David R. Henderson  

Taylor Rules

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Morning Commentary... CDS Paper...

My book review of John Taylor's latest book, Getting Off Track, appeared on Forbes.com yesterday.

Two excerpts from my review:

Throughout 2007 and 2008, Fed Chairman Ben Bernanke and others in policy-making positions assumed that the problem was that the financial system lacked liquidity, and virtually all their actions were calculated to inject more liquidity. But Taylor gives evidence, which he garnered with economist John Williams, that liquidity was not a problem. The problem, writes Taylor, was "counterparty risk." Taylor compares finance to the game of Hearts. In Hearts, you don't want to get stuck with the queen of spades. The queens of spades in finance, he writes, "were the securities with bad mortgages in them" and "people didn't know where they were." Increasing liquidity by increasing the money supply does nothing to solve that problem.
Many proponents of the bailout argued that the government's failure to bail out Lehman Brothers made the financial crisis worse. But Taylor, drawing on the well-known finding of financial economists that financial markets adjust within hours or minutes to new information, shows that the Libor-OIS spread did not widen much after the Lehman bankruptcy. Instead, the big widening occurred after Bernanke's and Paulson's Sept. 23 testimony spooked financial markets with their warnings of grim days ahead if the bailout were not passed. This is some of the key evidence that the bailout actually worsened the problem.

I do criticize, though, Taylor's criticism of Greenspan's monetary policy.


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CATEGORIES: Finance , Monetary Policy



COMMENTS (4 to date)
gnat writes:

One might question whether a review of a colleague can be “positivist” rather than “ “normative”. According to your review Taylor claims there is no empirical relation between the Lehmen Brothers failure and subsequent credit market lockup. He cites all the usual Hoverville suspects (government, Fannie/Freddie and CRA). You fail to note that his empirical evidence has been challenged (http://ftalphaville.ft.com/blog/2009/03/12/53515/why-letting-lehman-go-did-crush-the-financial-markets/); that Frannie/Freddie had left the field in 2005 and did not participate in the subprime mortgage explosion (http://www.econbrowser.com/archives/2008/07/did_fannie_and.html#more); and that CRA guidelines had no enforcement (http://en.wikipedia.org/wiki/Community_Reinvestment_Act).
Alternatively, a positivist review might have cited other (more) plausible explanations (e.g., http://blogs.ft.com/economistsforum/2009/03/the-root-cause-of-the-financial-crisis-a-demand-side-view/)

Commenterlein writes:

My understanding is that the volume actually transacted at LIBOR between the banks dropped to almost zero when Lehman went bankrupt.

"But Taylor, drawing on the well-known finding of financial economists that financial markets adjust within hours or minutes to new information, shows that the Libor-OIS spread did not widen much after the Lehman bankruptcy."

LIBOR is not (!) a market price and certainly not a market-clearing price. It is the result of a survey of leading banks. Right after the bankruptcy, it was pretty meaningless - everybody just kept reporting the same numbers as the previous week but nobody was lending at these rates.

Commenterlein writes:

Here is a good post on what happened right after the Lehman bankruptcy:

http://ftalphaville.ft.com/blog/2009/03/12/53515/why-letting-lehman-go-did-crush-the-financial-markets/

Bill Woolsey writes:

Economists often use the term liquidity to mean something like "money." If the "problem" is liquidity, then the problem is an inadequate quantity of money. The definition economists teach for liquidity is something like, easy to sell at any future time and a known price. Something that is very liquid is a good substitute for holding the medium of exchange.

In finance, the term liquidity is used something like that, but the key element is easy to sell. That the price at which it can be sold is known at any future time isn't so important. So, a thick market with lots of transactions makes something liquid. There is also the notion that if an asset is more liquid, then it will be worth more. People will pay more for an asset if it is easy to sell when they want to sell.

So, CDOs stopped trading. The market was thin. They weren't easy to sell. So they were worth less. And so, the proposals to "jumpstart" the market. If they started trading again, then they could be sold and then they would be worth more.

Of course, many of the CDOs were held by investment banks. They were acting as "shadow banks," borrowing with commerical paper, some of which was even "overnight." Their liabilities were close substitutes for money or money. (Overnight commerical paper is pretty much money.) The "plan" of the investment banks was to be able to pay off this short term paper by selling new short term paper. But, if that didn't work, they would sell off the CDOs. And so, when the CDO's became illiquid in the finance sense, the shadow banks couldn't operate on that plan, and so they couldn't sell short term commerical paper, including some that amounted to money.

This creates a crises of liquidity in the economists' sense.

Now, of course, was it just some kind of fluke that caused CDOs to be more difficult to trade? No. The notion that "jumpstarting" the market would help was always implausible. No one wants to hold them because no one wants to trade them? The risk was the problem.

And, of course, the shadow banks, the investment banks didn't simply wind down their portfolios because they didn't want to hold CDOs when they were not liquid enough to sell if people wanted to collect on the commercial paper they were selling. No.. people stopped lending to the shadow banks because they realized that the CDO portfolio couldn't be sold off. And, Lehman Brothers showed that the shadow banks could fail and their creditors take a loss.

There was a rush to safety. T-bills, of course. And so, the TED spread shoots up. Not solely because the 8 or so money center banks suddenly had to pay more to borrow, (LIBOR) but also because the Treasury had to pay less.

But there was also a move to FDIC insured deposits. With the checkable deposits and savings accounts under sweep arrangements being exactly like the overnight commerical paper but with a U.S. government guarantee and the CD's being like the longer term commerical paper.

And there was a move to deposits at the Federal Reserve by depository institutions.

All of these changes have important monetary consequences and turn a "risk" problem and maybe a market thickness problem with assets that are not even close to being money, into a problem of a shortage of the medium of exchange.

And...during the 4th quarter, spending in the economy dropped like a stone, reflecting the monetary problem.


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