New Economist

IMF: "Risks to financial stability have intensified"

For those hoping that credit conditions might gradually be returning to normal, today's IMF Global Financial Stability Report market update contained a stark warning:

Risks to financial stability have intensified since October 2008. Macroeconomic risks have risen as global growth has fallen precipitously alongside a sharp slowdown of global trade. Credit risks have also risen as a deterioration of economic and financial conditions have resulted in rising loan losses. At the same time, the flight from risky assets and illiquid market conditions has increased funding costs, even as risk-free rates have declined with monetary easing.

That is despite the massive bailouts, spending plans and other government interventions we have seen since the last report:

...With the help of extensive government support, market functioning toward the end of 2008 improved in a number of asset classes. However, the negative interaction between the economy and the financial sector has intensified as the credit crunch bites harder and extends globally, with confidence among financial counterparties remaining strained. Indeed, the recent shock to bank earnings and other bad economic news has put further downward pressure on bank equity prices, and the width of credit default swap spreads points to still-elevated systemic risks.

And if you think that prognosis was depressing, the sentence that follows is even worse:

Notwithstanding public injections of capital, many banks around the world may have an insufficient capital cushion to weather a deep global economic downturn.

Translation: many banks are insolvent and probably won't survive the global recession.

The credit crunch ain't over; not by a long shot.

'Lone dove Danny' quits the MPC

Controversial Monetary Policy Commitee member and Dartmouth professor Danny Blanchflower is leaving the Bank of England, according to The Times: Man who wanted early rate cuts David Blanchflower steps down from MPC

Professor Blanchflower, who has voted to cut interest rates every month since October last year, said that he would not seek reappointment when his three-year term ends on May 31.

Once can hardly blame him. Despite being one of the first to call the economic slowdown, global recession, downside risks to inflation and upside risks to unempoyment, he has routinely been derided by City economists and market commentators - and ignored by his fellow MPC members.

His doveish voting record often put him at loggerheads with members of the committee, who refused to cut rates earlier over fears about rising inflation. Professor Blanchflower, who travelled to rate meetings from his home in the United States, maintained that the sharp economic downturn in America could be replicated here and advocated taking evasive action by cutting rates.

'Lone dove' Danny has been proven right. The rest of the MPC stubbornly refused to acknowledge the growing downside risks to UK inflation from the global credit crunch and economic downturn.

A key lesson from this is the importance to bring a global (or US0 perspective to monetary policy. In a globalised world, what happens in the United States economy and financial markets clearly has major implicatiosn for the UK. While in theory British-based MPc members ought to be aware of these developments and factor them into their thinking, danny's example shows that they don't.

It is clearly time to globalise the Monetary Policy Commitee and move away from a parochial 'little England' approach. Let's see if Treasury have learned the lesson, and appoint another US-based member as Danny's replacement.

The credit crunch: what happened?

While Ken 'worst is yet to come' Rogoff is trying his level best to scare global financial markets about the credit crunch, research is now starting to filter through about just what happened last year. A new IMF working paper by Nathaniel Frank, Brenda González-Hermosillo and Heiko Hesse, Transmission of Liquidity Shocks: Evidence from the 2007 Subprime Crisis, does some of the spadework. As they explain, liquidity crisis soon segued into a solvency crisis (think Northern Rock, Bear Sterns):

It is found that the interaction between market and funding illiquidity increased sharply during the recent period of financial turbulence, and that bank solvency became important. ...What started out as a liquidity crisis, turned into a solvency issue.

It wasn't simply credit that dried up, it was trust - the whole basis of interbank money markets. Banks were unwilling to trust the disclosures or assurances of their counterparties. As a result central banks had to pump hundreds of billions into financial markets to address the liquidity spiral and to ensure the solvency of key financial institutions.

So why did these interactions and correlations spike when the sub-prime crisis hit?

The analysis presented here suggests that increasing financial integration and innovation can make market and funding liquidity pressures readily turn into issues of insolvency.

The easy answer would be to blame the quants and financial engineers. But the real culprit was greed, reinforced by the lousy risk management and lax prudential standards of most major banks (and their clients, many of whom bought products they did not understand). While the money kept rolling in the door, senior managers were quite happy to avert their eyes to the ever-mounting risks.

I was not surprised by the sub-prime crisis; it was an accident waiting to happen. But I didn't expect the credit crunch to have been protracted, particularly once central banks interviened with such gusto.

Rogoff is probably right to say that we are only about half-way through the crisis. But the key issue for me is not whether another major bank goes bust (some of them clearly deserve to). It is whether the risk of US recession is now receding (a U-shaped downturn), or whether we are instead facing a 'W'-shaped downturn, with another growth dip looming. So far my controversial call of no US recession this year has held up, and I still think I am odds on to be proved correct. But the outlook for 2009 has becoming bleaker; there are now too many uncertainties to rule out an eventual recession.

Cityphilia

Like most of us I have been reading a lot of commentary about the credit crunch lately. A more personal perspective about the City and the recent crisis is presented by John Lanchester in the latest London Review of Books. Here is a short extract from his piece, Cityphilia:

This uncritical and uninformed governmental Cityphilia received its biggest shock in decades this autumn, with the near collapse of Britain’s fifth largest mortgage lender, Northern Rock. Britain’s first genuine bank run in more than a hundred years shone a light in many places where the sun doesn’t routinely shine, and one of the first things to be brought into question was the ways banks work.

As I’ve already said, my father was a banker, and I grew up hearing about that mythical beast, the bank run. It was often spoken of but rarely seen in the wild. Bankers are said to dread a bank run, but my dad talked about them with a certain black humour. They were always a sign that somebody had fucked up, big-time. They can also be a sign that something in the financial system is fundamentally wrong.

The question hanging around in the residue of the Rock’s near implosion is which type of bank run this was – a fuck-up, or a harbinger of meltdown?

Do central banks react to house prices?

Some do and some don't, according to a new working paper by Swedish Riksbank economists Daria Finocchiaro and Virginia Queijo von Heideken:

The substantial fluctuations in house prices recently experienced by many industrialized economies have stimulated a vivid debate on the possible implications for monetary policy. In this paper, we ask whether the U.S. Fed, the Bank of Japan and the Bank of England have reacted to house prices. We study the responses of these central banks by estimating a structural model for each country where credit constrained agents borrow against real estate. The main result is that house price movements did play a separate role in the U.K. and Japanese central bank reaction functions, while they did not in the U.S.

Rate cuts due next year as UK growth slows

Today's Bank of England Inflation Report contains a whiff of stagflation in its latest economic projections. Inflation is heading higher, at least in the short-run, while growth risks are to the downside:

In the central projection, higher energy and import prices push inflation above the target in the near term. Inflation then falls back to settle around the target in the medium term. The risks to growth are on the downside, while those to inflation are balanced.

The Bank expects tighter credit conditions and a slowing in domestic demand will slow UK growth to around 2% in 2008. While this is in line with private sector forecasts, I would not be surprised to see sub-trend growth dip towards 1.5% next year. Governor Mervyn King was ceretainly rather gloomy at today's press conference (webcast here). According to a Bloomberg report he warned that:

The central projection is for growth to slow sharply in the next year. ...There has been some tightening of credit. Residential and commercial property investment are likely to moderate, possibly quite sharply.

The Bank's latest forecasts are based on market assumptions that they will cut base rates by 25bp in the first quarter of next year. Indeed, financial markets are now expecting not just one 25bp cut around February 2008, but have also priced in a second cut around May 2008, which would bring official cash rates back to 5.25%.

New Chancellor Alistair Darling will certainly have his work cut out keeping budget and revenue projections on track. But at least British home owners can look forward to lower mortgage rates next year.

Explaining the T-bond 'conundrum'

In February 2005, then Fed Chairman Alan Greenspan referred to the decline in long-term rates in the wake of the Fed increasing the target for the federal funds rate by 150 basis points as a "conundrum" St Louis Fed's Daniel L. Thornton has investigated Greenspan's remarks and provides an answer, in a new working paper: The unusual behavior of the federal funds and 10-year Treasury rates: a conundrum or Goodhart's Law?

I show that the relationship between the 10 year Treasury yield and the federal funds rate changed dramatically in the late 1980s, well in advance of Greenspan's observation. I argue that the marked change in the relationship between the federal funds rate and long-term yields is a natural consequence of Goodhart's Law.

Here is what happened:

Once the Fed began targeting the funds rate for policy purposes and the funds rate remained close to the target, the behavior of the funds rate is necessarily different from what it would have been had it been free to respond to market fundamentals. This implies that the relationship between the funds rate and rates that are less closely linked to the funds rate would necessarily change. Since long-term yields are much less affected by the funds rate than other shorter-term rates, it is reasonable that the relationship between the funds rate and long-term rates would be most affected.

This hypothesis is supported by the fact that there was a marked change in the relationship between changes in the 10-year Treasury bond yield and changes in the federal funds rate that occurred in the late 1980s. The change in the relationship is statistically significant at monthly and quarterly frequencies. Moreover, an analysis of the levels of these rates indicates that the change persists at lower frequencies as well.

Some of you may not have heard of Goodhart's Law. It was coined by British economist Charles Goodhart in the mid-1970s, when he was was Chief Adviser to the Bank of England. The basic idea is that when a government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends. This proved prophetic when Margaret Thatcher was elected Prime Minister in 1979, and sought - disastrously - to conduct monetary policy on the broad and narrow money supply targets.

UPDATE:
Almost as soon as this post went up, another paper on the same subject appeared. Cracking the Conundrum, by the Stern School's David Backus and Federal Reserve economist Jonathan H. Wright, has just been published as Finance and Economics Discussion Series No. 2007-46. The authors hedge their best a little more than Thornton, citing several possible contributing factors:

From 2004 to 2006, the FOMC raised the target federal funds rate by 4.25 percentage points, yet long-maturity yields and forward rates fell. We consider several possible explanations for this "conundrum." The most likely, in our view, is a fall in the term premium, probably associated with some combination of diminished macroeconomic uncertainty and financial market volatility, more predictable monetary policy, and the state of the business cycle.

I accept there was a decline in the term premium (the expected return on long-term bonds). But surely this begs the obvious question: 'why?'. A post by James Hamilton of Econbrowser fame provides some discussion: The term premium and reduced volatility

Monetary policy transparency - what impact?

Monetary policy transparency is generally considered these days to be a 'good thing' - though it was not always so. But what impact has greater transparency had? Carin van der Cruijsen and Sylvester Eijffinger from Tilburg University have reviewed the literature. Their paper, The Economic Impact of Central Bank Transparency: A Survey (PDF), provides an up-to-date overview of research on the desirability of central bank transparency from an economic viewpoint. Here are their main findings:

1) The theoretical literature does not come to a unanimous conclusion. Although the more recent theoretical literature argues in favor of more transparency, exceptions are procedural and political transparency.
2) Differences in outcomes occur because of differences in the models used. There is a tendency of more recent, micro-directed research to favor transparency.
3) The empirical literature shows that more transparency is indeed desirable. The only remaining question mark is procedural transparency.
4) There is still scope for some more research on transparency.

What direction might future research take?

..now that most central banks have already become more transparent, it is likely that the research will shift more towards communication, a trend that is already observable. As Winkler (2002) pointed out, the release of asymmetric information is not enough: communication should provide clarity to make sure that the re lease of information leads to common understanding between the public and the central bank.

The authors also argue that although central banks have increased their level of transparency, "there is still some room left for further improvements".

Who took the money out of monetary policy?

In a recent economic discussion paper, Will Monetary Policy Become More of a Science?, Federal Reserve Governor Frederic Mishkin reviewed the progress economists have made in monetary theory and policy in recent decades. He had some good news for central bankers:

Monetary policy will however never become as boring as dentistry. Monetary policy will always have elements of art as well as science. (That is good news because it will keep life interesting for monetary economists like me.)

Not so boring - but there's a caveat:

However, the advances in the science of monetary policy that I have described here suggest that monetary policy will become more of a science over time. Furthermore, even though art will always be a key element in the conduct of monetary policy, the more it is informed by good science, the more successful monetary policy will be.

Mishkin's paper is worth reading for anyone interested in monetary policy (see also the comments at Mark Thoma's post). The paper was given in Frankfurt on 21 September at a conference to mark the 50th anniversary of the Deutsche Bundesbank: Monetary policy over fifty years (PDF). One of the other speaks was David Laidler, professor Emeretus at the University of Western Ontario, who spoke on: Successes and Failures of Monetary Policy since the 1950s (PDF). While quite upbeat, he is not uncritical:

Successes and failures in monetary policy stem mainly from coherence or lack thereof in the monetary order, rather than the tactical skills of policy makers. Crucial here are questions of consistency among the economic ideas that the policy regime embodies, the way in which the economy actually functions, and the beliefs of private agents and policy makers about these matters.

These postulates are used to frame accounts of the Bretton Woods System and its collapse, the Great Inflation that followed, the subsequent disappointing performance of moneygrowth targeting, the breakdown of the Japanese "bubble economy" the onset of theEMS crisis at the beginning of the 1990s, and since then, the launch of the Euro and the apparent success of inflation targeting. Though monetary policy seems rather successful at present, certain weaknesses in currently prevailing monetary orders are noted.

The implications are interesting. Like fund managers, for central banking it is more about the coherence of the framework and the process of the 'monetary policy regime' than it is the specific people. On this reading, Greenspan is either an outlier (like a star fund manager) - or has simply taken too much of the credit for the 'great moderation'.

And what about the weaknesses Laidler identifes? His main concern is the mistaken "view that the quantity of money is irrelevant for monetary policy":

Over-exclusive emphasis on the role of interest-rates in monetary policy has already done damage, having, in the 1990s, led the Bank of Japan into thinking that, once short interest rates reach zero, it had exhausted its options, and hence into not tackling promptly and vigorously the credit deadlock which followed the collapse of the “bubble economy”.

...the fact that demand for money functions proved insufficiently stable over monthly or even quarterly intervals to provide a basis for regular monetary policy decisions, does not imply that the only variables of any significance for monetary policy under any circumstances are the short interest rates that central banks use as their instruments, but it seems to be widely believed nowadays that this is the case.

Laidler sums up:

In short, though inflation in the world economy is now lower and more stable than anyone would have predicted even as recently as the beginning of the 1990s, and though we may be closer to a coherent international monetary order now than at any time since the late 1960s, the way forward is not yet risk-free.

Crisis? Why crisis?

It is probably a little too early yet to know exactly what went wrong and who is to blame, but in the UK at least monetary and finance economists are starting to provide some answers.

This afternoon the LSE's Financial Markets Group hosts a half-day Financial Crisis Conference. I attach the draft agenda (PDF), which includes Charles Goodhart, Willem Buiter and the FT's Gillian Tett, among others. The web page states: "This is an open event and registration is not required. Please arrive early as places are limited".

Former MPC member Buiter has posted a copy of his powerpoint presentation 'What should the authorities have done?’ online. He summarised his arguments in a long post on his new weblog, Maveronomics, which begins thus:

The mess surrounding the rescue operation for Northern Rock demonstrated that the UK’s Tripartite arrangement for handling financial crises is not working properly.

There are three distinct sets of problems. First, the UK deposit insurance scheme is both limited in the degree to which it guarantees retail deposits and too slow in paying out on any claims submitted under the scheme.

Second, the division of labour among the Treasury, the Bank of England and the Financial Services Authority, as expressed in the Memorandum of Understanding, was disfunctional, mainly because it separated the agency in possession of the relevant information from the financial resources to act effectively upon that information.

Third, the Bank of England’s liquidity-oriented open market operations through repos, and its discount window are flawed in three ways: first, the eligible collateral is too restricted; second, the maturity of the operations (loans) is too short; and, third, the list of eligible counterparties is too restricted.

Specifically, five issues can be raised about the current set of arrangements:

(1) The UK deposit insurance arrangements did not work properly.

(2) The lender of last resort (LOLR) mechanism for dealing with individual financial institutions in distress did not work properly.

(3) The Bank of England’s Standing Lending Facility (its discount window) did not work properly.

(4) The Bank of England’s liquidity-enhancing open market operations did not work properly.

(5) The financial stability mess, and the Bank’s about face as regards the collateral requirements and the maturity of its liquidity-enhancing open market operations have created confusion about exactly what it is the Monetary Policy Committee decides on when it sets the official policy rate, or Bank Rate.