Arnold Kling  

Two Quick Takes

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1. Tyler Cowen asks


Will the commercial paper market dry up?

The Fed had to deal with this in 1970, when the Penn Central Railroad went bankrupt. In this narrative, "the Fed's index finger started to bleed" from dialing up every bank and telling them to make loans to corporations that were having trouble. That would work today, but--you knew I was going to say this--they would have to relax capital requirements.

2. In a comment on my Where are the Macro Theorists? post, G. Martinez says that he teaches the current crisis as a surge in money demand, with Treasuries playing the role of money. Everyone else's borrowing rate goes up, and the rest happens according to a textbook.

That's a good analytical approach.
UPDATE: I'm going to put my original continuation below the fold. I've thought more since.

OK, so now we have a story that we can put into a textbook macro framework (I'll play that game for now). We've had an increase in liquidity preference. Why, if we don't act this weekend, will we get the Great Depression? I don't think that what has happened so far is going to do it. Do we really think that the lagged response of spending to the increase in liquidity preference that has already taken place will be that large? I don't.

Instead, you have to tell a story that says that we could find ourselves with liquidity preference increasing even more in coming weeks, that only the bailout can prevent it, and that if it is not prevented it cannot be treated. That's a hypothesis, but I'd much rather test it (by not passing the bailout) than proceed as if it were nonfalsifiable.

Another hypothesis is that Paulson is too closely wedded to the financial industry, and Bernanke is too closely wedded to Paulson.

[original continuation] The right policy response to a surge in demand for this "money" would seem to be to exchange "money" for bonds, which in this case means issuing Treasuries and buying private securities. If that's the right policy, then I would have the government invest in bond mutual funds rather than mortgage securities. First, that would give you diversification, instead of putting all your chips on house prices. Second, it would allow you to undo the trade easily if market psychology changes in favor of corporate bonds. Third, there would be nothing magic about $700 billion. Maybe it takes a lot less to nudge corporate bond rates down.

UPDATE: Some similar thoughts from Andrew Feldstein via Joe Nocera, pointed out to me by reader Mike Gibson.


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CATEGORIES: Macroeconomics



COMMENTS (19 to date)
TC writes:

Between a strong dollar policy and a weak dollar policy, a tight monatary policy versus a loose monatary policy, which policy would help these struggling corporations/banks/businesses the most?

If we were to enact the 700 billion dollar Paulson plan, would it be better if the Federal Reserve simply printed the 700 billion dollars or would it be better if they sold 700 billion dollars of US Treasuries?

I think the Paulson plan it reckless, by the way. But I ask these questions regarding the money supply and the dollar because quite often I read that when the policy makers want to cut interest rates, they increase the money supply even at the risk of higher inflation. But wouldn't higher inflation result in a decline in the real value of mortgages from the creditor's perspective, since income from a mortgage is paid in nominal terms, not inflation adjusted terms?

Steve Roth writes:

>invest in bond mutual funds rather than mortgage securities

Now that's a fascinating proposal. Would it work, to simply flood the bond market with cash? In particular, would it result in the confidence/trust bump that's needed?

More discussion please!

Matt writes:

How about having the treasury sell three year bonds and buy back ten year bonds, thus smoothing out the yield curve, and leave it at that?

In fact, why doesn't Treasury do this as a matter of policy, keeping the yield curve shapely? This is a real question, can anyone answer?

Arnold Kling writes:

Matt: do a Google search for Operation Twist

Randy writes:

My quick take; I've been watching the lawmakers parade across my TV screen. The thing is, they're all smiling and joking and just generally having a great time. I thought this was supposed to be a "crisis". It just doesn't seem very crisis-y to me. I think we're being played.

E. Barandiaran writes:

Arnold,
I don't have time to look at series of interest rates, but it is my impression that the behavior of interest rates over the past 12 month, and in particular the past few weeks, contradicts your two points. Concerning your first point, take into account that in 1970 interest rates were regulated. On your second point, take into account that theoretical statements about money avoid to define money (in other words, they are irrelevant as Charles Goodhart showed in his famous law).
I believe you're still dancing around the Paulson plan with your libertarian hat on, praying for politicians to disappear. I'm sorry for you--they are coming with Chris Dodd in charge. Watch your wallet.

Marcus writes:

Concerning the government buying bond funds. One moral hazard that I see from that is this. One of the checks on fund managers is the threat of a run. In other words, if the government is investing into their fund they may be more inclined to take on greater risk to try and capture greater returns because they have the government covering them.

Just a thought.

Matt writes:

I did google Operation Twist and briefly read from a number of commentators on all sides of the issue.

My take was that Operation Twist tried to invert the yield curve, that is fool the economy into operating suboptimal.

The goal here is to make the yield curve look like it should in an efficient economy under the assumption that we are at forced dis-equilibrium and headed for a disruption. (Many different reasons why we are at forced dis-equilibrium, but my theory says federal programs are out of whack).

The test of whether the treasury is dealing with a forced dis-equilibrium would be to try twisting until it obviously fails to work.

Having treasury do this rather than Ben is that Treasury is an entity that is actually involved, nuts and bolts, in economic undertaking, that is, treasury and congress should come under increased pressure to rationalize government is the yield curve represents a more efficient economy.

Dave writes:

From the Economist:

Not a moment too soon, suggest the results of a new study by Luc Laeven and Fabian Valencia, two IMF economists.* They examined all systemically important banking crises between 1970 and 2007, creating a database on how much financial crises cost and how they are resolved.
...
An equally common tactic has been regulatory forbearance. Governments allowed banks to hold less capital than was normally required or softened their rules in other ways. These tactical responses, however, often did not work and ended up increasing the overall bill from a crisis. [emphasis mine]

Marcus writes:

"An equally common tactic has been regulatory forbearance. Governments allowed banks to hold less capital than was normally required or softened their rules in other ways. These tactical responses, however, often did not work and ended up increasing the overall bill from a crisis."

That's an important piece of information that seems to directly address Arnold's suggestion of lowering capital requirements.

It seems to me that is also shows that throwing out mark to market will work as throwing out mark to market is just a way of effectively lowering capital requirements.

Marcus writes:

It seems to me that is also shows that throwing out mark to market will work as throwing out mark to market is just a way of effectively lowering capital requirements.

God I need to learn to proof read.

What that's suppose to say is, "It seems to me that it also shows that throwing out mark to market will not work. As throwing out mark to market is just another way of effectively lowering capital requirements."

TC writes:

It seems that those supporting the Paulson plan are using the risk spreads, the difference between the yield on a treasury bill versus the yield on corporate debt, as their Exhibit A demonstrating that "something must be done."

But even if we agree that a significant number of participants in the financial markets are shifting towards less risky or even "risk-free" investments, doesn't a more conventional approach to this problem exist?

First, let me ask this: Is there some economic textbook somewhere that says that the financial structure of a nation collapses when the risk spread approaches to high a level? Let's just assume for the sake of argument that the answer to this is 'yes.' Can't the federal reserve deal with this using a more traditional approach?

Presumably the 700 billion dollars required to finance Paulson's plan in at least the short run would have to be either monatized, resulting in higher inflation or received by issuing more Treasury debt, which would put upward pressure on US Treasury yields.

The latter option would reduce the risk spread, but would also like increase, not decrease, real interest rates for businesses in need of loans.

Am I speaking Chinese here?

Today I had two gentlemen who were children during the Great Depression ask me what would happen to the economy if we did nothing. I told them that the companies in question would sell off their assets, other companies would buy them, and that it would have negligible long-term effects -- if we did nothing. They agreed that, the longer we have gone on doing nothing about this crisis, the more they think that's the right way to go.

This "don't think -- just do something!" attitude is a very, very, very dangerous one.

Matt writes:

I am with Troy and probably the other libertarians. The longer we debate with no conclusion, the better we are.

Let me posit the fundamental issue. Firms, collectively, are anxious to restructure, synchronously. That is, firms postpone restructuring until they get a quorum of fellow and competitive firms doing the same, Paul Krugman call it synchronized sinking. All deep recessions are driven by the need to restructure.

Why do firms like to restructure simultaneously? They get economies of scale, save money in the medium term. Ben and Paulson are caught off guard because they thought they could hold off the restructuring until the finance industry was better prepared.

AS writes:

Isn't a big part reason for the rush to get this done this week the fact that companies like Caterpillar have trouble selling commercial paper. If so why not have the government inject money directly into the commercial paper market. Sell 3 and 6 month Treasury Notes and buy commercial paper of the same term at rates that are above normal but below current rates. The chances of taxpayer losses are much lower and it seems more politically palatable by bypassing the banks that created our problems and help companies like Caterpillar who are suffering through no fault of their own. Although it's only a short term solution it buys time for us to come up with something better than the Paulson plan. Is there are reason why nobody else has propose this?

robbL writes:

Arnold,
You never seem to discuss the risk benefit ratio. A depression would be very bad. If you want to have anyone take your ideas seriously, you need to say something more than "I don't think" especially since you admit you were wrong about a lot of the issues leading up to where we are now.

I don't particularly like the paulson plan. I agree with many of the criticisms I read, but I know he is right to be scared out of his socks about the possibility of a depression. It is a big change from playing russian roulette with an empty gun to playing it with one bullet in the cylinder and anyone who expresses an opinion needs to address that.

It is all very well to say we don't need to put plywood up over the windows and it is a waste of money, but when there is a hurricane in the gulf and you live in Galveston then maybe it is better to waste the money sometimes.

TC writes:

robbL,

Based on your argument, the substance of the Paulson plan is irrelevant. The argument is simply, "We are headed for a depression if we don't pass the Paulson plan." The implication here is that if we do pass the Paulson plan there will be no depression.

But how can we know either proposition, that without the Paulson plan we are headed for a depression and that with the Paulson plan we will avoid a depression?

Does passage of the Paulson plan even reduce the risk of recession and if so by how much?

No one supporting the Paulson plan has provided any answers to these questions. The argument for the plan is simply, "Pass it or there will be a depression."

We don't know why Paulson is scared to death -- whether it's because he fears a depression (whether he knows there could be one or not -- which is itself doubtful), or whether it is simply because he is seeking to rescue some fellow Democrats from financial ruin, since it is Democrats in Congress and major DNC contributors who are tied to all the failures.

I should have said, "Fellow liberals," since Paulson is a Republican, but is not a free market conservative.

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