didn't mention (last September) that I'd become a semi-Sumnerite, a believer in much of the theorizing of Scott Sumner at The Money Illusion, who claims that

even a major misallocation of resources such as the housing boom of 2003-06 does not cause a big enough misallocation to create a recession. That’s why the initial downturn in housing was handled well, with only a minor bump in unemployment between mid-2006 and mid-2008. The big jump in unemployment more recently was caused by a sharp fall in NGDP, i.e. tight money.

I've come to believe him about that, to a large extent, so I owe both of them an intellectual debt of sorts. But today I think they're both wrong...well, also they're both right, and I think they both exaggerate the real differences between them. Sumner is saying in reference to the same article (I think) that I quoted,

Back in May 2003 The Economist said that many countries were in the midst of a housing bubble:

and that

in all 6 countries their predictions were wildly inaccurate for the 4 year time window they specified.

He really doesn't believe in bubbles. Or does he? As quoted above, he does believe in "a major misallocation of resources such as the housing boom." The Economist rebuts that they were giving "Good housing market advice", and that

the story The Economist was telling about what was happening was fundamentally correct

My current view is that the Economist was and is praiseworthily right to call "bubble", but the Economist of 2003 was mildly blameworthy in making the specific predictions it made (I didn't even take these seriously, remembering how "irrational exuberance" had gone on for years) and is mildly blameworthy now to evade the flat admission that anybody who believed those specific predictions and invested accordingly would have lost money. The 2010 Economist sounds like an astrologer or psychic claiming credit for being almost right, which is another way of saying wrong. But that doesn't mean bubbles don't exist; it just means that when markets are irrational it's really hard to outguess them (The market can stay irrational longer than you can stay solvent.) I mostly like Bill Woolsey's response:

I believe bubbles exist. Vernon Smith's experiments provide enough evidence for me. The basic problem is "momentum" traders. They buy into a rising market and sell into a falling market. They have naive expectations, projecting past price changes into the future.

Like Woolsey, I do think bubbles are real, like the Economist I think bubble-probability is worth thinking about from an investment standpoint.

I think Sumner could respond (and maybe has responded) that if you can detect this, then you're free to make money from it -- but I don't think that's an adequate response. I didn't and don't know any good way to bet that "I think this asset is priced above trend" apart from staying away from it: selling short doesn't work unless you have a time-frame in mind. I didn't believe the Economist's specific predictions, but I do think the Economist helped me (and my son) avoid losing money. We avoided investing in stuff which the Economist (and then Shiller) had suggested was risky. Shiller does better, trying to invent financial instruments which I've interpreted as ways in which to make money from such information, so that the markets will in fact become more efficient. But they're far from perfect, and always will be.

Or maybe not?

Bubble Thoughts

I haven't posted for a long time, but it's not that I haven't made any mistakes. Indeed, I've participated to some extent in one of the biggest mistakes of my lifetime -- the market crash of 2008.

Personally, I did see the bubble as such, earlier than some...I sent a message titled "Housing bubble warning" on June 5, 2003. Was I prescient? No, I was just quoting the Economist of that time:

 http://www.economist.com/displaystory.cfm?story_id=1794873

 This survey will conclude that the latest housing boom has inflated
 bubbles in several countries, notably America, Australia, Britain,
 Ireland, the Netherlands and Spain. Within the next year or so those
 bubbles are likely to burst, .... ... ... Significant numbers of
 owners may be left with homes worth less than their mortgages...  

After the quote, I closed that message saying

 And of course if houses are worth less than their mortgages, there
 might be bunches of trouble of various kinds. "Within the next year or so".

 Tom of-course,with-stocks-irrational-exuberance-kept-going-for-years Myers 

And I went on talking about it for the next few years, as I had talked about the original "irrational exuberance" starting around 1997, and I sold some real estate and urged people to read Shiller's second edition when it came out, and urged my son not to buy real estate (and he didn't), but I didn't foresee the crash. I didn't realize that the global financial system was betting trillions that Shiller was wrong.

It doesn't worry me that I didn't foresee the timing of the pop; I never expected to be able to do so, so I did not even think about betting against the market myself. ("The market can remain irrational longer than you can remain solvent.") It does bother me that neither I nor the experts foresaw the disaster it has become. If you'd told me in 2006 that we'd be having a banking crisis, I'd have said something like

"of course we have a real estate bubble, and when it pops we'll have a wealth-effect problem, perhaps a small recession, but people who run banks or investment firms know what Shiller has been saying and they know they've got to hedge against his being right, even if they don't believe him. I read a bunch of economists' blogs; they talk about the housing bubble, they're not talking about a crash."

In other words, I depended upon experts. There were some who kept on predicting one disaster or another, most notably Paul Krugman and Nouriel Roubini. They seem to have gained credibility from the meltdown and recession, but they both predicted a dramatic fall in the dollar as part of the meltdown they predicted. Krugman, it seems, has been predicting a dramatic fall in the dollar since the mid-1980s. Understandable, of course, but that doesn't count heavily as a prediction. As to Roubini, it doesn't really bother me that he "was one of those who predicted 10 crises out of three", but it does bother me that, like Krugman, "In 2004, he predicted that the oncoming recession would precipitate the crash of the dollar. The crisis has mainly buoyed it."

Of course the dollar still might fall -- it seems to me I put something about that in class notes (computer science, looking around for random examples of numerical stuff to model) of the late 1980s, and I may have been reading Krugman back then. For me it went along with a comparison of the savings rates of Americans vs. Japanese, as now it would go along with thoughts about our suddenly increased Federal debt, with the prospect of continuing increases. But the dollar didn't fall as part of the crash we're talking about, so the crash we're talking about is not the one Krugman and Roubini predicted. Or so it seems to me.

To a disturbing extent, I think expertise in (macro)economics has been discredited. I don't believe this is adequately answered by Greg Mankiw's

It is fair to say that this crisis caught most economists flat-footed.
In the eyes of some people, this forecasting failure is an indictment
of the profession.

But that is the wrong interpretation. In one way, the current downturn
is typical: Most economic slumps take us by surprise. Fluctuations
in economic activity are largely unpredictable....

Likewise, students should understand that a good course in economics
will not equip them with a crystal ball. Instead, it will allow them
to assess the risks and to be ready for surprises. 

Yes, but macroeconomists did not assess the risks, at least not correctly, and were not ready for surprises. We were all clueless. The academics, the legislators, the regulators, the raters, the financial moguls, investment advisors, ordinary investors... clueless. That's not good. So, do I have a theory? Sure. Lots of overlapping theories, and I think that each of them is probably somewhat true. More later.

Or then again, maybe not.