16. The Evolution and Perfection of Monetary Policy
Shiller: I want to talk today about monetary policy.
First though, I wanted to just review some
thoughts about Carl Icahn, who spoke on Monday.
I thought he was very amusing. I’m again happy that you asked
questions because that’s when you bring out a speaker really
well. I thought you could have given
him more trouble. He is a controversial figure.
What he does, as you know,
is takes over a company and shakes them up and,
in some cases, is accused of stripping their
assets. But, it’s all legal and you
could make an argument that it’s in a general good of our society
that people do that. If a company–if its stock
sells for less than its assets are worth, then the company
maybe should be broken up and the assets taken and given
somewhere else because the low stock price indicates a problem.
I don’t know how to evaluate everything Icahn has done,
but some corporate raiders have been unkind to employees.
Maybe it’s not always the raider;
it’s that some employees had trusted in an implicit contract
that they were offered by their employer.
For example, the employer may have said
verbally–or suggested to an employee–that if you do well,
we’ll promote you up and you will have various advantages in
the future. Then an outside raider comes in
and just fires the employee, so naturally the employee feels
wronged. There are instances of that
sort of thing. Again, it’s like anyone who
does important things, it’s hard to judge the whole
picture and on that I am sure he has created value for the
economy. Someone suggested that we
should bring in corporate regulators as well.
I think maybe in the next year I’ll do that to offset–I’m
bringing in a lot of very successful finance practitioners
and I don’t have any regulators this year.
Also, one of you asked, what literature do you read?
He mentioned the Nicomachean Ethics, which I have never
read–I don’t know what that is. He also mentioned a poem by
Rudyard Kipling called If.
I didn’t recognize what he was referring to immediately,
but I looked it up and it’s a famous poem that you must have
seen–written in 1910–an inspirational poem.
I put it up on the ClassesV2, not as part of the reading
list, but it’s under Resources, so you can read Kipling.
Maybe he thought of that because it’s really a
poem–seems to be a poem of advice for young people because
it ends up–the last line is–do you know the last line?
Can someone recite it? What’s the last line?
“If you follow these instructions,
you will be a man my son.” So, that’s the mode of thought
he may have been in when he talked.
Anyway, we have our second mid-term exam on Monday and it
will be like the first mid-term, but it will be less
mathematical. This part of the course had
less technical apparatus than the first part of the course,
so it will concentrate on the middle third of the course,
up to this lecture. You have to read Fabozzi, et al.
again carefully because I’m free to take anything from Key
Terms and Key Concepts from the chapters that were assigned for
this part of the course. Of course, every reading that
is online–I don’t expect you to go to the library–is something
I might ask about. April eleventh,
we have Stephen Schwarzman coming and I’m looking forward
to that. That will again be a Friday,
but it will be at nine o’clock and he will be here,
so I think that will be a lot of fun also.
I want to then start today’s talk–lecture–which is
about monetary policy and it’s really apropos right now.
We are living in very unusual times and I am sure that Ben
Bernanke and other central bank presidents are losing sleep
right now because this is a time to challenge monetary policy
makers. The thing that really emerged
just in the last week or so is that–of course,
monetary policy is about setting of interest rates.
In the last week, the Treasury bill rate on the
United States four-week Treasury bill,
which is the standard, essentially–three-month–it
fell to 0.2%. This is shocking.
What is happening now? Interest rates have hit
zero–0.2%; that’s twenty basis points
above zero. People have long thought that
these kinds of things happen only in Japan,
but that’s not true at all; it’s happening right now in the
U.S. There’s been a total crash in
Treasury bill rates, so it’s not going to–one thing
we know is that this crash is over.
The Treasury bill–the three-month Treasury bill rate
has crashed–it’s virtually zero–and the story is over
because it can’t go any lower. Well, it could go twenty basis
points lower, but interest rates can never be
negative. So, that’s it;
it’s over; we’ve just hit zero.
This is the thing that worries central bankers.
When interest rates hit zero, then they don’t have–it’s a
little bit like your steering system on your car freezing up
or hitting a–you’re hydroplaning on the highway;
your steering wheel doesn’t work anymore.
Once interest rates hit zero, you can’t cut them anymore and
that’s what the Fed wants to do. I’m talking about four-week
Treasury bills; the Federal Funds Rate is still
at 2 ¼%, but at least the more prominent
three-month T-bill rate is at the end.
What I want to do is talk about what the Fed in this country is
doing and what other central banks are doing.
I want to start by putting it in historical perspective.
If you’ll allow me, I will talk first about just
what is a central bank, such as the Federal Reserve,
and what do they do. I want to first just go
back–the story I told you in a recent lecture was the story of
a goldsmith banker. This is how it started.
There were people–goldsmiths were people who worked in the
metal gold and made beautiful things for people–jewelry and
other things. They had safes in their shop
and some people would say to the goldsmith, I have some
valuables. I don’t have a safe–can I put
it in your safe? The goldsmith would say, okay.
Then he’d write on a little note and hand it to the guy and
say, just keep this note. If it was a bearer note–if the
note said, I’ll pay–if it wasn’t a unique object but just
gold, the note would say that this
goldsmith will pay to the bearer so many ounces of gold.
And that’s how banking got started.
It emerged into an institution in which banks would have
notes–bank notes–that circulated widely and we began
to think of them as money. If you put your gold in the
care of a goldsmith, initially you don’t think–you
think the money is there. But eventually,
you have this bearer note that you start passing around to
spend to other people and they start to think of them as money
and that’s the origin of banking.
If you ask someone a couple hundred years ago,
what’s the essence of a bank? They would say,
oh they print paper money–private banks print paper
money, not just government banks.
Well, there weren’t government banks;
originally, they were all private.
There is an institution called the “gold standard”–now totally
and completely gone everywhere in the world.
What it was–it began–the first country to adopt the gold
standard officially was the United Kingdom and that was in
1717. What it meant was that the
government of the U.K. committed that their paper
money would always and at all times be redeemable in gold.
It was gradually adopted by other countries through time and
the United States didn’t officially adopt it until 1900. Let me just go back to the way
the thing worked. It used to be that it
was–actually, the gold standard kind of came
in by accident in England, originally;
that was in the 1600s. The prominent coin was called
the shilling and it was a silver coin.
The British pound was twenty shillings, so effectively,
the pound was on a silver standard.
Then they started minting new coins out of gold and the
government was issuing coins–they called them guineas.
They started out as a–they just minted the amount in one
coin, which they thought was equivalent to twenty shillings.
So, they had a guinea, which they said was twenty
shillings, and then there were two coins–either shillings or
guineas–that was the money at the time.
Then, the problem was that the price–relative price of those
two–was not really fixed by the government.
So, it started to drift and people started to think,
I think a guinea is worth more than twenty shillings and the
market price drifted up to twenty-one shillings.
So, the government was upset–of the U.K.
We wanted this to be a twenty shilling coin,
but now in the market it’s trading at twenty-one.
Then they implemented a rule that the guinea is worth
twenty-one shillings. Then, the relative price of
gold versus silver shifted to the point that the gold with–at
the twenty-one shilling exchange rate,
the gold shilling was worth less–the gold guinea was worth
less than twenty-one shilling. So, all the shillings
disappeared and the only coin left was the guinea.
So, England became on the gold standard.
The Bank of England was founded in 1694 and that was the world’s
first central bank. It was granted a monopoly on
joint stock banking by Parliament in return for giving
war loans to the government. It started out just a powerful
bank. It did not have a government
monopoly on note issue, but over the time,
it became the prime issuer of U.K.
notes. Now, what actually developed in
the 1700s was that the Bank of England, being the most powerful
bank in England, started to demand that other
banks in the U.K., who were also issuing notes,
would leave their–would keep a deposit with the Bank of
England. The Bank of England–if you
were a little bank somewhere in the U.K., the Bank of England
would say, you’ve got to keep a deposit
with us, otherwise we’ll destroy you.
Because the Bank of England could then demand all the–it
could start accumulating notes from some issuing bank and then
demand payment in gold. The issuing bank would be
driven out of business if it didn’t–They all were using
fractional reserve banking, so if you have a big player
that’s demanding gold from you, you’re in trouble.
All the banks complied and kept deposits with the Bank of
England. You see what the Bank of
England emerged into was a banker’s bank.
You have lots of banks; the banks are taking in gold
and issuing notes, but they are forced by the Bank
of England to keep a deposit at the Bank of England.
So, the Bank of England then became a kind of regulator of
these banks and it would also loan to them when they were in
trouble. They had a relationship,
between the Bank of England. The Bank of England became the
source of stability in the UK. The problem with private banks
issuing notes is that there would periodically be banking
crises when the banks failed to pay on their notes and they
couldn’t pay out the gold that was demanded–that was required.
With a fractional reserve system, you’re in an unstable
equilibrium. If people start demanding
payment on their notes, then they will destroy the
system. If they start demanding,
then we’re in trouble. So, the Bank of England
effectively enforced that the banks in England kept adequate
reserves and they would see some of these reserves in the
deposits at the Bank of England. England’s money was more stable
than other countries. In the United States,
we did not have a central bank until 1913 when we created the
Federal Reserve System. Before that,
the United States went through repeated banking crises when
people would start demanding the gold for their notes.
When did we have–we had a severe banking crisis in the
United States in 1797, in 1819, in 1837,
in 1857, in 1873, in 1893, and in 1907.
We just had one after another; the banking system kept
collapsing. What would happen is there
would be a panic; people would say,
they’re not paying on the notes.
So, everyone would run to the bank and demand their money.
When that happened, it would destroy the economy.
It was a subject of much discussion of what to do to
prevent these bank runs. In the United States,
in Massachusetts, a bank called the Suffolk Bank
created a little Bank of England in the State of Massachusetts.
They created what was called the Suffolk System,
in 1819. What the Suffolk Bank did is it
just, on its own, it just declared that it was
the Bank of England for the State of Massachusetts and it
required that all banks in the Boston area keep deposits with
them. So, the Suffolk Bank became a
banker’s bank and it lasted until 1860.
It then made Massachusetts the most stable state,
or essentially the most stable state, in the country and it was
widely-admired. The thing you have to
understand is, if you could go back in a time
machine to before 1860 in the United States,
you would have real problems with paper money and you would
be very much aware of the paper money.
If you took out your wallet and looked at the paper money in
your wallet, it would be issued by lots of different banks,
not any one standard bank. If you went to a store to buy
something with paper money, then the person at the–would
it be a cash register? What did they have?
Cash box would be–would have something called–it was called,
Van Court’s Bank Note Reporter and Counterfeit
Detector [sic]. It was a magazine that would
be–every retailer would subscribe to it.
So, what the guy would do is he would say, okay you’ve got–if
it was local money–if it was from this town–if it was New
Haven money–there were New Haven banks–the guy would
immediately know what it’s worth.
But, if you were to make the mistake of trying to spend
Boston money in New Haven, they would get out Van Court’s
and then they would read the discount.
So, Boston money was probably pretty good because of the
Suffolk System, but if you tried spending New
York money in New Haven, they would get out the Bank
Note Reporter [sic] and put a discount on it.
Well, it was a messy system, so you’d only get like ninety
cents on the dollar. That’s because nobody trusted
these banks, they could go under any day and so they tended to
sell at a discount. Incidentally, the U.S.
did create what sounded like central banks.
They were The First Bank of the United States and The Second
Bank of the United States. The First Bank of the United
States was created in 1791 and they had a twenty-year charter,
which expired in 1811. It wasn’t immediately renewed
because the United States got into a war that we call The War
of 1812. It was the U.S.
connection to the Napoleonic Wars.
It wasn’t until after the war that we created a new Bank of
the United States in 1816 and gave it a twenty-year charter as
well. But those were not central
banks because they–there was– [Speaker arrangements]
In the United States, we created the National Banking
System in 1863 after a banking crisis and that worked fairly
well. Instead of having a central
bank, we decided that there would be a list of banks called
the National Banks. The National Banks would be
required to help bail out any bank that was failing.
It was something like a central bank, but it was different
essentially in that the National Banks really didn’t have
authority to run monetary policy.
They merely were there in a time of emergency to prevent,
hopefully, a banking crisis. They didn’t succeed;
we still had banking crises, so the system didn’t seem to
work very well. The 1907 banking crisis then
led finally to the creation of the system that we have now–the
Federal Reserve System. What it was was,
in many ways, an effort to bring the Bank of
England to the United States. They wouldn’t have said that
because it doesn’t sound–we want to think that we invented
this here, but it actually was a new
invention in a way because the United States has a different
philosophy, which the United States has
been committed, since its beginning,
to federalism. That is, they don’t want–or
more broadly–they don’t want centralization of power in the
government. Instead of setting up a central
bank in the United States, as was done commonly in other
countries, the United States instead created twelve banks;
they’re the twelve Federal Reserve Banks.
That was an effort to disburse power away from the center.
The idea was that power to the people, rather than the central
government. The Federal Reserve System that
was created in 1913 was different in that it was
independent, or much more independent than
central banks in other countries.
Other countries had set up central banks following on the
Bank of England, but the U.S.
didn’t set up a central bank; it set up a system of twelve
banks and they were regional. The idea was that this is
better, it’s more democratic; each region of the United
States has its own bank. The banks were not technically
government institutions–well, they’re semi-government;
it’s kind of strange set-up. The Federal Reserve Banks are
owned not by the government but by the banks in the region where
they operate; they’re called member banks.
So, banks that become a member of the Federal Reserve System
get shares and they become stockholders in the Federal
Reserve Bank. They get dividends–does it
work now? Can I walk away?
Thank you.–but they’re not traded.
There’s no price per share that you can observe and the banks
can’t do anything except passively receive the dividend.
But they can also participate in choosing the directors and
the president of the Federal Reserve Banks.
That’s a very dispersed system, but it still works because
member banks keep deposits at the Federal Reserve Banks and
they’re required to keep these deposits.
Moreover, they can also borrow from the Federal Reserve Banks
when they’re in trouble and need money and that’s supposed to
help prevent banking crises. So, that’s the Federal Reserve
there are twelve banks and there are twelve districts.
The districts back in 1913 represented the population
distribution of the U.S. at that time.
There are a lot more districts in the East Coast of the U.S.
than the West Coast. There are also two Federal
Reserve Banks in one–in the state of Missouri–the Federal
Reserve Bank of Kansas City and the Federal Reserve Bank of St.
Louis. You wonder, why would it be
that the whole western half of the U.S.
gets only–or the western third of the U.S.–gets only one
Federal Reserve Bank–that’s San Francisco–but Missouri gets
two. That’s kind of political
history; it’s kind of absurd,
but that’s the way it is. The real difference between
Federal Reserve Bank System of 1913–the most important
difference–and the Federal Reserve System of today is that
we are no longer on the gold standard.
The Federal Reserve System was a gold standard institution like
the Bank of England. It was supposed to maintain the
convertibility of the currency into gold.
Under the gold standard, your dollar bill represented so
many ounces of gold and you were supposed to be able to always
get that gold. That means you could go to a
bank and demand gold and the bank then could go to the
Federal Reserve and get gold for it.
That was the system. The gold standard was a success
in the sense that the price of gold stayed constant because
that’s what the whole system was designed to do.
There’s a famous story about Irving Fisher,
who was a professor here at Yale, who–remarking on how few
people understand the gold standard.
I don’t know if I’m repeating this, but he was at his
dentist–I didn’t tell you this. He was at his dentist and they
used to give gold fillings in those days.
He said to the dentist, just out of curiosity,
can you tell me what the price of gold has–what it’s been
doing lately? The dentist said,
gee I don’t know, I’ll look at my records.
I have some old records and I’ll see what I’m paying for my
gold for the gold fillings ten years ago.
The dentist came back and said, funny thing;
it hasn’t changed at all; I’m paying exactly what I did
ten years ago. Irving Fisher then told that
story as an illustration of how poorly the understanding was of
what was going on. Of course the price of gold
never changed in the gold standard because that was the
whole point of the gold standard–that’s if currency was
convertible into gold. What happened in the 1930s was
that one country after another abandoned the gold standard.
The United Kingdom was the prominent first case,
even though they had invented the gold standard hundreds of
years earlier. In 1931, they dropped
convertibility of the pound sterling–still called pound
sterling even though it’s not silver, it was gold.
They dropped the pound convertibility.
The United States dropped it in 1933 and other countries did it
later. The reason that countries
dropped the gold standard was that, under the effort to keep
the currency convertible into gold,
they were worsening the depression of the 1930s.
In order to keep the currency convertible, they had to keep
interest rates high to prevent people from demanding the gold.
Keeping interest rates high was destroying the economy.
So, the gold standard ended in the 1930s and every country
dropped it. We’re left with the central
banking institutions that are now functioning without
convertibility to gold. Then you start to wonder,
well what is the system and what is it supposed to do?
The old gold standard was supposed to maintain the
convertibility of gold in currency but now we’re not even
backing it with currency anymore–with gold anymore–so
what does it mean? Well, what it means is that
starting in the 1930s, we began to think of central
banks as managing the money stock to stabilize the economy.
That’s what–that’s the view that’s developed–that has been
with us ever since. They still hold gold and right
now the Federal Reserve System has about eleven billion dollars
of gold. They still have it.
Remember what happened in 1933 is they abandoned convertibility
with gold. That means that you no longer
have the right to get it, but that doesn’t mean they
don’t still own gold; it’s just sitting there in
their vaults from way back. Some people ask,
what is the currency backed by? It used to be backed by gold.
The question is–what it means to say something is backed by
something because, well you could say it’s backed
by gold because the Fed has eleven billion dollars of gold.
That’s a lot less then the amount of money out there,
but they always had fractional reserve of banking anyway.
They never kept all the gold for all the dollars that they
issued, so you could say it’s still backed by gold.
The really important thing is, it’s not convertible into gold.
So, since 1933, the Fed has been managing
inflation. It used to be that there was
zero inflation, if you define it with respect
to gold, and they were really true to
that–zero inflation in terms of gold.
Now, there was inflation with regard to a basket of–the
Consumer Price Index is not just the price of gold;
it’s the price of many things, but the–there would be
inflation or deflation as the relative price of gold changed.
After 1933, we had lost our moorings;
there was no longer any idea that the dollar was backed by
anything. The concept changed
fundamentally. The concept that became the
Federal Reserve or the central banks in any country is managing
the economy and their management of the money supply is their way
of managing how well things go. Generally, it has been
inflationary after 1933; central banks have generally,
gradually allowed prices to rise.
The general view is that if it’s not extreme–the rise is
not too extreme–it’s good for the health of the economy as
long as we don’t have inflation that’s too high.
So, central banks around the world began to manage–became
managers of inflation rather then defenders of a gold
standard. Let me just mention a couple of
other central banks. The Bank of England has been
providing an example for the world for a long time.
The Bank of Japan was established in imitation of the
Bank of England in 1882. Many central banks in Europe,
they have dates that go back to the eighteenth or nineteenth
century. Some banks, however,
are very new; the European Central Bank,
which issues the Euro currency, was founded in 1998,
so it’s only ten years old. That’s because it replaced
central banks of the member countries of the European Union.
The central banks still exist, so you still have the Bank of
France, the Deutsche Bundesbank, etc., but they no longer have
the importance that they once did because they no longer
manage the currency. The currency is centralized at
the European Central Bank. One thing that’s been a trend
around the world is that the–I mentioned that the U.S.
Federal Reserve System was different from other central
banks in that it was designed to have independence.
The thought was that the central bank is guarding the
money stock and governments have a tendency to sometimes want to
raid the bank when they’re in trouble.
Typically it happened during wars.
The government gets into a war. During the war,
the government needs resources; it’s in trouble;
it raises taxes to try to pay for the war, but then it finds
it unable to collect taxes well. People start evading taxes;
there’s a lot of discord. It’s just hard to raise money
by taxing. What the government would do is
send someone over to the central bank and say,
hey expand–give us–-just lend us the money.
You’re the central bank, lend us the money.
So, the central bank would print up notes and give it to
the government and the government would start spending
it on the war. Then you’d have inflation
because they’re printing all this money.
So, war time periods were typically periods of great
inflation and debasement of the currency.
That’s why we need independence of the central bank;
we want to have a central banker that can say no to the
government. The government comes to the
bank and says, it’s a war we need the money.
The central bank would ideally say no.
How can you get a central banker to do that?
Well, they definitely have to be independent of the government
and that was the idea in the U.S.
There’s been a trend to making central banks more independent
and there are particular things that happened.
In Japan, in 1997, the government of Japan granted
the Bank of Japan independence like the U.S.
central bank. It also happened in the U.K.
in the same year. Now, I’ve been describing the
Bank of England as the model for everyone, but in fact,
the Bank of England was not independent until 1997.
These people are–the people who run these banks–they may
still be appointed by the government, but they have terms
of office that are lengthy. The government can’t kick the
central head–head of the central bank out for failing to
offer them loans when they want it.
In the United States, we have twelve Federal Reserve
Banks, but we have a Federal Open Market Committee.
The Federal Reserve Board in Washington organizes policy for
all twelve banks and the members of the Federal Reserve Board
have fourteen-year terms. Plus, all of the presidents of
the Federal Reserve Banks come and serve on something called
the Federal Open Market Committee.
The Federal Open Market Committee makes monetary policy,
so it’s decentralized and long terms.
The board members have fourteen-year terms,
which is quite a long time. And the central–and also there
are the banks from the regional banks that have a roll.
The Federal Open Market Committee meets about every six
weeks or so and they decide on monetary policy.
In fact, they decide on how to set interest rates and borrowing
requirements for member banks. One of the things that the
Federal Reserve does is it sets reserve requirements for banks.
Reserve requirements are like what the Bank of England did or
the Suffolk Bank did long ago. It says that you have to keep
deposits with us here at the central bank;
either that or else keep vault cash and show that you have it
as reserves for your deposits. Now, these banks no longer
issue notes. We’ve centralized the note
issue in the United States starting in 1913 with the
Federal Reserve Board, so your notes that you see are
called Federal Reserve Notes. Banks still are vulnerable to
bank runs because they still have deposits,
so the system is still vulnerable and,
therefore, the Federal Reserve has a set of reserve
requirements. Now the reserve requirement is
progressive. Small banks have lower reserve
requirements but it rapidly gets up to a standard.
The reserve requirement now is 10% on demand deposits,
so they’re forced to keep those reserves and much of that is in
the form of deposits at the Federal Reserve Banks.
One form of monetary policy that the Fed does is they can
change these reserve requirements.
The other, but more commonly used, monetary policy is to
change the rate–is to effectively alter the rate of
interest on deposits. So, the interest rate–the
policy tool in the United–the policy interest rate or key rate
in the United States is called the Federal Funds Rate.
The Federal Funds Rate is an overnight lending rate between
banks. The Federal Reserve conducts
monetary policy by targeting the Federal Funds Rate and it
announces–since 1994, it has been announcing after
the meetings of the Federal Open Market Committee–it’s been
announcing the Federal Funds Rate publicly.
The Federal Funds Rate was recently cut to 2.25% and it’s
expected to be cut further because of the recession that
we’re now apparently in. So, that will be the monetary
policy tool. What’s happening right now in
the United States is that the economy is collapsing–maybe
that’s overstating it. It’s contracting,
so the Fed is trying to prevent a serious recession by cutting
interest rates; they’ve been cutting them
rapidly. The Federal Funds Rate is a
rate that is targeted by the Fed and it’s their principle target.
The Federal Funds Rate is the rate that banks borrow and lend
to each other overnight. There’s another interest rate
that the Fed sets and that’s called the discount rate.
The discount rate is the rate that the Fed charges for loans
to member banks. The member banks,
just as with the Bank of England–when they’re in
trouble, they are supposed to be able to borrow money from the
central bank. The central bank posts an
interest rate that is the rate at which these member banks can
borrow. There was an important change
in the discount rate in January of 2003.
It used to be that the Fed would grant loans to member
banks in the form of discount rate lending if the bank could
certify that it was in trouble. At that time they would give
generous–this was before 2003. The discount rate was a policy
variable set by the Fed and it was typically fifty basis points
below the Federal Funds Rate. They were lending to banks that
were in trouble and the–so, we’ll give them a good rate;
that’s what they used to do. In 2003, they decided to change
that and they decided to raise the discount rate above the
Federal Funds Rate. Actually, there are two
discount rates; there’s primary and secondary.
The primary discount rate is typically a hundred basis points
above the Funds Rate. That’s not so recently;
they’ve been cutting it relative–but that was
originally the idea. What they wanted to do starting
in 2003, was to eliminate the idea that the discount rate is
only for banks who are in trouble.
They wanted to eliminate the stigma–it used to be
embarrassing to borrow at the discount window,
because the discount rate would–because it would be an
admission that the bank is in trouble.
So, in order to try to eliminate that stigma,
they made it a penalty rate. They made the discount rate
higher than the Federal Funds Rate;
so now, the Federal Funds Rate is at 2.25%.
The discount rate is now only twenty-five basis points higher;
it’s at 2.5%. They’ve been cutting the spread
between the discount rate and the Federal Funds Rate–again
it’s an effort to stimulate the economy.
I think one reason why they may have changed it in 2003 is that
interest rates were getting really close to zero in 2003.
They were worried that if the discount rate is fifty basis
points below the Federal Funds Rate,
then it’s going to hit zero and that would be embarrassing;
so they moved it. I think that might be the
reason–no one knows what all their reasons were. The basic idea that’s developed
is that the Fed is looking at inflation and unemployment as
the two major things that it looks at.
Inflation is the most important thing, according to many views,
because the Fed has to guarantee the soundness of the
money supply and there have been so many cases in history when
the central bank allowed debasement of the currency
through inflation. It’s thought that that is a
serious error because it destroys trust in the currency.
On the other hand, the Fed is also concerned with
unemployment and the possibility of a collapse in the system.
Right now, the Fed is in a difficult situation.
Last year, we had 4% inflation–4% inflation is high
by traditional standards. It’s above what we’d like;
we’d like it to be more like 2%–4% is high.
So, that would mean that the Fed should be raising interest
rates to try to tighten up the economy and bring the inflation
rate down. Unfortunately,
we’re in this collapse situation in the economy,
so the Fed has a problem. There’s a name for this–it’s
called stagflation. Stagflation was a term that was
developed in the 1970s to refer to a time when inflation is–we
have both high inflation and high unemployment;
and so we’re in that situation apparently again.
With interest rates hitting zero–I say Alan Greenspan–Ben
Bernanke must be losing sleep at night.
This is exactly the worst nightmare of a central banker.
You’ve got this policy tool of interest rates,
but once it hits zero you’re out of business.
So, he has been working on trying to find other tools of
monetary policy. Ben Bernanke has been very
creative in doing–maybe I ought to write some of these things
down. The Term Auction Facility–or
TAF–was created by the Federal Reserve under Bernanke,
on December 12^(th). It’s a new form of monetary
policy–a new invention, which we’ve been doing only for
a matter of months now. What the term auction
facility–it was also created in connection–in
collaboration–with the Bank of Canada,
the Bank of England, the European Central Bank,
and the Swiss National Bank. So, we’re seeing an
internationalization of bank monetary policy.
All of these central banks–of Canada, England,
Europe, and Switzerland–got together with the Federal
Reserve and said–obviously they were worried about the financial
crisis that was engulfing the world.
So, they agreed to auction off–it’s a little bit different
than a–it’s a little different from an ordinary monetary
policy. It’s a way of helping troubled
financial institutions. What they did instead of
just–remember, the Federal Funds Rate is a
target interest rate that the Fed attempts to hit through
buying and selling treasury bills in the U.S.
or in other countries buying and selling government bonds to
affect the market. If the Fed wants to push the
Federal Funds Rate up–down–it goes and buys
short-term government bonds. Buying them tends to push up
the price; that tends to influence the
yield down, so it encourages a lower level of interest rate.
The term auction facility is different.
In this facility, banks are allowed to–the Fed
announces a certain amount of money that it wants to put out
there in the form of collateralized loans with other
banks–with member banks. What the Fed said it would do
is announce an auction of so many billion dollars of loans to
member banks and the banks have to supply collateral to the
Federal Reserve. The collateral could be a
number of things, including
mortgages–securitized mortgages–that are risky and
dangerous assets. In effect, the Fed is trying to
solve the subprime crisis by taking on, as collateral,
some of these risky things in exchange for offering loans to
member banks. It’s different from Fed policy
in that they set up a certain amount of money and auction that
off to the highest bidder. Troubled banks then,
who have this–the problem banks have now is they have
these securitized mortgages that they’ve bought and the
homeowners are defaulting on the mortgages now.
So, there’s a panic in the market for securitized mortgages
and the price is often very low or if it’s–they’re very hard to
market and hard to sell. Banks are in trouble and,
as you know, they’re starting to fail
because they–the value of their assets in the market is falling
rapidly. The Fed is effectively just
saying, we’ll take those assets as collateral for loans to you.
So, they’ve given, as of today,
it’s eighty billion dollars on the term.
This thing–this new invention is three months old at this
point. The system continues to look
more precarious. This is a very interesting time
because the Fed is continuing to invent.
Then they came up with the Term Securities Loan Facility.” Don’t look this up in Fabozzi
because the date of founding was March 11,2008;
that’s the date that they announced it.
What they’re going to do is have auctions of loans of
treasury securities in exchange for collateral,
such as the mortgage securities.
The first auction is March 27,2008, which you may note is
tomorrow. Actually, I mentioned the Term
Securities Loan Facility because it’s a new innovation but it
hasn’t started yet. In their announcement on March
11^(th), they said the Fed would lend up to $200 billion of
securities to the market. What they’re really doing is
just–we’re facing this seize up of our financial system,
so we have banks that–we’ve just seen the failure of Bear
Stearns, which is actually a broker-dealer.
But banks and broker-dealers are in trouble because their
assets are collapsing under them.
They can’t sell them to get money, so the Fed is saying,
fine we’ll just take those and we’ll give you Treasury bills,
which are completely–everyone trusts them.
So, you have some asset that nobody trusts,
the U.S. Federal Reserve will take it on.
This is an effort–this is different from most monetary
policy. Now, it’s different in
important ways because it’s really focused at preventing the
collapse of the economy that is created by a financial system
failure. It’s looking at the problem
that certain troubled institutions have–that their
assets can’t be sold–and it’s just saying,
okay we’ll replace them with assets that can be sold.
The Fed is taking on a serious risk in doing this because these
assets that it takes on in exchange for Treasury securities
could fail. Nobody knows how bad the
mortgage crisis is going to get, but Ben Bernanke thinks that
it’s so important that we prevent a collapse that we
should take that risk. Incidentally,
both of these things–this is called a TSF and this is called
a TAF–both of these are joint with the Fed in the United
States, the ECB, the Bank of England,
and the Swiss Bank, and Bank of Canada.
These are all international efforts to forestall a financial
crisis. There’s a third one,
which is even newer. It made–this one was
announced–the third innovation is called the Primary Dealer
Credit Facility and that was announced March 16,2008.
So, that’s how many days ago? A few days ago–ten days
ago–and that’s called the PDCF. What the PDCF is,
it’s really an extension of the discount window beyond member
banks. You have to know what are
primary dealers. Primary dealers are
broker-dealers; they are not banks.
The critical thing that’s happening is that at a time of
financial crisis, which exceeds any that we’ve
seen perhaps since The Great Depression,
but certainly bigger than we’ve seen in many years,
the Fed is worrying about not just member banks but also other
financial institutions. For example,
Bear Stearns, which is a broker-dealer failed
recently. The Fed is worried about a
collapsing house of cards. What’s essential about the
Primary Dealer Credit Facility is that they’re opening up the
discount window of lending beyond the member bank to
primary dealers. What is a primary dealer?
When the Treasury in the United States sells Treasury bills,
notes, and bonds, they deal almost
exclusively–or we say primarily–with broker-dealers,
not the general public. The Federal Reserve has a list,
which you can find on their website, of dealers who are
eligible to participate in Treasury security auctions.
There are twenty–actually, I’m not sure there are twenty
anymore. One of them was Bear Stearns,
so I don’t know whether they’re still on the list–maybe they
are, maybe they’re not; we might be down to nineteen.
These are broker-dealers–some of them are international,
like BNP Paribas is one of them–it’s French.
By opening up the Primary Dealer Credit Facility,
we are–what the government is offering to do is to take bad
investments that they made on as collateral for loans at 2.5%,
which is the current discount rate.
This is quite a remarkable change, reflecting the
seriousness of the crisis. I think it’s reflecting the
fact that we’re moving into possibly a situation
of–protracted situation–of nearly zero interest rates.
In an effort to get more–to keep the economy from collapsing
at a time when–at a time of great concern about the
structure of the financial system.
This is different than other recessions.
We’ve had other economic problems that have led to
recessions, but it hasn’t seemed to be something as potentially
global as it is now. We had the Savings and Loan
crisis of the 1980s. In the Savings and Loan crisis,
it was a certain segment of the banking community–the
S&L’s–that seemed to be in trouble,
but it didn’t seem to be then a house of cards that could spread
around the country and around the world.
In 1998, there was the Russian default crisis and then there
was some seize up of–that maybe resembles what is happening now.
Long-term Capital Management was a big hedge fund that failed
in 1998 and got bailed out by the Fed.
I didn’t see then the proliferations of these new
instruments that reflect concerns about the current
economic situation. I think maybe the concluding
lesson–the central banks were institutions that emerged out of
experience with bankers. It started not really as a
planned system–not planned by any government.
The Bank of England was its own bank and the Suffolk Bank was
its own bank, and they developed ways of
doing business without government planning to help try
to preserve stability of the system.
There have been fundamental changes through time that make
the role of the central bank evolve and change through time.
I mentioned earlier that we used to be on the gold standard
and central banks were gold standard institutions that were
trying to stabilize the economy but subject to the constraint
that they had to maintain convertibility with gold,
but those central banks’ role has changed a lot.
It seems like the nature of recessions is always changing.
The biggest recession we’ve had since The Great Depression was
actually a pair of recessions in–there was a short recession
in 1980. It lasted just a few months and
people–once we got out of it people thought,
maybe we’re getting a brief–a respite.
But then the U.S. crashed into a huge,
well actually, it was as worldwide recession
of 1981-2. This was the biggest recession
since The Great Depression. What caused that recession?
I think there’s a simple story, which is very different from
what’s causing the current–apparently
current–recession. In the 1960s and 70s,
central banks around the world were inflating the currency.
It was getting out of proportion.
We had inflation rates in the United Kingdom on the order of
20% a year and people were asking, what is going on in the
UK? Bastion of enlightenment,
what’s going on? They elected Margaret Thatcher
and there was a resolve to do something about it,
but it wasn’t just the U.K.; it was all over the world.
Inflation rates had gotten very high, even in Germany,
where anti-inflation sentiment was the highest.
Central banks, around this time,
I think it was under the leadership of Paul Volker,
who was the Federal Reserve Chairman, they raised interest
rates to kill inflation and they threw the world into a huge
recession. What caused it?
It was caused–maybe it’s oversimplifying it–it was
caused by a change in our resolve to let’s get inflation
under control and a willingness to accept the recession–to stop
the advance of inflation. You can blame it on other
things, like the oil crisis of 1979–nothing is completely
simple. Anyway, this recession has been
a model for what happens in recessions.
The idea that emerged–the memory of the ’81-82 recession
is very strong in our imagination because we think
that it was caused by lax monetary policy,
by liberal thinking, by the soft-hearted liberals
who just didn’t want to create any pain and suffering.
I’m talking about the view that’s commonplace.
So, we finally got tough and we got Paul Volker in there and
central banks around the world all managed to get tough around
that time and we killed inflation,
but it created a recession. That’s what happened in ’81-82,
but you have to remember that times are different.
Subsequent recessions were not like that.
We had another recession in 1990-91 and it wasn’t very big
or bad. This recession was,
I think, just a Gulf War recession.
It was caused by, well partly by,
an oil price spike caused by the Saddam–the war against
Saddam Hussein. It was also caused by just a
general lack of confidence. It wasn’t caused by the Fed’s
sudden tightening against inflation.
It was different, it was–this recession was not
understood, not anticipated; the Fed came in late to cut
interest rates to try to prevent it from being worse because it
just didn’t seem to have any reason for happening.
It just surprised everyone, so it was not a repeat of this.
Then we saw the 2001 recession; that recession again is
different. I think the 2001–if you want
to have a story about it, the 2001 recession was caused
by the end of the stock market boom.
We had a bubble in the stock market in the ’90s and it
collapsed after 2000 and with that it brought the economy
down. The Fed then again cut interest
rates in 2001 in response to the very definite weakness of the
economy. Then that brings us to the 2008
recession. Now, it still hasn’t been
identified as a recession and some people are still hoping
that we won’t have a recession in 2008.
I think it’s really looking like we are in a recession.
Notably, there are different indicators.
The one that just came out is the Consumer Confidence Index,
which was a Conference Board publication.
That index is now way below the lowest that it got in the 2001
recession. It’s at the level–almost down
to the lowest that we got in the 1990-91 recession.
So I–by that indicator, we are in a recession and we
don’t know that it’s over yet; it’s been falling.
Home prices are falling at the highest rate we’ve ever seen.
I have my own index, the Standard &
Poor’s/Case-Shiller indexes, and we announced our indexes
yesterday. We saw record price declines on
a monthly basis for fourteen of our twenty cities that we
reported. That means that they’ve never
declined as much in one month before;
our data started in 1987. We don’t have data on
individual city basis, but it really looks like the
housing collapse–price collapse–that we’re going
through now is on a magnitude not paralleled since The Great
Depression of the 1930s. I think that we are in a
difficult situation, but maybe let’s not panic about
it. The optimistic thing is,
I think that we have a very good Fed chairman and we have
coordinated efforts by central banks around the world and we’re
doing things that are attempts to prevent the collapse of the
financial institutions. I think we’re still in a
precarious situation, but I think we do have central
bankers who are working effectively, given the tools
that they have. Now incidentally,
I’m writing a book, the title of the book is
Subprime Solution; I just sent off the draft to
the copy editor last Friday. The book–my publisher,
Princeton University Press, wants to get it out before this
crisis is over. We’ve got them on a rush to try
to get the book out and they’re thinking that we’ll at least
have copies to reviewers by June.
I’ve been worrying that my book will be too late and that by
June everything will be rosy–that it’ll all be over.
I guess I should hope that that happens, but I have a suspicion
that come June, this crisis will not be over.
Unfortunately, some of you are on the job
market this year and I want to give you some consolation if you
have not had a great success so far in finding a finance job.
The consolation is, they’re killing people at the
top too, so they’re going to–so when you do get a job in a
financial institution, there will be more spaces above
you on the ladder to move up. I’m saying that kind of
jokingly, but I think you are facing a rather–if you’re out
in the job market, you are facing a difficult
economy, but I’m sure that you will emerge all right in the