Two things spring to mind at once. The classifying criteria is rating. That's right - the ratings agencies, who did such a sterling job at rating ABS that they are facing multiple lawsuits and much approbrium, are still at the heart of regulatory capital. And given that, 20% is hardly penal for a AAA CDO squared tranche. Roll on re REMIC.
Two things spring to mind at once. The classifying criteria is rating. That's right - the ratings agencies, who did such a sterling job at rating ABS that they are facing multiple lawsuits and much approbrium, are still at the heart of regulatory capital. And given that, 20% is hardly penal for a AAA CDO squared tranche. Roll on re REMIC.
What can we learn from the fact that Goldman Sachs earned record profits despite the stagnation in the broader economy?:
The Joy of Sachs, by Paul Krugman, Commentary, NY Times: The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits — and it’s preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?
First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America.
Second, it shows that Wall Street’s bad habits — above all, the system of compensation that helped cause the financial crisis — have not gone away.
Third, it shows that by rescuing the financial system without reforming it, Washington has ... made another crisis more likely.
Let’s start by talking about how Goldman makes money.
Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared...
Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? ...
Goldman’s role in the financialization of America was similar to that of other players, except for one thing: Goldman didn’t believe its own hype. ... Goldman, famously, made a lot of money selling securities backed by subprime mortgages — then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.
And Wall Streeters have every incentive to keep playing that kind of game.
The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. ... You have every reason, then, to steer investors into taking risks they don’t understand.
And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong. ... Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.
You can argue that such rescues are necessary if we’re to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system’s liabilities are now backed by an implicit government guarantee.
Now, the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didn’t abuse their privileges. This time, new regulations are still in the drawing-board stage — and the finance lobby is already fighting against even the most basic protections for consumers.
If these lobbying efforts succeed, we’ll have set the stage for an even bigger financial disaster a few years down the road. The next crisis could look something like the savings-and-loan mess of the 1980s, in which deregulated banks gambled with, or in some cases stole, taxpayers’ money — except that it would involve the financial industry as a whole.
The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.
The other reason we are more vulnerable is, as this story points out, is that "two giants" are emerging from the financial crisis, and they are "starting to tower over the handful of financial titans that used to dominate the industry." Thus, if other competitors cannot recover similarly, and if the government does not use regulation and other means to level the playing field, the banking industry could end up even more concentrated and vulnerable than it was before (a point I wish I'd made here).
1) Is China really growing or not? Wait, is that a stupid question, or what? Of course China is growing, and pulling the global economy out of the ditch as well. Read this report from Time. Uh, maybe not. What if it is all a lending bubble?
- Michael Pettis seems to think so, and I rely on his insights: RMB 1.5 trillion in new Chinese lending — can we turn this thing off?
and, I wasn’t impressed by China’s high reserve and GDP growth numbers.
- Also this article from Bloomberg.
- And this comment from Andy Xie of Morgan Stanley. This makes me less bullish on energy and commodities.
What seems to be happening is that the powers that be in China are encouraging banks to lend aggressively. Firms in China aren’t finding a lot of opportunities in export markets, so they build up inventories “that they know they will need eventually.” Financial counterparties and individuals speculate on financial assets like real estate and stocks as they find cheap financing available. (Example)
That’s my view of China at present. I think those that are arguing for a resurgence in China at present are missing the similarities to the late 1980s with Japan where large amounts of productive capacity were built up with no markets large enough to sell the incremental production to.
I could be wrong, but this is leading me to lighten up on cyclicals. Maybe some utilities…
2) With all of the noise of those looking for a replacement for the US Dollar as the world’s global reserve currency, I have two questions:
- Are the surplus nations looking to reduce their surpluses, and thus suck in fewer foreign assets?
- Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time? Surplus nations need a safe place to invest.
3) In the meantime, the US tries to assure trading partners that their purchasing power is safe. We remember the laughable assertion of Tim Geithner trying to assure the Chinese that they did not have to worry about devaluation of the dollar. Well, now he is saying the same things to the Saudis. At least with the Saudis, we are doing their bidding in the Middle East, by bottling up Iran, so perhaps he does not have to worry so much there.
4) Back to point 2. Are the current account surplus nations willing to consume from the rest of the world and flip around to deficit conditions, letting their currencies appreciate, and killing their politically powerful export industries? That’s what it will take to replace the US Dollar. I don’t care who is arguing against the US as a reserve currency. The reserve currency must by nature offer high quality securities on net to the surplus nations to invest in. It must run current account deficits on average.
That’s why China can’t be the world’s reserve currency. China isn’t willing to stop export promotion, or encourage domestic consumption. India and Russia may kvetch as much as they like, but both are in the same boat as China, but to a lesser degree.
Oddly, the best policy for most of the complainers would be to allow/encourage imports, and stop export promotion. Freed from these distortions, the global economy would start to normalize. Cross-border capital flows would decline because exports would not need to be balanced out.
5) The US has no interest in selling Yuan-denominated debt yet. China eagerly buys Treasuries today.
6) Does the one child policy fuel excess savings in China? Maybe, but I doubt it is a big factor. Dowries are unlikely to eclipse the actions of the central bank and government.
7) A final note from Andy Xie — there is a lot of momentum in China, but little underlying change in the fundamentals.
My summary is this: To the degree that the recent upturn is driven by expectations that China pull the global economy out of the ditch, the move is mistaken. As my friend Cody Willard asked me three years ago, what happens if Chinese growth proves to be a sham? Can you trust their statistics?
My answer was that I wasn’t certain, but that things would get more clear if that were the case — and I think things are clearer now. My policy implication is to move assets out of export-driven sectors, and those driven by China demand. Utilities, here I come.
Tim Duy analyzes the economic projections in the minutes from the June FOMC meeting:
FOMC Forecasts - Reality or Fantasy?, by Tim Duy: It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.
The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":
In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.
Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.
Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then accelerate further in subsequent years. Is such optimism justified? Yes and no.
I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle. Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007. Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:
See also consumption data:
Not to mention to mention the initial claims data (see CR and his caveats). To be sure, one could worry that industrial production continues to fall, but note the rate of decline is slowing and capacity utilization looks to be stabilizing. Moreover, the recent stability in auto sales will lend support for manufacturing in the months ahead:
Notice that the vehicle sales increased 1.3% during the quarter, pointing to a gain in this component of GDP. As always, do not underestimate the data impact of moving from significant declines to just flattening out. With such clear evidence of bottoming out emerging, not only does the near term data get a boost, but downside risks fall - and both point to upward revisions of near term forecasts.
The more interesting parts of the staff's forecast are in the 2010 and beyond range. The fact that they suggest immaculate recovery, I suspect, is largely a model driven outcome. Econometric models tend to force forecasts back to trend, and, in this case, are likely fighting with a large gap between actual and potential GDP. The only way to close that gap is through rapid growth which would in turn lead to "significant" declines in the unemployment rate.
How should we handicap this optimistic forecast? First off, I would remind readers that the bar has been lowered. The long run growth forecast from the FOMC participants are in the 2.5-2.7% range. While this is not a revision, I think commentators tend to forget how much the bar has been lowered since the late 1990s, when some foresaw potential growth as 4% or higher. Likewise, I believe evidence was building prior to the recession that the corresponding job growth rate is around 100k a month. In other words, 100k holds the unemployment rate roughly steady, rather than the 150k that is commonly suggested. In short, diminished expectations likely help the forecast clear the hurdle of reducing the unemployment rate in 2011 and beyond.
Moving toward the diminished expectation for potential output, I suspect, will not be terribly hard to accomplish. Stabilizing consumer spending itself will go a long way toward keeping GDP growth in positive territory as will just a lessening of the inventory drag. Moreover, fiscal stimulus will add positively over the next year, as will the external sector, especially if China can maintain its current dynamic and a weakened US consumer continues to weigh on import growth. And if consumer and export spending hold together, then investment spending will also cease to be a drag.
That said, positive territory for growth could easily be consistent with an economy limping along above recession but insufficient for any significant job growth, a scenario that remains my favorite. Given that 70% of the economy is driven by consumer spending, I find it hard to believe that you can supercharge growth well above potential without the active participation of households. We know, however, that households continue to struggle under heavy debt burdens which, combined with the now tighter underwriting conditions that are likely to be more permanent than temporary, suggest that spending growth is likely to be constrained sufficiently to prevent supercharged growth. I would imagine that to propel consumption growth to rates consistent with the staff's forecast, the staff must be anticipating significant real wealth gains sufficient to drive savings rates back to zero. That, I believe implies a housing rebound…which I can't see unless conditions revert back to the "let's give everyone one with a pulse a loan" era.
Could the Fed staff really believe that the stage is set for such a rebound? More importantly, could FOMC members? Perhaps some do, at least that is the impression from the growth projections:
The range of growth expectations is quite wide, as noted in this Bloomberg article. Some policymakers are expecting a solid V shaped recovery evolving in 2010, while the other side of the spectrum is looking for a more gradual acceleration to potential growth (the scenario I tend toward). The latter scenario suggests a jobless recovery, with growth insufficient to make much of a dent in unemployment. From a policy perspective, such a scenario points to additional pressure to ease further, complicated by the unknown impact of general balance sheet expansion. It certainly does not point to any rush to unwind the liquidity/credit support programs. The optimistic view implies the opposite, a concern that programs need to be unwound quickly, with a rapid move to normalize interest rates. Until the 2011 forecast comes more fully into view, sometime around the second quarter of 2010, policy will remain in a holding pattern. But note that the wide range of forecasts implies a wide range of Fedspeak, which will lend an irritating feature to the discourse: Seemingly opposite opinions nearly side by side in the press.
A final point: The range of forecasts, both high and low, can be used to argue against another stimulus package as the direction of growth is headed in the right direction. This is especially the case if unemployment stabilizes, even if at a relatively high level. Moreover, note that US Treasury Secretary Timothy Geithner is on something of a world tour, first China, now the Middle East, promising US fiscal restraint:
"Policies of the United States are designed to lay the conditions for a strong dollar," Mr. Geithner said on Tuesday, adding: "We are very committed ... to making sure that as we get through the crisis, we bring down fiscal deficits and we reverse these extraordinary interventions we've taken."
I suspect conditions would need to deteriorate markedly in order to force the Administration to push a fresh round of stimulus. That is not the Fed's projection.
Bottom Line: Clear signs of a bottom are an obvious reason to stabilize and boost near term forecasts. Still, the Fed staff's projections appear overly optimistic, seeming to imply that future dynamics will be very similar to the past. I am skeptical. Remember to interpret forecasts of potential GDP in the context of diminished expectations. The wide range of projections speaks to an interesting spectrum of Fedspeak in upcoming months. The game will be to track the data, being wary not to read to much into a short-lived bounce off the bottom. I side with the low end of the FOMC forecasts; call me a pessimist. Place your own bets, being prepared to adjust with the data.
This is Rachel Ziemba. Brad will I think be back soon but I figured I’d get in one last post going into some excessive details on the Treasury International Capital (TIC) data.
These days, the TIC data released monthly by the US Treasury and detailing the capital flows to and from the U.S. often seems anti-climactic given sharp moves in the fx and treasuries market. Despite the lag, data released yesterday and detailing May purchases tells a few interesting stories.
Most importantly, it illustrates the fact, that in the face of capital inflows to overheating emerging market economies in May, the central banks of these countries kept buying U.S. dollar assets. Q2 has been the first quarter of significant reserve accumulation of the last year. Preliminary estimates we’ve done at RGE Monitor suggest that reserve accumulation was around $180 billion in the quarter (adjusted for valuation), the first significant increase since mid 2008. As in 2008, China accounts for the bulk of the accumulation.
Despite supra-national reserve currency rhetoric given the reluctance for currency appreciation, there was little choice to buy dollars. China added $38 billion in U.S. short and long-term treasuries - a net increase of $26 billion in U.S. short and long-term assets. The discrepancy can be explained by China’s reduction in its USD deposits and continued reduction in agency bonds.
However, they shunned the long-term assets. The major foreign buyers of US assets went back to the short-end of the curve, buying T-bills and adding other short term claims. Total purchases of T-bills by foreign official investors were $53.1 billion.
This move could help explain why long-term treasury yields rose in May. With concerns about the U.S. fiscal position, worries expressed by major U.S. creditors about the dollar’s value, perhaps the move to the short-end of the curve is little surprise. It also suggests that the U.S. government is again becoming more reliant on bills financing as it was towards the end of 2008. This may not be sustainable in the longer-term.
While the decrease in the US current account deficit means that the U.S. may be less reliant on foreign finance in 2009, the U.S. has become even more reliant on China as a share of its foreign finance. China has been the largest reported holder of U.S. treasuries for some months now. But as of May China now accounts for 20% of total outstanding foreign holdings and almost equals the combined holdings of Russia and Japan.
Since last fall, China dramatically scaled up its purchases of the shortest term, most liquid U.S. assets. It has purchased $196 billion in treasuries of less than 1 year maturity from July 2008 to May 2009. In part this might reflect a shift last fall within China’s US dollar portfolio. It also vastly decreased its holdings of US agency bonds, while slightly adding long-term treasuries.
However, as the chart below shows China’s purchases of long-term US assets fell sharply in the last year and continue to fall.
12 month rolling sums of Chinese purchases of U.S. assets
So why short-term assets? Investing the most liquid assets could keep funds freer for other purchases, including the extension of dollar denominated loans to resource countries. In theory, with shorter maturities, China could allow these assets to expire and not re-purchase them. However, in an environment where Chinese growth is re-accelerating, Q2 is unlikely to be the last with hot money inflows. As a result, expect further dollar purchases. No wonder Chinese officials were worried about USD holdings this spring given how many US assets they were buying.
Like China, Brazil also added short-term claims in May, with $12 billion in short-term claims offsetting net sales of $9 billion in treasury bonds. Short-term treasury holdings rose by almost $10 billion. Brazil has also been wanting to diversify its reserve holdings.
What of the Gulf, the major creditor region, visited by the Treasury secretary this week? Asian oil exporters likewise added to short-term holdings in May, prompted likely by local liquidity needs even more than dollar value worries. Given lower oil prices, the regions sovereign wealth funds have fewer new funds at their disposal. That may be changing slightly, yet, the increase in domestic spending and reduction in oil output limit new funds available. Meanwhile with the shifting from the dollar peg off the table as a policy option reserve diversification is limited. Moreover, given the pegs, their need for dollar liquidity and dollar financing remains high.
Based on the reported data, the GCC has a reported dollar portfolio of about $400 billion - $140 billion in U.S. equities, which hasn’t budged much in the last 2 years. Holdings of long-term treasuries increased from by about $30 billion from June 2008 to May 2009 to almost $200 billion despite a slight decrease in May. Holdings of Agency bonds fell by about $10 billion though.
The GCC total dollar portfolio is likely significantly bigger – over half of the estimated $2 trillion managed by public and private sector GCC investors. The discrepancy can be explained by the GCC tendency to buy through intermediaries. However, it seems likely that the use of local intermediaries has increased. The flows from the GCC have been higher in the last year. But again, the currency pegs may constrain the GCC to dollar purchases.
Japan, Russia and Canada, had notable net sales of U.S. assets in May. Japan’s shrinking current account surplus could reduce the amount of US assets it buys.
Canada’s sales may reflect the shift away from government bonds to equities outside of the U.S. in the midst of the rally.
Russia’s net sales, mostly of short-term assets, seem to be a bit more puzzling. Russia has been reducing its U.S. dollar assets from some time but given the inflows Russia received, one would have expected dollar purchases. In fact Russia’s central bank data on its fx interventions suggests that it bought $18 billion in US dollars in the month of May. Russia could be adding to offshore dollar deposits that would not be captured in U.S. data.
- IBM reported an unexpected surge in quarterly profit, providing further evidence that the technology industry is stabilising and poised for a comeback in the second half of the year. The technology group’s strong results followed a similar showing by top chip-maker Intel on Tuesday and came as dominant internet search group Google said that online advertising had steadied.
- Facebook has “serious privacy gaps” and must make changes to comply with Canadian laws, according to a report issued by the country’s privacy commissioner on Thursday. The report is the first time a government has found Facebook in direct violation of its laws, and comes as the world’s largest social network with 250m users is pushing its users to share more of their information with everyone on the web.
- Palm suffered a blow as Apple released a new version of iTunes that prevents syncing the popular music software with the Palm Pre. The Pre, launched last month, had been able to snyc with iTunes, and will still sync with older versions. Lauded as the first true rival to Apple’s iPhone, the Pre won positive reviews, but has not yet captured a significant share of the smartphone market.
- Mashups maybe ain’t what they used to be. Microsoft has announced that its two-year-old Popfly service, which showed off what its Silverlight technology could achieve, will shut down on August 24. It gave no explanation for the closure.
The Big Picture suggests that it might be, and provides this initially compelling illustration (which I have edited slightly to make it less confusing). However, I think that what we are really seeing is that both overall credit spreads and Goldman's stock price are driven by confidence. The more economic activity there is, the more money Goldman can make from the flow. A similar phenomenon was observable with the Merrill stock price in the 90s -- it acted like a call on the S&P, for similar reasons.
Update. Given ...the furore about Goldman's continued use of a SEC rather than FED VAR calculation, despite being a bank holding company, I am driven to wonder how big Goldie's IRC is. If it is just a giant credit punt, one might expect it to be enormous...
Apple customers may have downloaded 1.5bn applications from its AppStore in the past year for their iPhones and iPod touches, but the service does not represent the future for the mobile industry, according to Google.
Vic Gundotra, Google Engineering vice president and developer evangelist, (pictured centre) told the Mobilebeat conference in San Francisco on Thursday that the web had won and users of mobile phones would get their information and entertainment from browsers in future.
He claimed that even Google was not rich enough to support all of the different mobile platforms from Apple’s AppStore to those of the BlackBerry, Windows Mobile, Android and the many variations of the Nokia platform.
“What we clearly see happening is a move to incredibly powerful browsers,” he said.
“Many, many applications can be delivered through the browser and what that does for our costs is stunning.
“We believe the web has won and over the next several years, the browser, for economic reasons almost, will become the platform that matters and certainly that’s where Google is investing.”
Mr Gundotra won some support from the rest of the panel. Michael Abbott (pictured right), head of application software for Palm, said advances in the browser being introduced through HTML5 standards meant that web applications could tap features of particular phones such as their accelerometers.
Mr Gundotra pointed out that the latest version of the Safari Webkit-based browser on the iPhone allowed positioning technology on the phone to be used - Google’s home page can now display where users are located.
Webkit, which Apple had turned into an open-source project, was also powering the browsers on the Android and Palm operating systems.
Mr Gundotra said even Steve Jobs, Apple’s chief executive, had said “Build for the web,” when the iPhone was launched, but the idea had met with resistance from developers at the time.
The timing was not right, he suggested, but “the rate of innovation in the browser [over the past 12 months] is surprising.”
“I think Steve really did understand that, over the long term, it would be the web, and I think that’s how things will play out.”
* OVERSEAS/OVERNIGHT NUMBERS: 4:00 AM CT - EU, construction, foreign trade balance; 6:00 AM CT - Canada, CPI; 7:30 AM CT - Canada, Leading economic indicators.
* EARNINGS: BAC, C, GE
* WORTH READING:
-- Foreclosures continue to set records;
-- Weak investor sentiment and more good reading;
-- Economic implications of Fed's exit strategy;
-- What TIPS and Treasury yields tell us about inflation;
-- "Mancession" and where unemployment is coming from;
-- Questioning a housing bottom.
The Fed’s balance sheet expanded for the first time in three weeks, rising back over $2 trillion. Direct-bank lending rose after posting declines in the four previous weeks, though the increase was relatively small. A bigger contribution came from a more than $5 billion boost in the Term Asset Backed Securities Loan Facility, which is aimed at spurring consumer lending but hasn’t been used nearly as much as originally envisioned. The largest expansion in the balance sheet came through purchases of Treasurys, agency debt and mortgage-backed securities. The Fed started a program in March to ramp up such acquisitions in order to push down long-term interest rates low. Since that time the makeup of the balance sheet has shifted substantially, with less direct emergency lending to banks and more holdings of debt. Central bank liquidity swaps increased for the first time in 14 weeks, but still remain lower than crisis levels reached soon after the collapse of Lehman Brothers.
In an effort to track the Fed’s actions, Real Time Economics has created an interactive graphic that will mark the expansion of the central bank’s balance sheet. Every Thursday afternoon, the chart will be updated with the latest data released by the Fed.
In an effort to simplify the composition of the balance sheet, some elements have been consolidated. Portfolios holding assets from the Bear Stearns and AIG rescues have been put into one category, as have facilities aimed at supporting commercial paper and money markets. The direct bank lending group includes term auction credit, as well as loans extended through the discount window and similar programs.
Central bank liquidity swaps refer to Fed programs with foreign central banks that allow the institutions to lend out foreign currency to their local banks. Repurchase agreements are short-term temporary purchases of securities from banks, which are looking for liquidity and agree to repurchase them on a specified date at a specified price.
Click and drag your mouse to zoom in on the chart. Clicking the check mark on categories can add or remove elements from the balance sheet.
Mark Gertler says the Fed's independence should not be compromised:
Congress must not touch the Federal Reserve, by Mark Gertler: The economy was experiencing the worst recession since the war. In Congress, members were beginning to wonder whether the Federal Reserve’s intervention strategy was extracting too great a toll on the economy. Some started to suggest publicly that it may be time to rein in the central bank’s independence.
Sound familiar? Though they bear a strong resemblance to ... today, the events I refer to in fact happened in the early 1980s, in the midst of what was then the most serious economic crisis since the Depression. The head of the institution under threat of losing its independence was none other than Paul Volcker.
Of course, Mr Volcker would go on to be recognised as one of the great central bankers of modern times. He would do so by standing firm against political pressures. By continuing on the course he set out, the economy recovered and a new era of price and output stability began. ... In the Volcker era, the political outcry occurred in the midst of the economic contraction that the Fed had engineered to tame inflation. The costs of the policy were plain to see, but the long-term benefits that would eventually emerge were difficult for many to imagine at the time.
The Fed’s role has been different this time round. Rather than trying to slow the economy, it has been acting to contain the damage brought on by the most complex financial crisis of modern history. By the accounts of many, the Fed has acted masterfully under difficult circumstances. ...
Given that hard times remain, nonetheless, it is natural that Congress is questioning the Fed, just as it did in the early 1980s. ... Unfortunately, the Fed cannot demonstrate what would have happened to the economy if it had not intervened in the way it did. Many observers agree that the situation would be far worse than it is today. Yet discussions of reining in central bank powers proceed as if the financial system would have stabilised itself without any Fed intervention.
The Fed well understands the lesson from the Volcker era that it can be effective only when it resists political attempts to influence its decisions. One can only hope that sober voices in Congress who appreciate the importance of central bank independence will help keep Capitol Hill from taking any measures that do permanent damage to the Fed.
A more constructive route for Congress would be to proceed with regulatory reform that would prevent a repeat of the current situation. At the core of the crisis is an antiquated regulatory system that permitted large financial institutions to take excessive risks. By giving the Fed the ability to monitor risk-taking by these institutions, Congress would diminish greatly the likelihood the central bank would again need to intervene directly in private credit markets.
The Fed may not have been perfect in its response to this or previous crises, but that doesn't mean that a less independent Fed would have done better. Taking away Fed independence - including subjecting the Fed to audits by the GAO - would be a mistake. In addition, if we are going to strengthen regulatory authority so that we can better monitor and reduce systemic risk that threatens the financial system - and we should - that authority needs to be in the hands of an independent entity, and the Fed is the natural place for this. Finally, its role in regulating system-wide risk is complementary to many of its other activities. For example, its role as a systemic risk regulator would involve monitoring risk within large institutions. Should a bank get into trouble, that would be helpful in assessing whether the bank should be granted access to the discount window in its capacity as lender of last resort.
We need to maintain an independent Fed, to give the Fed the powers it needs to monitor and regulate the level of overall risk, and to give the Fed the authority it now lacks to put banks through an orderly bankruptcy process so it can avoid bailing out financial institutions that are in trouble and a threat to overall the financial system.
Update: See Willem Buiter for a longer, more detailed version of many of the same points, e.g.:
Probably the single most damaging failure of the US Treasury, the US Congress and the US financial regulators was there inability/unwillingness to create a special resolution regime (SRR) with structured early intervention and prompt corrective action for all systemically important financial institutions (those too big, too complex, to interconnected, too international or too politically connected to fail in the ordinary Chapter 11 or Chapter 7 way). ...
But however weak its past performance and credentials, they are rock-solid compared to those of the other candidate institutions. ...
Only the Fed can fulfill the macro-prudential regulator-supervisor role. That is because it has the short-term deep pockets. It is the source of the ultimate, unquestioned liquidity in the economy, through its monopoly of the issuance of base money. Without the short-term deep pockets, a macro-prudential regulator/supervisor cannot act as lender of last resort, market maker of last resort or provider of enhanced credit support. It would be ... toothless...
He also makes this point:
The problem with this solution of the macro-prudential regulator/supervisor problem is that it is incompatible with central bank operational independence as interpreted since 1989 or thereabouts. ... When the central bank plays a quasi-fiscal role, as the Fed has been doing on an unprecedented scale in the current crisis, the fullest possible degree of accountability to the Congress, the tax payer and the citizens is essential. The Fed has no mandate to engage in quasi-fiscal operations, even when it is for a good cause. ...
If the same institution, the central bank, has to be in charge of both normal monetary policy and systemic risk regulation (albeit jointly with the Treasury for the systemic risk role), there is no elegant, first-best solution. Either monetary policy will be driven by politicians whose macroeconomics is limited to a partial understanding of the Keynesian cross and whose monetary policy views can be summarised by the proposition that the have never seen an official policy rate so low they would not want it even lower, or the central bank continues to act as an off-budget, off-balance sheet special purpose vehicle of the Treasury.
Okay. As much as possible, monetary policy should be kept out of the hands of politicians.
Update: Jim Hamilton (I also signed the petition a day or two ago):
I joined many of my colleagues in urging Congress and the President to remember just how valuable an independent central bank is for the ordinary citizens of this country. You may not pay much attention to central bank independence. But you'll miss it when it's gone.